Policy coordination in fiscal federalism: drawing lessons from the Dubai debt crisis

Purpose With the global financial crisis, the United Arab Emirates (UAE) experienced its own unraveling of macro-financial imbalances and thus presents an interesting case to analyze the underlying fragilities in federal governments. The purpose of this paper is to investigate the evolution of fiscal policy in the UAE at consolidated and subnational levels in the run-up and after the crisis, and provide pertinent insights about the importance of policy coordination in other federal fiscal systems – and monetary unions, as brought to light by the recent developments in Europe. Design/methodology/approach In measuring the cyclicality of fiscal balances at the consolidated and emirate level in the UAE, this paper uses the non-hydrocarbon primary budget balance, excluding interest spending and hydrocarbon revenues, investment income of the sovereign wealth fund, scaled by non-hydrocarbon GDP. The cyclically adjusted primary balance is estimated by deducting cyclical components from the actual balance. It is important to correct for cyclical changes because the budget balance tends to vary endogenously according the state of the economy – deteriorating during a bust and improving in a boom. Furthermore, since hydrocarbon revenues are dependent on the erratic behavior of hydrocarbon prices, the cyclically adjusted non-hydrocarbon primary balance is computed, using the elasticity of non-hydrocarbon revenues and primary expenditures relative to non-hydrocarbon GDP, to assess whether fiscal policy exacerbates economic fluctuations in the UAE at the aggregate and emirate levels. Findings The empirical findings show that procyclical fiscal policies prior to the crisis reinforced the financial sector cycle, exacerbated the economic upswing, and thereby contributed to the build-up of macro-financial vulnerabilities. The paper also sets out policy lessons to develop a rule-based fiscal framework that would help strengthen fiscal policy coordination between the various layers of government and ensure long-term fiscal sustainability and a more equitable intergenerational distribution of wealth. Originality/value The lack of fiscal policy coordination among subnational governments complicates macro-economic management at the federal level. Since the UAE has a pegged exchange rate regime and consequently a limited scope to use monetary policy, the burden of macro-economic stabilization falls on fiscal policy. Accordingly, this paper shows that procyclical fiscal policies prior to the crisis reinforced the “financial accelerator” effect, exacerbated the economic cycle, and thereby contributed to the build-up of economic and financial vulnerabilities in the UAE.

Beggar-Thy-Neighbors

Diverse groups are a hotbed for free riders. This chapter thus tests whether fiscal policy coordination was marred by collective action failure. The central claim of this chapter is that accusations of stability or growth free riding are not borne out by factual evidence. Using regression analysis and Qualitative Comparative Analysis, the chapter shows that despite their greater ability to free ride (given their political clout and trade links), larger and more open economies implemented larger stimulus programs. Fiscal policy is further analyzed vis-à-vis a country’s fiscal space. Results show that, by and large, member states stimulated their economies in line with their fiscal room for maneuver. These findings are contrasted with the political discourse of the time, when indictments of growth free riding were widespread. Accusations of beggar-thy-neighbor politics were rife; first-order free riding was not.

Market Discipline

Free riding is endemic. But it is not the type of first-order free riding that politicians and EU officials publicly chastised. Instead, fiscal policy coordination is burdened by a serious internal enforcement problem; that is, second-order free riding. The argument presented here is different from the usual decrying of a lack of enforcement in fiscal policy coordination, which is said to invite member states to engage in rampant fiscal free riding. This chapter contests that without internal enforcement within the EU, fiscal policy coordination has come to rely on market discipline with dire consequences for its members. The chapter demonstrates that, in contrast to fiscal rules and intergovernmental agreements, the incentives provided by market discipline shape public finances.

Fiscal Policy Coordination

This chapter sets the scene for this study by providing historical context and introducing the key aspects, processes, and players of fiscal policy coordination. In so doing it charts key developments of pre-crisis fiscal policy coordination, before turning to the creation of the European crisis agreement, the European Economic Recovery Plan (EERP), and finally the reform packages post-crisis. Despite impressions to the contrary, the procedures for fiscal policy coordination are extensive, albeit enforced and reinforced with little political and legal power. Although there is persistent continuity for some ideas and procedures—the Stability and Growth Pact (SGP) and its fear of stability free riding chief among them—new innovations and reforms have made inroads.

Free Riding Beyond Hard Times

Looking ahead, the legacy of the crisis years shapes fiscal policy coordination. The two main aspects of change considered in this chapter are purview and pliancy. First, fiscal policy has ceased to be defined in narrow ‘low-deficit’ targets and instead is set to encompass a twin notion of free riding: growth free riding and stability free riding. Second, fiscal policy coordination has become more flexible and as a result more adaptive to the challenges of sound public finances in the twenty-first century. While the institutional architecture for collective action has been strengthened, there is little reason to be optimistic as to the containment of endemic second-order free riding. Member states, this chapter argues, are continuing to rely on market discipline as the erratic enforcer of rules they are unable to bring to bear amongst themselves.