This blog was also published on VOXEU
Proposals to reform the euro area are on the agenda again (see, in particular, Benassy-Quéré et al. 2018). An overhaul of the complex set of European fiscal rules should be on high on this agenda, because the fiscal framework in place has not worked well.
The current fiscal framework suffers from massive problems
It has generated excessive fiscal austerity during the crisis, thereby contributing to aggravating and prolonging its economic, social, and political consequences. 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. In addition, these rules suffered from large 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 nice 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. Such huge revisions and other problems related to its measurement 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, non-transparent 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 which infringes on national sovereignty.
However, fiscal rules to ensure debt sustainability in the euro area are a necessity. The main reason is that the no-bailout clause is not credible in a monetary union because of the specific collateral damage generated by a fiscal crisis that may lead the breakup of the common currency (Gourinchas et al. 2018). However, fiscal rules are not a silver bullet and cannot be substituted to the national democratic debate on fiscal choices and debt sustainability but should help framing this debate. Fiscal rules should be as transparent and simple as possible, should set targets under the direct control of the government, should allow countercyclical fiscal policy and should generate incentives to reduce excessive public debt.
How to change the rules?
In a recent study, we assess the current framework and propose a major overhaul (Darvas et al. 2018). We recommend substituting the numerous and complex present rules with a new, simple rule focused on limiting annual growth rate of expenditures. Other economists (Claeys et al. 2016, Benassy-Quéré et al. 2018, Feld et al. 2018) have made similar recommendations and international organizations – such as the IMF – have published positive analysis on such rules (Debrun et al. 2018).
Our expenditure rule requires that nominal expenditures not grow faster than long-term nominal income, and that they grow at a slower pace in countries with excessive levels of debt. This translates into a two-pillar approach: (1) a long-term target debt level, such as 60% of GDP; and (2) an expenditure-based operational rule to achieve the anchor.
The expenditure rule could take the following form: the growth rate of nominal public spending (net of interest payments and of unemployment spending and after properly taking into account public investment) is the sum of real potential growth and expected inflation, minus a debt brake term which takes into account the difference between the observed debt-to-GDP ratio and its long-term target (which we take to be 60% from the EU Treaty).1
The key parameter in this formulation is the speed at which the country converges to its long-term debt target (i.e. the debt-brake parameter). In our simulations of this formula (see footnote and the original paper for details), we found that a public spending rule with a constant and homogenous debt brake parameter to reach the 60% target does not generate realistic fiscal policy recommendations for certain European countries. In countries with debt levels significantly higher than the 60% of GDP, the necessary initial budgetary effort is unrealistically high if, for example, the debt brake parameter is chosen to fit France or Germany.
By recognising this limitation, instead of a set-in-stone numerical formula, we recommend an expenditure rule based on a rolling five-year country-specific debt reduction target in a properly designed institutional framework. This would work in practice as follows:
Each year, the government proposes a rolling medium-term (e. g. five-year-ahead) target of reduction in the debt-to-GDP ratio. This could be part of the existing Stability Programme provided each year by member states to the European Commission. Both the national independent fiscal council and the euro area fiscal watchdog are consulted and provide a public assessment of the target in terms of both feasibility and ambition. A discussion follows with the European Commission. The discussion should be based on an economic analysis where the important parameters would be (1) the distance between the actual debt-to-GDP ratio and the long-term target of 60% (the higher the gap, the more ambitious the adjustment); (2) a broader analysis of fiscal sustainability (in particular, to give credit to countries that undertake solvency-improving entitlement reforms, or major reforms expected to raise potential growth); and (3) an economic analysis of the economic situation and the relevant path of debt reduction. As a result, the pace of medium-term debt reduction should not be determined by a formula. The Commission then presents its conclusion for the debt reduction targets for each country to the Council that can vote against it by a reverse qualified majority.
The national fiscal council would prepare a medium-term nominal GDP growth projection based on expected potential output growth, expected inflation, and a possible cyclical correction in case initial conditions depart markedly from long-run equilibrium. Given the medium-term target on debt reduction, the national fiscal council provides a consistent medium-term nominal public expenditure path and uses it to set a nominal expenditure ceiling for the coming year, for use in the preparation of the corresponding budget.
Nominal expenditures are calculated net of interest payments, of unemployment spending (except when these are due to discretionary changes to unemployment benefits), and of the estimated impact of any new discretionary revenue measures (changes in tax rates and tax bases). The first two adjustments allow for more counter-cyclicality, while excluding the effect of expenditure-increasing structural measures. The last adjustment is meant to preclude the manipulation of tax rules (for example, tax cuts ahead of an election) that are not compensated by offsetting expenditure measures. It also allows elected governments to make fiscal policy choices (implying different but consistent long-term levels of expenditures and taxes) that reflect political preferences.
It is also important to properly account for public investment, which tend to vary a lot from one year to the next. For example, when a big infrastructure project is launched, public investment can be huge in that year and small in subsequent years. The best way to treat such public investment is the same as private companies treat private investments: the cost of investment is distributed across years during the service life of the capital good purchased.
Limited deviations between actual and budgeted spending could be absorbed by an ‘adjustment account’ that would be credited if expenditures net of discretionary tax cuts run below the expenditure rule, and debited if they exceed it. These types of accounts exist in Germany and Switzerland. If a country passes a budget with no excessive spending but realised spending is above the target, the overrun could be financed without breach of the rule, provided that the deficit in the adjustment account does not exceed a pre-determined threshold (e.g. 1% of GDP). If the threshold has been breached, the country violates the fiscal rule.
