The political economy of fiscal rules and financial markets: when, why, and how does the market enforce rules?
Lead Research Organisation:
King's College London
Department Name: European and International Studies
Abstract
Fiscal rules (FRs) were swiftly employed during the great
recession as a response to procyclical policy. The recent
stand-off between the Italian government and the European
Commission over FRs, however, raises serious concerns
about how they are enforced (Khan & Brunsden, 2018). This
development is worrying as FRs have been a key post-crisis
institutional response from international organisations such
as the IMF and European Commission (Frayne, Jaffee, & Riso,
2013; Kumar et al., 2009). Recent experiences call into
question the validity of key assumptions about the
enforceability of FRs, such as the market discipline
hypothesis (Bishop, Damrau, & Miller, 1989) which states
that markets discipline sovereigns by increasing bond yields.
Likewise, it is uncertain if non-democratic countries enjoy the
same benefit as democracies when adopting FRs, or if a
7 / 12
'democratic advantage' exists (Schultz & Weingast, 2003).
My aim is to address a critical debate in the existing
literature about rule enforceability, which is couched in a
broader debate about IMF conditionality (Mishkin, 2004;
Rodrik, 2000). I will research FRs and financial markets across
three dimensions investigating: when and why FRs are
adopted, when markets enforce rules, and if markets enforce
FRs in non-democracies. The question about rule
enforceability will be addressed through a neoliberal
institutionalist framework (Keohane, 1989) and will contribute
with empirical work on the enforceability of institutions.
recession as a response to procyclical policy. The recent
stand-off between the Italian government and the European
Commission over FRs, however, raises serious concerns
about how they are enforced (Khan & Brunsden, 2018). This
development is worrying as FRs have been a key post-crisis
institutional response from international organisations such
as the IMF and European Commission (Frayne, Jaffee, & Riso,
2013; Kumar et al., 2009). Recent experiences call into
question the validity of key assumptions about the
enforceability of FRs, such as the market discipline
hypothesis (Bishop, Damrau, & Miller, 1989) which states
that markets discipline sovereigns by increasing bond yields.
Likewise, it is uncertain if non-democratic countries enjoy the
same benefit as democracies when adopting FRs, or if a
7 / 12
'democratic advantage' exists (Schultz & Weingast, 2003).
My aim is to address a critical debate in the existing
literature about rule enforceability, which is couched in a
broader debate about IMF conditionality (Mishkin, 2004;
Rodrik, 2000). I will research FRs and financial markets across
three dimensions investigating: when and why FRs are
adopted, when markets enforce rules, and if markets enforce
FRs in non-democracies. The question about rule
enforceability will be addressed through a neoliberal
institutionalist framework (Keohane, 1989) and will contribute
with empirical work on the enforceability of institutions.
Organisations
Studentship Projects
| Project Reference | Relationship | Related To | Start | End | Student Name |
|---|---|---|---|---|---|
| ES/P000703/1 | 01/10/2017 | 30/09/2027 | |||
| 2285964 | Studentship | ES/P000703/1 | 01/10/2019 | 30/12/2021 | Tehminah Naz Malik |
| Description | One new dataset and three academic articles (yet to be submitted for publication) have been produced during the project duration. Fiscal rules are the puzzle I engage with and break down in my thematic chapters. When are they appropriate? Where do they work? Does the market interact with this type of institution? I develop and expand on these research questions in the hypotheses presented in each thematic chapter. In my thesis, I contribute to the broader discussion about fiscal rules by emphasizing adoption, compliance, and enforcement. Fiscal rules address a deficit bias, which may arise due to the common pool problem, fiscal illusion, political business cycles, or time inconsistency. Essentially, fiscal rules are designed and introduced to ensure governments do not engage in excessive spending by lowering taxes or increasing expenditures. Existing work on fiscal rules is often largely theoretical and Eurocentric and does not consider instances when rules are broken. I address these gaps in my thesis. First, I have created a novel dataset that captures fiscal rule-breaking instances. Second, I explore theoretical claims about adoption and enforcement on a novel and rich panel of indicators, countries, and years. My work relies on quantitative methods, providing reliable and transferable findings with strong theoretical validity and transparency in assumptions. I explore the preconditions for fiscal rules and find that enforceability and transparency are not necessarily in place when countries adopt fiscal rules. Using advanced statistical methods on an extensive panel of countries and years, I find no clear link between regime type and changes in the budget balance. While fiscal rules can improve the budget balance, they don't affect borrowing costs when considering a broad sample of countries (including countries outside the EU). Interestingly, a higher democracy score is associated with lower borrowing costs but not necessarily improvements in the budget balance. The lack of a clear link between regime type and variation in the budget balance challenges the idea of a deficit bias and the need for fiscal rules to address it. In another chapter, I investigate the market's response to fiscal rules and find that markets do not react to fiscal rules being broken. This has important implications for designing and implementing fiscal rules, suggesting that market discipline alone may not be enough to ensure their enforcement. By incorporating this into policy discussions, policymakers can better design and implement fiscal rules that promote sustainability and stability. Moreover, my novel dataset, which codes instances of broken fiscal rules across countries for different vintages, provides opportunities for even more research on when and why countries break fiscal rules. My work challenges assumptions about the preconditions for fiscal rule adoption. In addition, it investigates the market reliance on fiscal rule enforcement for the first time. As a result, I believe I make a novel and significant contribution to the broader academic discussion on fiscal policy and shed light on issues that hamper fiscal rule effectiveness. Furthermore, the novel dataset provides opportunities for more research on the effectiveness of fiscal rules in different contexts. In conclusion, introducing fiscal rules is insufficient to ensure a country's economic stability. As I stated, numerous countries have fiscal rules but still suffer from public finance issues. Without proper enforcement, these rules become little more than words on paper. Therefore, policymakers and voters must understand and implement robust enforcement mechanisms beyond market discipline to ensure the effectiveness of fiscal rules in promoting economic stability and ensuring accountability. |
| Exploitation Route | Each individual chapter presents avenues for future research. I intend to maintain, develop, and promote my novel dataset on EU fiscal rule breaks. The dataset will be updated annually. I also intend to expand it to cover countries outside the EU. Over 60 countries outside the EU have one or more fiscal rules covering debt, deficit, expenditure, or revenues. Collecting and coding data on when fiscal rules are broken will allow for a better understanding of when and why they are not complied with. |
| Sectors | Financial Services, and Management Consultancy,Government, Democracy and Justice |