Fixed-Rule Policy

What Is a Fixed-Rule Policy?

A fixed-rule policy is a fiscal or monetary policy that operates automatically based on a predetermined set of criteria. Advocates of fixed-rule policies argue they eliminate policymakers' discretion in an attempt to avoid the problem of misaligned incentives between individual policymakers and the broader public.

Understanding a Fixed-Rule Policy

Fixed-rule policies derive from the public choice theory of political economy. This theory emphasizes the economic incentives of policymakers and the economic effects of those incentives.

The general concept is that elected officials and policymakers tend to overly focus on the short-term impact of policies and are easily influenced by special interests over the interests of the general public (both of which help determine their re-election or reappointment to office and career prospects after leaving office). This often results in policy choices that are not in the public interest.

Fixed-rule policies constrain officials to policy choices based on predetermined criteria. Because policymakers, in general, cannot bind their own future choices, fixed-policy rules usually have to be enforced by a higher authority in order to be binding, such as a constitutional amendment or high court ruling.

The criteria used to limit policy choices generally include economic, fiscal, legal, or demographic factors beyond the policymakers' control. These criteria limit the discretion of policymakers, which can make economic decisions more stable and predictable for voters and market participants and can counterbalance the political incentives created by concentrated interests. Popular criteria for fixed-rule policies include inflation and population growth rates. 

Types of Fixed-Rule Policies

Fixed-rule policies are common at many levels of government. In terms of economic policy, fixed-rule policies can apply to fiscal or monetary policies.   

Monetary Policy

Taylor's Rule, invented by economist John Taylor, is the most famous example of a fixed-rule monetary policy. Calculation of the Taylor Rule results in what the targeted federal funds rate should be. The rule's equation includes variables for the rate of inflation as measured by the GDP deflator, real GDP growth, and the potential output of the economy. 

Previously, the gold standard served as a fixed-rule policy for monetary policy (and indirectly for fiscal policy as well). Because currencies were denominated in gold (or other metals), a central bank's ability to print paper notes (and a government's ability to borrow for deficit spending) was limited by its available gold reserves.

Fiscal Policy

A fiscal policy is often subject to fixed rules as well. These rules can include basic constitutional requirements to maintain a balanced budget as well as more nuanced tax, expenditure, and debt limitations.

For example, the European Union has the Stability and Growth Pact, which limits members to a budget deficit of no more than 3% of gross domestic product (GDP) and public debt levels to 60% of GDP. The pact came under pressure following the global financial crisis of 2008 and the subsequent European debt crisis.

In the United States, the House of Representatives and Senate each have rules that require new legislation not to increase the federal budget deficit. These rules, known as PAYGO, were first introduced in 1990. The rules mean that offsets must be found for any proposed tax cuts or spending increases. However, Congress can waive rules for a particular bill, such as for the bailout and recovery bills passed in 2008 and 2009, and tax cuts adopted in 2012 and 2017. The American Rescue Plan of 2021 is subject to these rules (unless Congress passes legislation to exempt the law from PAYGO).

Arguments for and Against Fixed-Rule Policies

Advocates of fixed-rule policies argue that sticking to a predetermined plan creates certainty in the market. This system avoids subjecting policy decisions to the skewed incentives of individual policymakers or a political party. Supporters argue that central bankers, for example, are incentivized to keep interest rates low in the short term to stimulate growth, which will gain public approval while the central banker is in office. However, low rates could be bad in the long run if they contribute to boom-and-bust fluctuations in the economy.

Critics argue that fixed-rule policies are too rigid and do not leave governments with enough room to handle emergencies or set policy at levels needed to restart economic growth. Fixed rules tie policymakers' hands precisely when bold action is needed.

On the other hand, advocates say fixed-rule policies can be ignored and are often overridden in emergencies anyway. For example, despite the EU pact, member states routinely avoid sanctions for structural budget deficits of more than 3%.