Spending Rules Research Articles

What determines government spending multipliers?

This paper studies how the effects of government spending vary with the economic environment. Using a panel of OECD countries, we identify fiscal shocks as residuals from an estimated spending rule and trace their macroeconomic impact under different conditions regarding the exchange rate regime, public indebtedness, and health of the financial system. The unconditional responses to a positive spending shock broadly confirm earlier findings. However, conditional responses differ systematically across exchange rate regimes, as real appreciation and external deficits occur mainly under currency pegs. We also find output and consumption multipliers to be unusually high during times of financial crisis. — Giancarlo Corsetti, André Meier and Gernot J. Müller

Investment in Education and Strategic Asset Allocation

This work analyzes the optimal allocation of assets over the life cycle of an investor who has the option to invest in his education. We characterize the optimal spending rule for education, and compare the optimal asset allocation of such investors with the optimal portfolios of investors with no extra education. In particular, we are able to describe how the criteria for investing in risky assets change through time as investors acquire additional education. Our main findings are as follows. Investors undergoing the educational process tend to invest proportionally more in risky assets during that period than other investors. After the educational period investments in the risky asset usually decrease. In the working period after the investment in education a negative covariance between the working income and the returns of the risky asset induces the proportional investment of educated agents in the risky asset to be larger than the proportional investment of non-educated agents. For positive covariance, as it increases, the proportion of wealth invested in the risky asset decreases for both agents. Finally, in the retirement period the investments of people who invested in education earlier are not distinguishable from those of non-educated.

What Determines Government Spending Multipliers?

This paper studies how the effects of government spending vary with the economic environment. Using a panel of OECD countries, we identify fiscal shocks as residuals from an estimated spending rule and trace their macroeconomic impact under different conditions regarding the exchange rate regime, public indebtedness, and health of the financial system. The unconditional responses to a positive spending shock broadly confirm earlier findings. However, conditional responses differ systematically across exchange rate regimes, as real appreciation and external deficits occur mainly under currency pegs. We also find output and consumption multipliers to be unusually high during times of financial crisis.

Optimal Discrete Ratchet Consumption

Dybvig [1995] finds optimal spending and investment strategies for a perpetual endowment that has no tolerance for spending declines. His spending rule is a ratchet --- spending never decreases, but has a substantial chance of increasing. We find the ratchet consumption rule for an investor with a finite planning horizon. We maximize an expected utility that eschews pending declines, yet permits a range of choices for felicity and time preference functions. For optimality, a spending rule must be paired with an investment rule. Here, we investigate dynamic investment strategies --- we treat consumption as a derivative security and derive formulas for its delta-hedge.

Fiscal sustainability, volatility and oil wealth

Whether fiscal policy is sustainable depends on a government’s future revenue and expenditure streams, both of which are highly uncertain. In commodity-rich countries, this problem is intensified by unpredictable and volatile commodity prices. We show how spending rules for oil income and non-oil primary deficits interact and influence the stochastic distribution of future debt stocks and demonstrate the variance reducing impact of feedback rules for primary deficits in a case study of oil-and-gas exporter Azerbaijan.

Preventing a National Debt Explosion

Executive Summary The projected path of the U.S. national debt is the major challenge facing American economic policy. Without changes in tax and spending rules, the national debt will rise from 62% of GDP now to more than 100% of GDP by the end of the decade and nearly twice that level within 25 years. This paper discusses three strategies that, taken together, could reverse this trend and reduce the ratio of debt to GDP to less than 50%. The first strategy, which focuses on the current decade, would reduce the administration’s proposed spending increases and tax reductions that would otherwise add $3.8 trillion to the national debt in 2020. The second strategy, which would augment the tax-financed benefits for Social Security, Medicare, and Medicaid with investment-based accounts, would permit the higher future spending on health care and pensions with a relatively small increase in saving for such accounts. The third strategy focuses on “tax expenditures,” the special features of the tax law that reduce revenue in order to achieve effects that might otherwise be done by explicit outlays. Tax expenditures now result in an annual total revenue loss of about $1 trillion; reducing them could permanently reduce future deficits without increasing marginal tax rates or reducing the rewards for saving, investment, and risk taking. The paper concludes with a discussion of how the high debt to GDP ratio after World War II was reversed and how the last four presidents ended their terms with small primary deficits or primary budget surpluses.

The debt brake: business cycle and welfare consequences of Germany’s new fiscal policy rule

In a New Keynesian DSGE model with non-Ricardian consumers, we show that automatic stabilization according to a countercyclical spending rule following the idea of the debt brake is well suited both to steer the economy and in terms of welfare. In particular, the adjustment account set up to record public deficits and surpluses serves well to keep the level of government debt stable. However, it is essential to design its feedback to government spending correctly, where discretionary lapses should be corrected faster than lapses due to estimation errors.

Fiscal Sustainability, Volatility and Oil Wealth: A Stochastic Analysis of Fiscal Spending Rules

Whether fiscal policy is sustainable depends on a government's future revenue and expenditure streams, both of which are highly uncertain. In commodity-rich countries, this problem is intensified by unpredictable and volatile commodity prices. We show how spending rules for oil income and non-oil primary deficits interact and influence the stochastic distribution of future debt stocks and demonstrate the variance reducing impact of feedback rules for primary deficits in a case study of oil-and-gas exporter Azerbaijan.

