Fiscal discipline
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Year over year budget deficits accumulate into public debt, and the conventional macroeconomic belief is that in the long run eventually lead to inflation and credit risk for the government debt (IMF, 2014). Since the stagflation crisis of the 1970’s there is general consensus on these relationships. There may not ever have been a serious debate among mainstream economists. While the Keynesian modelling approach may have temporarily suffered a credibility defeat shortly after the stagflation period in the 1970s, it never claimed that the capacity for public debt was limitless and it has since regained acceptance. In practice, when developing policy recommendations the European Central Bank uses both Keynesian and Monetarist models in policy design and find that they often arrive at similar conclusions and use both of them in a two-pillar strategy to cross-check each other’s results (Beck, ECB 2010). One area of possible confusion could be the difference between monetary and fiscal policy.
The scope of monetary policy and central banks is the supply of money and fiscal policy is the state budget. Free market supporters aim to limit monetary policy to an independent central bank authority and set policy to a fixed low long term inflation target (Miller, 2020). Political support for the use of monetary expansion in response to temporary liquidity shocks was strengthened following the evidence of the recovery from the 2008 financial crisis (Jahan, 2014). Expansion response to a liquidity crisis is consistent with an inflation rate target. The monetary policy advocated by the Monetarists was not a source of criticism from the World Bank economists. Monetary stabilization and dropping inflation from the reforms in Latin America were cited as one of the more successful outcomes of the Washington Consensus by the World Bank economists (Birdsall, 2010). Furthermore a survey of monetary policy of the Scandanavian countries with the US and continental European economies found general consensus of central bank independence and fixed target monetary policy (Schettkat, 1999). While free market supporters call for floating exchange rate, fixed inflation targeting (Miller, 2020) the survey commented that in practice there was little difference between fixed inflation vs fixed exchange rate policy for open economies because of interest rate parity relationship for open economies (Schettkat, 1999). In either case financial markets adapt to monetary policy so long as the policy is predictable (Schettkat, 1999).
Fiscal policy on the other hand is a more contentious subject. Politically there is never a good time for fiscal consolidation. Three political challenges in particular are ;
Political challenges for fiscal consolidation
Political costs of reforms
Relative ambivalence to modest inflation and public debt
Economic case for deficit as a temporary counter-cyclical intervention measure
The dilemma faced by policy makers is that neither raising revenue from taxes nor cutting spending are popular proposals (IMF, 2014). The political cost of modest inflation <8% in advanced economies is generally low compared to other macro-economic factors such as employment and subjective well-being (Ward, 2015 ; Helliwell, 2017). The hyperinflation experiences in Latin America however are a warning of the economic damage potential of long neglected fiscal irresponsibility. The transition from the modest to the extreme inflation conditions can occur without warning from shock events, such as the Mexican peso crisis in the 1980’s (Birdsall, 2010). For that reason fiscal discipline is a long term investment, an insurance paid to accept some political discomfort in the short term for long term stability. A complication is the uncertain dynamic of the business cycle. The need for fiscal deficit as an economic countercyclical stimulus intervention has reached a consensus both in public perceptions and among economists following the events of the financial crisis of 2008 (Jahan, 2014). The Economic Freedom Report recognizes a limited role of public debt for long term investments and countercyclical stabilization (Miller, 2020). A more difficult political challenge is recovering the stimulus again trough taxes during the recovery, and there will always be critics to argue that the economy has "still not yet fully recovered".
While both free market advocates and critics acknowledge the importance of fiscal discipline, they diverge on what to do about it. Logically there are two ways to balance a budget. Either the total size of government and taxes as % of GDP is increased, or it is reduced by cutting spending. Small government as measured by taxes as % of GDP is one of the key policy agendas of free market ideology. They discourage raising taxes as a remedy and places more emphasis on cutting government spending (Miller, 2020).
The IMF Fiscal Monitor provides guides for policy makers in managing fiscal health. Unlike the Heritage Foundation authors in the Economic Freedom Index report, the IMF maintains a neutral position on the overall size of government and considers it a matter of social preference (IMF, 2014 ; Miller, 2020). The reports offer advice for either raising taxes or cutting spending. The 2014 report on cutting spending provided tips for policy makers on areas of efficiency, public wage bill, pensions and building the political consensus through effective outreach communication. A complimentary report in 2013 on taxes reported that tax increases were more common using excise taxes such as VAT rather than corporate and top marginal tax rates on personal incomes (IMF, 2013). The report also identified wealth taxes on property and inheritance as alternative politically feasible potential sources for raising revenue (IMF, 2013).
The strengths of free market capitalism - property rights, credit, anti-corruption, decentralization and balanced budget are not mutually exclusive to alternatives. These features are shared by historical and contemporary welfare state models such as the Scandanavian states. Recognizing these strengths can help improve understanding of which parts to keep and sharpen the focus for the weak areas in need of reform.
The strengths should also be understood in contrast to the deficiencies of the ideology - an incomplete agenda for known market failure externalities - volatility, environment and inequality, over-extended claims where evidence is not conclusive on labor and taxes, poor foundations of the human behavioral model, differentiated needs of advanced and developing economies and limits to growth.