Thursday, November 20, 2008

Undersaving governments

A lot of governments are now expecting to face severe revenue shortfalls, especially for US states. They should have had some rainy day funds, but the conventional wisdom is that they find it very difficult to build up in good times, because of both the pressure from the electorate to reduce taxes and the temptation to extract political rents beyond lower taxes. These problems led to many states to impose limited borrowing rules on themselves, but it still seems that rainy day funds are vastly insufficient, just look at the current emergency slashing of public spending left and right.

Ricardo Caballero and Pierre Yared argue that this should not be so in an economy with substantial fluctuations, where a rent-seeking government over-saves compared to a benevolent government. The idea is that if economic uncertainty is more important than political uncertainty, politicians over-save in order to make sure to get reelected and exploit rents in the future. For example, if the economy is low, the government keeps taxes low to guarantee reelection, in the anticipation that when the economy is better, the taxes will be increased and more rents can be extracted. This will also prevent future politicians to extract anything significant.

How can one then force the government to act more benevolently? Cap deficits again, but for different reasons than usually, as politicians tend to behave the opposite way of other situations. They still want to run deficits, just at different times. This contrasts, however, with my earlier post showing that soft budget constraints may be optimal. the case then was that there could be substantial moral hazard in completing investment projects if spending needs to be curtailed.