Incomplete Fiscal Rules with Imperfect Enforcement

We develop a model for analyzing the effect of numerical limits on fiscal deficits when fiscal policy outcomes depend on automatic stabilizers and when fiscal rules lack perfect credibility. Our model, which includes interactions between monetary and fiscal policy, provides support for existing arguments that fiscal rules contracted on a structural deficit will be welfare-enhancing relative to rules written on the actual deficit. In addition, we show that rules written on the actual fiscal deficit risk running into a credibility trap; higher marginal penalties will be necessary when initial credibility of enforcement is imperfect, but announcing a higher penalty for violating a fiscal rule can actually reduce credibility if the penalty is disproportionately large relative to the violation. We then test one of the predictions of our model empirically, focusing on the extent to which fiscal policy in EMU countries has become more procyclical under the Stability Pact. We show that there is evidence of a procyclical shift in policies in several countries since 1997.