We show (see also Claeys et al. 2016) that structural budget balance estimates are subject to large revisions, partly due to the uncertain estimates of the output gap. Based on that finding, one might argue that the medium-term potential growth estimates, which are the basis of our proposed expenditure rule, could be also subject to large revisions – but this is not the case. With the exception of the year 2008, even European Commission estimates were subject to rather small revisions. For example, for the EU15 core countries, the typical revision in the medium-term potential growth rate is about 0.15 percentage points per year. A 0.15 percentage point downward revision in medium-term potential growth estimate would imply that if in spring 2018 a country is allowed to increase expenditures by 3.0%, in spring 2019 the allowed growth rate of expenditures is revised downward to 2.85% per year. Given that public expenditures amount to about half of GDP, a 0.15% revision in expenditures implies an impact of 0.075% of GDP on the budget balance, which is rather small and well below the impact of revisions in the structural balance.
The properties of our proposed new rule
We assess the consequences of an application of an expenditure rule through several quantitative simulations by the Observatoire français des conjonctures économiques (OFCE 2018).
Examples of the simulations run by OFCE of France’s debt dynamics and real public expenditures growth rates under three objectives (a -2%, -4%, or -6% decrease in debt over GDP at a five-year horizon) suggest that, depending on the degree of ambition of the five-year debt reduction target, an expenditure rule can generate debt reduction dynamics that are similar or less stringent than the present rule. In all cases of the proposed expenditure, the real growth rate of expenditures for France would converge to a bit less than 1% (i.e. less than the potential growth rate assumed to be 1.1%) but with more front loading of the adjustment in the first years.
Next, we analyse the cyclical properties of the rule on a calibration based on French data. The rule has good countercyclical properties for unexpected demand shocks. First, the nominal growth rate of expenditures is not affected by the shock and automatic stabilisation is at work due to lower revenues and higher deficits. Second, a negative demand shock generates inflation below expectations. As the growth rate of nominal public spending is based on expected inflation, such a shock induces a higher real growth rate of public expenditure and therefore a positive fiscal impulse. Concerning supply shocks, such as oil price shocks generating a fall in output and an increase in inflation, the expenditure rule is still stabilising because it induces a budget deficit but the higher unexpected inflation slightly reduces its stabilising properties (relative to the current rule). Overall, if, as is mostly believed, demand shocks are predominant in the euro area, we conclude that the expenditure rule has a better cyclical properties than the current rule.
To illustrate the better countercyclical properties of the expenditure rule, Figures 1 and 2 show the observed growth rate of primary public spending in France (in black) and of the fiscal impulse and a counterfactual simulation performed by OFCE of these two series (in colour) as generated by an expenditure rule.
Figure 1 Nominal growth rate of primary public spending in France for the period 1998-2017 (%, current euro)
Source: INSEE, OECD, Budget Bill, OFCE calculations.
Figure 2 Fiscal impulse in France for the period 1998-2017 (% of potential GDP)
Note: The simulations consider actual tax measures as given, such as the tax cut in 1999 and tax increases in 2011-2013.
Source: INSEE, OECD, Budget Bill, OFCE calculations.
Both figures suggest that the rule would be more countercyclical than was observed in France. During good years, the growth rate of public expenditure as well as the fiscal impulse would have been lower; and vice versa, in the period 2011-2013 French fiscal policy would have been more expansionary. Note however that in 2009, the rule would have implied less fiscal stimulus and this is the reason we advocate to keep an escape clause in case of exceptional circumstances.
Enforcement of the rule
The European experience suggests that enforcing compliance through penalties imposed by what is seen in many countries as bureaucracy from Brussels or political might from Berlin has major deficiencies. Instead, we advocate for a credible enforcement of fiscal rules, mixing several instruments pertaining to surveillance, positive incentives, market discipline, and increased political cost of non-compliance.
Benassy-Quéré A, M Brunnermeier, H Enderlein, E Fahri, M Fratzscher, C Fuest, P O Gourinchas, P Martin, J Pisani-Ferry, H Rey, I Schnabel, N Véron, B Weder di Mauro and J Zettelmeyer (2018), “Reconciling Risk Sharing with Market Discipline: A Constructive Approach to Euro Area Reform”, CEPR Policy Insight No 91, January.
Claeys G, Z Darvas and A Leandro (2016), “A Proposal to Revive the European Fiscal Framework”, Bruegel Policy Contribution No. 2016/17.
Darvas, Z, P Martin and X Ragot (2018), “European Fiscal Rules Require a Major Overhaul”, Les notes du conseil d’analyse économique no. 47, September.
Debrun, X, L Eyraud, A Hodge, V Lledo, C Pattillo and A Senhadji (2018), “Fiscal Rules: Make them Easy to Love and Hard to Cheat”, IMF blog.
Feld, L P, C M. Schmidt, I Schnabel and V Wieland (2018), “Refocusing the European fiscal framework”, VoxEU.org, 12 September.
Gourinchas P O, P Martin and M Todd (2018), “The Economics of Sovereign Debt, Bailouts and the Eurozone Crisis”, mimeo, Sciences Po
OFCE (2018), “Simulation of a Fiscal Public Expenditure Rule Dependent on the Level of Public Debt”, Focus du CAE no. 23, September.
 Formally :
where the growth rate of nominal public spending (net of interest payments and of unemployment spending and after properly taking into account public investment) g ̂i,t for country i in year t is the sum of real potential growth y ̂i,t, expected inflation Et-1 πi,t minus a debt brake term which takes into account the difference between the observed ratio of debt to GDP di,t and the long term target d* . The parameter γi,t is important as it drives the speed at which the country converges to its long-term debt target.