Endowment spending in volatile markets: what should fiduciaries do?

Spending rules often guide institutions in determining the annual expenditures from their endowments. A typical rule is five percent of some measure of the value of the endowment. That many institutions utilize the same type of spending rule suggests that these institutions set their spending rules independent of their investment strategy. This paper argues that for many institutions the spending rule and the investment strategy need to be determined simultaneously. The key to understanding this simultaneity is the institution’s willingness to reduce its endowment expenditures when the endowment drops in value. As an institution becomes more reluctant to reduce its expenditures in bad times, the need to set both its spending rule and investment strategy simultaneously increases. One practical implication is that even if an institution believes, for instance, that the returns of a particular class of assets, like equities, will be greater over the long run than the returns of other assets, that institution may still choose to hold some of these other assets if the resulting portfolio has smaller short-term volatility—despite the smaller long-run return.

The Debt Brake: Business Cycle and Welfare Consequences of Germany's New Fiscal Policy Rule

In a New Keynesian DSGE model with non-Ricardian consumers, we show that automatic stabilization according to a countercyclical spending rule following the idea of the debt brake is well suited both to steer the economy and in terms of welfare. In particular, the adjustment account set up to record public deficits and surpluses serves well to keep the level of government debt stable. However, it is essential to design its feedback to government spending correctly, where discretionary lapses should be corrected faster than lapses due to estimation errors.

Are Spending Policies of European Foundations Sustainable?

This paper considers the extensive literature from the US which has developed spending rules for endowments and foundations, and attempts to consider the impact of applying such rules to European foundations under a range of scenarios. By undertaking a broad-ranging investigation of this nature the paper provides an insightful comparison of some of the most widely referenced spending rules, which in turn should prove very useful to European foundations and endowments that strive to successfully achieve their mandate within their financial constraints.

Welfare Implications of Public Education Spending Rules

In this paper, we quantitatively assess the welfare implications of alternative public education spending rules. To this end, we employ a dynamic stochastic general equilibrium model in which human capital externalities and public education expenditures, financed by distorting taxes, enhance the productivity of private education choices. We allow public education spending, as share of output, to respond to various aggregate indicators in an attempt to minimize the market imperfection due to human capital externalities. We also expose the economy to varying degrees of uncertainty via changes in the variance of total factor productivity shocks. Our results indicate that, in the face of increasing aggregate uncertainty, active policy can significantly outperform passive policy (i.e. maintaining a constant public education to output ratio) but only when the policy instrument is successful in smoothing the growth rate of human capital.

Spending Stabilization Rules: A Solution to Recurring State Budget Crises?

Recurring state fiscal crises raise a fundamental question: Is it possible to stabilize budgets over the business cycle? This paper examines spending stabilization rules, an alternative to the inaccurate process of budget forecasting. Under two spending rules, we assess how state budget situations would compare with actual experience. Our analysis reconstructs recent aggregate state budget patterns assuming states had adopted a rule and then takes a closer look at California and South Carolina. With surpluses partially invested in a rainy‐day fund, a spending rule resulted in stable growth of state budgets throughout the recession and sluggish recovery of the early 2000s.

The Looming Crisis in Endowment Spending

Investment losses in equity markets in the past three years, and the prospect of a truncated recovery, have left endowed institutions in a double bind. Colleges and universities that in the 1990s enjoyed the luxury of self-replenishing investment portfolios “net of inflation”now face hard choices between the elimination of vital projects and programs on the one hand and irreversible damage to core endowment assets on the other. Simulations assuming median projected returns, average institutional spending rules, and 2%-3% inflation show endowment spending is likely to decline for two to three more years, before beginning a slow recovery. Nominal spending rates for fiscal 2000 will not be supportable again until at least 2017. The imposition of Draconian spending policies looks very likely at many institutions, especially those with the smallest endowments.

Simulation-Based Spending Rules for Investment Funds

The authors focus on the problem of determining the most appropriate cash withdrawal plan from an investment portfolio and investigate different methodologies. They note that economic theory suggests that an optimal spending rule needs to maximize some multi-period utility function, but argue that this is merely a formal restatement of the problem and not an operational solution. They suggest that an important consideration should be the volatility or variability of the cash withdrawal stream over time. They fault market-based spending rules arguing that spending then reflects the volatility of the investment portfolio. Noting that the use of Monte Carlo techniques to determine spending plans is growing, they show that there exist certain flaws in the way simulation is used to address this cash withdrawal problem. They ultimately argue that the plans generated by a simulation approach are essentially equivalent to other approaches, require the same type of evaluation, and offer little not already available to planners facing this situation.

Hysteresis In Market Response: When Is Marketing Spending An Investment?

