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External Publication

Simple Rules for Better Fiscal Policies in Europe

Proposals to reform the euro area are on the agenda again. An overhaul of the complex set of European fiscal rules should be top priority on this agenda because the fiscal framework in place suffers from clearly identified problems: rules are complex (therefore difficult to internalise for policymakers), pro-cyclical (therefore potentially destabilising), and noncompliance is the norm (therefore not credible).

By: , , , , and Date: September 24, 2019 Topic: Macroeconomic policy

Either because countries did not abide by the rules or because the rules were not sufficiently stringent during good years, there was insufficient debt reduction in many countries in the 2000s, and this reduced fiscal capacity during bad years. Consequently, several countries experienced excessive fiscal austerity during the crisis, contributing to the aggravation and prolonging of its consequences. A major drawback of these rules lies in measurement problems. The structural budget balance (the budget balance cleaned from the impact of the economic cycle and one-time budget measures like bank rescue costs), which is the cornerstone of current rules, is a useful theoretical concept but it is not observable and its estimation is subject to massive errors. The typical annual revision in the change of the structural balance is larger than half a percent of GDP, while half a percent of GDP is the baseline fiscal adjustment requirement for countries in breach of EU fiscal rules. Alone, such huge revisions highlight that this indicator is not suitable for policymaking.

The policy mistakes generated by the fiscal rules also led to overburdening the ECB as the main remaining stabilisation instrument. The fiscal framework has also put the European Commission in the difficult position of enforcing a highly complex, nontransparent, and error-prone system, exposing it to criticism from countries with both stronger and weaker fiscal fundamentals. The rules are used as a scapegoat by anti-European populists because they are seen as a centralised micro-management that infringes on national sovereignty.

However, in a monetary union like the euro area, arguments exist to justify the existence of fiscal rules and the adoption of a common framework. A specific issue in a monetary union is that governments may not fully internalise the risk of accumulating public debt. The reason is that they (and markets) may expect a bailout in case of difficulties to finance themselves. Indeed, a debt restructuring event accompanied by exit risk may generate financial disruption, contagion to other countries, and collateral damage so large that other members of the eurozone prefer a bailout. This implies that the no bailout rule is not fully credible in the eurozone (see Gourinchas, Martin, and Messer 2019) and this itself is a reason why a fiscal rule that binds all members of the monetary union is necessary.

In addition, expected bailouts may also have reduced market discipline in the sense that the cost of borrowing for some countries may have been too low in the period before the crisis. This may also have reduced the incentive for fiscal prudence, as was the case in Greece in the 2000s. Note, therefore, that debt sustainability, not public deficit per se, should be the core objective in the EMU. Note also that macroprudential rules that limit the vulnerability of financial institutions are a necessary complement to fiscal rules, as we have seen (for example in Ireland and Spain) that bank debts can rapidly be transformed into public debts.

Finally, because countries in a monetary union loose the monetary instrument to stabilise the economy against asymmetric shocks, the fiscal instrument is a key countercyclical policy tool. Hence, fiscal rules in the EMU, more than in countries with independent monetary policy, must play a countercyclical role. However, fiscal rules are not a silver bullet and cannot substitute the national democratic debate on fiscal choices and debt sustainability. Instead, they should help frame this debate. In particular, it is important that fiscal rules do not impose a low or high permanent level of public spending, or a low or high permanent level of taxation. This should be left to the democratic debate. However, the fiscal rules should be such that the levels of public spending and taxation are consistent and generate a sustainable level of public debt. If we agree on the necessity to change the rules, how should this be done?

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Blog Post

European governance

Discretion lets Croatia in but leaves Bulgaria out of the euro area in 2023

Crucial decisions about whether a country can join the euro area depend on questionable discretionary decisions.

