The effectiveness of fiscal institutions: International financial flogging or domestic constraint?

Many have argued that financial markets are crucial in ensuring that governments maintain sustainable fiscal balances - the so called ‘market discipline hypothesis’. A recent version of this theory holds that both fiscal rules and fiscal transparency are necessary to enable markets to discipline overspending governments. I argue, however, that while these fiscal institutions are effective at improving governments fiscal balances, financial markets are likely not the causal mechanism which discipline governments’ fiscal policies. Instead, I propose that fiscal rules and transparency promote better budget balances because domestic political actors use fiscal institutions to constrain executive policymaking. I test these competing hypotheses of why these fiscal institutions are effective – financial markets vs political competition – and find that country budget balances are increased not as a consequence of financial markets, but when the level of political competition and civil society engagement is sufficiently high. These results are robust to accounting for the possible selection bias of who adopts fiscal institutions.