Functionality of fiscal rules in a low interest rate environment: New empirical results for Swiss cantons

The trade-off between consistent (rule-based) and optimal fiscal policy became evident in the zero lower bound era. With such low interest rates, the argument goes, optimal fiscal policy required extending debt financed public investment spending. But while fiscal rules ensured consistency, they prevented this fiscal expansion. Using data of Swiss cantonal public finances between 1990 and 2019, we employ a bias corrected least squares dummy variable (LSDVC) model to investigate as to how fiscal rules affect fiscal policy in an environment with decreasing interest rates. Furthermore, we introduce the novel forecasted average treatment (FAT) approach into empirical public finance by exploiting the SNB's unexpected and substantial interest rate drop in 2015 following the termination of the Swiss Franc-Euro peg. The methodological novelty of the FAT approach lies in the investigation of an exogenous shock in absence of a control group. Our results show, first, that fiscal rules constrain public debt and expendi- ture, but do explicitly not constrain investment expenditure. Second, interest rate declines are mirrored by lower public debt and total public spending decline, the latter conditional on constraining fiscal rules. Third, we find varying reactions to the monetary policy shock in 2015 depending on rule stringency, but public investment is not systematically more constrained by strict rules.