Conventional wisdom says that it takes ever increasing marketing budgets and/or lower prices to create sustained growth in sales, which may or may not be profitable in the long run. However, some documented cases and conceptual evidence suggest that marketing spending or prices can exhibit hysteresis in market response, a condition where temporary changes in the marketing mix are associated with permanent movements in sales performance. As such, hysteresis creates a long-run investment benefit from marketing actions, which can be highly beneficial to the firm, or detrimental to competition. Yet the assessment and formal implications of market response hysteresis for marketing resource allocation are unexplored. This paper addresses the modeling of marketing hysteresis in three ways: one, it shows how the presence of full vs. partial hysteresis in response may be assessed from longitudinal data on sales and marketing-mix allocations. Two, it develops the link between sales hysteresis and profit hysteresis, and derives the long-run optimal spending rules for a firm whose marketing efforts exhibit some form of hysteresis. Three, it illustrates both the measurement of hysteretic marketing effects and their optimal spending implications for a leading supplier of computer printers. The paper concludes with an agenda for future research in this important, yet under-researched area of marketing strategy.

The Case for Spending Rules

According to the Stability and Growth Pact (SGP), European countries should achieve a budgetary position ‘close to balance or in surplus’ over the medium term while keeping the public deficit within the value of 3 per cent of GDP. The ‘close to balance or in surplus’ target is usually interpreted as applying to the cyclically-adjusted fiscal balance: the governments should let the automatic stabilisers operate freely, with discretionary policy being the exception rather than the norm. Such type of behaviour implies a substantial change compared to the past experience: empirical evidence indicates that European fiscal policies have tended to behave pro-cyclically. However, the ‘close to balance or in surplus’ target is a guideline rather than a rule as there is no process to sanction deviations from this objective. Within the boundaries of the Maastricht Treaty and of the SGP, a number of European countries have complemented the SGP with multi-year frameworks. These frameworks are designed to ensure consistency between the SGP and the medium-term objectives for the debt and the government share in the economy. In addition they bring more discipline to fiscal policy-making during ‘good times’. The objective of the paper is to shed light on the usefulness of a medium-term framework anchoring fiscal policy on spending rules. Although it is widely recognised that expenditure-based fiscal retrenchments are more successful that tax-based consolidations (Alesina and Perotti, 1997; Zaghini, 1999), permanent spending rules have not retained much attention in the economic literature. We argue here that a spending rule curbs the tendency to relax fiscal policy during ‘good times’, hence preserving the free operation of automatic stabilisers on the revenue side. The first section of the paper discusses to what extent a stable cyclically-adjusted position – ‘close to balance or in surplus’ - can be seen as a relevant target for fiscal policy. In a second section, we draw the lessons from the difficulty to adjust for the cycle in real time: a spending rule is more transparent than a cyclically-adjusted balance and more operationally targeted. The spending rule could be usefully inserted in a medium-term framework to ensure ex post compliance and to avoid excessive tax cuts during ‘good times’. The framework should, in particular, specify how expenditure overruns should be clawed back in the following years and how ‘growth dividends’ and revenues overshoots should be used.

“A Market-Yield Spending Rule” Revisited

Observing that trustees must navigate their endowment and trust portfolios through the narrow channel that lies between spending too little or too much, the author explains the need for spending rules. He defines them as primitive tools that point the way through this uncharted terrain, given the uncertainty associated with future returns from stocks and bonds and the inflation and taxes that made erode these returns. He shows that the challenge faced by trustees as the balancing of current and future spending needs, a task which is not only an investment problem, but also a political and psychological issue as well. After having described current spending rules, he revisits an alternative he introduced in the late 1980s, a spending rule based upon dividends rather than market values, as the former have been far more stable than the latter. This article answers the criticism levied at the previous paper written in 1989. Certain readers, then, were skeptical of a rule that worked well in a back-test, but that didn9t have any real-time experience under its belt. This article is meant to set such skepticism to rest, presenting twelve years of out-of-sample data covering the years 1987 through 1998.

Expectations about Real Returns

In this article, the authors provide empirical evidence concerning real returns for stocks and bonds in order to consider their impact on spending rules for large portfolios. Their analysis of the data supports the argument that 5% (or higher) real returns are not sustainable in the long run. Therefore, an endowment fund that is invested in equities, spends 5% a year, and earns the real return on stocks will, in all likelihood, see its market value decline below the beginning value at some point, absent new contributions. The actual record, shown in the article from probability standpoint, could lead institutional investors in particular to reformulate their expectations about real returns, and may also influence individual investors9 expectations about future real returns.

Using Asset Allocation to Protect Spending

The management of an educational endowment or other income-producing portfolio involves two strategic decisions at the fund level: asset allocation and choice of a spending rule. Traditionally, these two decisions are linked, for example, to preserve capital on average, but the optimal link would be more dynamic. This article describes a new protective strategy that links spending and asset allocation in a way that preserves spending power in down markets but participates significantly in up markets. The strategy is similar to constant proportions portfolio insurance, in that part of the fund is maintained in safe assets to preserve the value needed for continued expenditures. Like portfolio insurance, the strategy outperforms traditional strategies when markets are persistently up or persistently down but underperforms when portfolios are whipsawed by alternating ups and downs.