By: Zsolt Darvas Topic: European governance, Macroeconomic policy Date: June 22, 2022
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External Publication

European governanceEuropean Parliament

Fragmentation risk in the euro area: no easy way out for the European Central Bank

The ECB should design a specific tool that will accompany interest rate hikes to neutralise the risk of fragmentation directly for countries facing it, staying within the bounds of the EU treaties and ensuring political legitimacy. We also advocate structural changes to the ECB’s collateral framework to avoid unnecessary uncertainty surrounding the safe asset status of European sovereign bonds.

By: Maria Demertzis, Grégory Claeys and Lionel Guetta-Jeanrenaud Topic: European governance, European Parliament, Testimonies Date: June 8, 2022
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Opinion

European governance

Three headaches for the European Central Bank

Even though inflation in the euro area is lower than in the US, three issues make it a lot more difficult for the ECB to control inflation and preserve financial stability. Once again, the limits of EMU architecture are visible and will require a rethink.

By: Maria Demertzis Topic: European governance, Macroeconomic policy Date: May 31, 2022
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Podcast

Podcast

Taming inflation?

What are the implications of prolonged inflation?

By: The Sound of Economics Topic: Macroeconomic policy Date: May 25, 2022
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Past Event

Past Event

What is in store for Euro area economies?

ECB Executive Board Member Philip Lane discusses the outlook for Euro area economies.

Speakers: Maria Demertzis and Philip Lane Topic: European governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: May 5, 2022
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Policy Contribution

European governance

Fiscal support and monetary vigilance: economic policy implications of the Russia-Ukraine war for the European Union

Policymakers must think coherently about the joint implications of their actions, from sanctions on Russia to subsidies and transfers to their own citizens, and avoid taking measures that contradict each other. This is what we try to do in this Policy Contribution, focusing on the macroeconomic aspects of relevance for Europe.

By: Olivier Blanchard and Jean Pisani-Ferry Topic: European governance, Macroeconomic policy Date: April 29, 2022
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Opinion

European governance

How to reconcile increased green public investment needs with fiscal consolidation

The EU’s ambitious emissions reduction targets will require a major increase in green investments. This column considers options for increasing public green investment when major consolidations are needed after the fiscal support provided during the pandemic. The authors make the case for a green golden rule allowing green investment to be funded by deficits that would not count in the fiscal rules. Concerns about ‘greenwashing’ could be addressed through a narrow definition of green investments and strong institutional scrutiny, while countries with debt sustainability concerns could initially rely only on NGEU for their green investment.

By: Zsolt Darvas and Guntram B. Wolff Topic: European governance, Green economy, Macroeconomic policy Date: March 8, 2022
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External Publication

The Euro in 2022

An annual review of the euro published jointly by Fundación ICO and Fundación de Estudios Financieros to expand knowledge, raise awareness of the single currency, and suggest ideas and proposals for strengthening its acceptance and sustainability.

By: Grégory Claeys, Maria Demertzis and Fernando Fernández Topic: Macroeconomic policy Date: February 17, 2022
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Past Event

Past Event

A debate on fiscal rules and the new monetary strategy

Presentation of the Yearbook of the Euro 2022.

Speakers: Maria Demertzis, Fernando Fernández, Gonzalo García Andrés, José Carlos García de Quevedo, Pablo Hernández de Cos and Jorge Yzaguirre Topic: European governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: February 17, 2022
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Blog Post

Who is suffering most from rising inflation?

The lowest income households are suffering disproportionally from the current inflation increase, with rising energy prices the main culprit.

By: Grégory Claeys and Lionel Guetta-Jeanrenaud Topic: Macroeconomic policy Date: February 1, 2022
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Opinion

European governance

The euro comes of age

A well-functioning euro reflects a degree of unity that allows the EU to credibly claim a position at the global table and therefore help shape the policies that will deal with global problems. That is a decisive success.

By: Maria Demertzis Topic: European governance, Macroeconomic policy Date: January 13, 2022
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Opinion

A role for the Recovery and Resilience Facility in a new fiscal framework

Discussions on reforming European Union fiscal rules must consider a more permanent but targeted role for the Recovery and Resilience fund to meet climate ambitions.

By: Maria Demertzis Topic: Macroeconomic policy Date: January 10, 2022
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