Economic stabilization in the post-crisis world: Are fiscal rules the answer?

• Procyclicality of fiscal policy exacerbates business cycle fluctuations.
• Fiscal rules help to reduce the procyclicality of policy during business cycles.
• Fiscal rules are effective if combined with a minimum threshold of government efficiency.

We investigate whether fiscal rules help to reduce the extent of policy procyclicality—how government expenditure policy responds to GDP-- in a dynamic panel framework with 81 advanced, emerging and developing countries over 1985–2012. We construct two new fiscal rule indices and investigate whether rules help to dampen procyclical policies. We condition our empirical specifications on the degree to which governments appear able to manage and enforce fiscal rules. We find that fiscal rules are very effective in reducing procyclicality of policy once a minimum threshold of government efficiency/quality has been reached. Government efficiency alone is not enough to reduce procyclicality of fiscal policy. However, high government efficiency combined with strong fiscal rules is a potent combination facilitating counter-cyclical policy responses to GDP movements.