The Washington Post

How bond markets police balanced budget rules

(Markus Schreiber/AP)

One of the puzzles of political economy is why balanced budget rules work. Nearly all U.S. states have legal balanced budget requirements so that they stay solvent. Yet it isn’t at all certain that states which breached their requirements would lose if they were taken to court. State courts usually show a lot of deference to the political branch, and have tended to treat fiscal limits as a matter for the discretion of legislatures, not as a fundamental right. Nonetheless, U.S. states stick to the requirements, despite the obvious political temptations to borrow and spend. Why?

Dan Kelemen and Terence Teo have an article forthcoming in the American Political Science Review which argues that the real enforcers of balanced budgets aren’t courts but bond markets. Because the value of bonds depends on market perceptions, each bond buyer wants to know how other bond buyers are going to react to new information. No one wants to get trampled in the rush away from an asset when market confidence has collapsed. Yet much of the time, it isn’t obvious how other market actors are going to respond, for example, to news about a change in a state’s fiscal policy.

From this perspective, balanced budget rules provide a “focal point”  — that is, an easily understood benchmark that all bond buyers can coordinate on. If a state has promised to keep its budget in balance, it allows buyers to evaluate not only what the state is doing, but also (and perhaps even more importantly) how other bond buyers are likely to behave if the state breaks its guarantee. Bond buyers will expect other bond buyers to demand much higher rates from a state that has broken its balanced budget rule, creating a self-fulfilling prophecy.

They find evidence that this is indeed the case. States that have balanced budget rules that are clear and strict (and hence, better at providing a focal point) tend to have higher credit ratings. However, states with strict rules that are unclear tend, perversely, to have lower credit ratings, suggesting that it is clarity in the eyes of the bond markets, rather than legal enforceability, that makes these rules effective.

Kelemen and Teo argue that this suggests that the European Union’s  efforts to introduce some version of balanced budgets for its member states are likely to fail. Because the politics are so sensitive, the new E.U. rules are murky and unclear. This in turn means that they will provide only ambiguous information to bond buyers, making it far less likely that they will be able to coordinate expectations with each other, and hence to police E.U. budgetary arrangements.

Henry Farrell is associate professor of political science and international affairs at George Washington University. He works on a variety of topics, including trust, the politics of the Internet and international and comparative political economy.

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