The austerity policies implemented in many European countries since 2010 have contributed to the poor economic recovery, raising questions about why EU budget rules failed to deliver both economic stabilisation and public debt sustainability.
In theory the current rules could do a good job, but in practice they face major hurdles. A key indicator used in the current rules is the structural budget balance. This is the government budget balance corrected for the effects of the business cycle and one-off payments such as bank bailouts.
If the structural deficit is too high, then countries must adjust their budgets. If not, they do not have to adopt austerity measures. In theory, when a recession hits, the actual budget deficit deteriorates because of falling tax revenues and increased unemployment benefit payments, but the structural balance does not change for these reasons and therefore it does not trigger austerity policies.
But in practice the structural budget balance is hard to estimate. The estimate relies on uncertain assessments of the economic cycle and its impact on government revenues and spending. Estimated changes in the structural balance are typically revised by more than half a percent of GDP (see here), which is more than the adjustment that the rules require.
Unsurprisingly, finance ministers of eight euro-area countries recently expressed doubts about EU methods for estimating the cyclical position of the economy and its implications for analysing budgets.
Economic forecasts are also a major source of errors. Current fiscal rules rely on European Commission forecasts on growth and inflation, which often turn out to be wrong. In recent years the commission repeatedly forecast that the economy would return to growth and inflation would quickly return towards 2%, but this has not turned out to be true.
As a consequence, policy recommendations based on these forecasts actually made the economic situation worse. Forecasting accurately is certainly very difficult, especially in uncertain times. Other forecasters, such as the IMF, the OECD or private institutions, did not do better than the Commission. It would be better to have a fiscal rule which is less dependent on economic forecasts.
Another key problem with the current EU fiscal framework is the opaque web of ‘flexibility’ clauses. This leads to never-ending bargaining between member states and the European Commission about the implementation of the rules, which undermines trust in them.
Several politicians in countries that breach the rules regard the rules as inappropriate and openly disregard the rules. Other politicians in countries that comply with the rules worry that the rules are not enforced on their partners.
Preserving the current fiscal framework would therefore be highly inefficient. A new framework is needed.
The best option would be to scrap the current fiscal framework altogether. One way would be to remove the option for European bailout for governments completely, establish conditions for market discipline to work effectively, allow a large degree of fiscalindependence to member states and design European instruments to dampen economic cycles, such as a European unemployment insurance scheme.
However, such a complete overhaul appears politically unrealistic today. That’s why we suggest a second best option. All rules related to the badly-measured structural balance should be dropped. We propose a new rule limiting the growth rate of public spending, excluding certain items such as unemployment benefit payments and large one-off payments like bank bail-outs.
Under our rule, public expenditure growth would be limited to the country's potential GDP growth, plus the central bank's inflation target. In bad times, this would reduce the incentive of governments to cut expenditures. Even if tax revenues fall and spending on unemployment increases, governments would still be allowed to support growth. In good times, it would dampen excessive booms, such as the ones that happened in Ireland and Spain before the crisis, as governments would not be allowed to spend the extra tax revenues generated by bubbles.
The limit would also take into account the level of public debt. Countries with high public debt should have slower expenditure growth than countries with low public debt, to support long-term debt sustainability.
We also propose to get rid of the opaque web of flexibility clauses in current fiscal rules. Instead, the rule would be monitored by national fiscal councils and a newly-established independent European fiscal council. The latter should be composed of an executive board and the chairs of national fiscal councils. The European fiscal council would assess when countries can deviate from the rules in exceptional times.
This overhauled framework would be simpler, more transparent, and easier to monitor than the current system and would avoid relying on an unpredictable indicator.
Enforcement of the rules at the European level should move away from the threat of sanctions. They are not credible in the current framework anyway, and could have highly negative political consequences if they were applied.
Ultimately, countries should not – and will not – observe the rules because they fear sanctions, but because they all agree that the rule represents the best guidance for their fiscal policies to be both sustainable and supportive in a recession.
See more details in our recent policy contribution “A proposal to revive the European Fiscal Framework”.