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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: European Macroeconomics & Governance

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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Past Event

Past Event

The Covid Crisis and European State Aid Rules: The Case for a Rational Approach

Considering a new approach to find the way out of the Great Financial Crisis.

Topic: European Macroeconomics & Governance Date: May 27, 2020
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Blog Post

Banking regulation in the Euro Area: Germany is different

Despite progress in recent years towards a single banking policy framework in the euro area – a banking union – much of the German banking system has remained partly sheltered from uniform rules and disciplines that now apply to nearly all the area’s other banks. The resulting differences in regulatory regimes could generate vulnerabilities in the still-incomplete banking union, which is being tested in the context of the COVID-19 pandemic.

By: Nicolas Véron Topic: European Macroeconomics & Governance Date: May 7, 2020
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Opinion

A European approach to fund the coronavirus cost is in the interest of all

We had not seen a common challenge as clear as this pandemic. The sum of national actions and programs is likely to be insufficient.

By: Agnès Bénassy-Quéré, Arnoud Boot, Elena Carletti, Jan Krahnen, Miguel Otero-Iglesias, Lucrezia Reichlin, Dirk Schoenmaker and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: April 6, 2020
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External Publication

Facing the lower bound: what will the ECB do in the next recession?

In responding to the global financial crisis, the ECB has pushed its monetary policy into unchartered territories . Today, it appears increasingly constrained by persistently low interest rates. This paper seeks to understand this challenge and assess whether its toolkit would allow the ECB to weather a European recession.

By: Aliénor Cameron, Grégory Claeys and Maria Demertzis Topic: European Macroeconomics & Governance Date: March 27, 2020
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Blog Post

What should be done to reduce euro-area spreads?

Spreads are rising again in the euro-area at the worst possible time, when fiscal policy is needed to fight the coronavirus pandemic and the related economic shock. This blog post reviews the main options available to European policymakers, their feasibility and potential effectiveness to deal with this issue.

By: Grégory Claeys Topic: European Macroeconomics & Governance Date: March 18, 2020
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Opinion

Why OMT is not the solution for Italy right now

The Outright Monetary Transactions tool is not well suited for Italy right now. Italy needs fiscal support both by itself and by the EU. Italy and the rest of the EU need a fiscal bazooka. We should find a way of backstopping our economies immediately.

By: Maria Demertzis Topic: European Macroeconomics & Governance Date: March 16, 2020
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Opinion

Berlin will make or break the European Green Deal

€1 trillion isn't enough for the European Green Deal and the EU's fiscal framework is constraining public investment. "Mrs Merkel, tear down this rule".

By: Grégory Claeys and Simone Tagliapietra Topic: Energy & Climate Date: February 3, 2020
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Policy Contribution

Market versus policy Europeanisation: has an imbalance grown over time?

This Policy Contribution tests the hypothesis that an imbalance has grown in Europe over the last few decades because markets have integrated to a greater extent than European-level policymaking, potentially creating difficulties for the democratic process in managing the economy. This hypothesis has been put forward by several authors but not so far tested empirically.

By: Leonardo Cadamuro and Francesco Papadia Topic: European Macroeconomics & Governance Date: January 9, 2020
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Blog Post

The European Green Deal needs a reformed fiscal framework

The European Green Deal should include a sustainable investment strategy that will help citizens change behaviour and companies switch technologies. But to finance it, the EU will have to increase the flexibility of its fiscal rules to encourage member states to invest in the transition.

By: Grégory Claeys Topic: Energy & Climate Date: December 10, 2019
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Policy Contribution

Crisis management for euro-area banks in central Europe

Euro-area bank integration has decreased as post-financial crisis national rules require banks to hold more capital at home. It might be undermined further by bank resolution planning. Either a Single Resolution Board takes the lead for the entire banking group or independent local intervention schemes need to be developed for crisis resolution.

By: Alexander Lehmann Topic: European Macroeconomics & Governance, Finance & Financial Regulation Date: November 19, 2019
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Opinion

Politics, not policy will help Lagarde save the eurozone

Her success at helm of Europe’s central bank will depend on her ability to mend fences with hawkish policymakers.

By: Guntram B. Wolff and Rebecca Christie Topic: European Macroeconomics & Governance Date: November 4, 2019
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Blog Post

Long term real interest rates fell below zero in all euro area countries

The 10-year real government bond yield, which is the nominal yield deflated by expected inflation, has fallen below zero in Italy and Greece, boosted by increased market confidence for their new governments. Romania is the only remaining EU country with a positive real interest rate. Negative real interest rates vastly help fiscal sustainability and provide a great opportunity to invest in much needed infrastructure and the transition to a carbon-neutral economy.

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: October 8, 2019
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