When it comes to European governance, the fiscal architecture behind the European Monetary Union is probably one of the most important things to take into consideration. Through the years, this fiscal architecture has increased its level of complexity, and, in some cases, it has failed to deliver the outcomes it was pursuing. In the next two articles I will explain which are the main fiscal rules, their rationality, their performance during the 2 most recent crisis and some of the characteristic of the new economic reality, as a way to understand the rationality behind the main reform proposals.
The case for fiscal rules.
When it comes to fiscal rules in the context of the EMU, these can be mainly seen as a complement of the euro’s architecture. The institutional set-up of the common currency was based around a single monetary policy in a supranational level together with national fiscal and economic[1] policies. In light of this, the negative consequences on the overall union coming from the fiscal behaviour of some countries made policymakers to consider the introduction of these fiscal rules.
When it comes to the negative effects derived from the fiscal behaviour of some countries, we need to take into consideration the existence of demand spillovers and the risk of fiscal dominance. When it comes to demand spillovers and, due to the fact that the EMU is an integrated region in terms of trade, the fiscal induced trade imbalances of one country can have effects on the inflation and growth of other member states. These effects are likely to be transmitted through trade and price competitiveness. Concerning the risks of fiscal dominance, it is possible to say the debt externalities arising from the fiscal liabilities of some countries may influence the independency of the central bank. In this regard, if the central bank raises the level of inflation to diminish the real cost of public debt, the whole monetary union would be affected by the inflationary costs. Since the positive consequences of fiscal expansions are mainly restricted to national levels, it is possible to say that if fiscal dominance takes place, the high indebted member states free ride vis-à-vis the supranational monetary policy.
From a monetary union perspective, the common pool problem is probably another important reason behind the existence of deficit biases. In this light, national governments may have incentives to pursue expansionary fiscal policies as a consequence of the asymmetries in the allocation of costs and benefits. While the national governments are the ones that benefit the most from the expansionary fiscal policy, the costs are borne by all the member states in the form of higher bond spreads and interest rates. The common pool problem is also related with asymmetric information and, more precisely, with moral hazard. In an extreme situation, the negative spillovers derived from a sovereign default would be likely to force other member states to bailout the defaulting country.
Apart from these reasons the existence of debt and deficit biases also calls for the implementation of fiscal rules. According to the political economics literature the existence of these biases may be explained by different reasons. One of the first explanations for the deficit biases was related with the fiscal illusion. In first place, the lack of understanding of the intertemporal budget constraint by voters as a consequence of high information costs may be behind the origin of these deficits. Secondly, can also arise because of the existence of electoral cycles as a consequence of rational and imperfectly informed voters inducing politicians to conduct expansionary fiscal policies. Finally, the distributional conflicts across different generations or interest groups also explain the existence of these biases.
In addition, the existence of time inconsistency problems of fiscal policy may explain the existence of fiscal rules. The long-term goals of fiscal policy (understanding these as fiscal discipline and debt sustainability) are somehow reduced when output stabilization and short-term discretion are considered. Fiscal rules can somehow influence the incentives of policymakers, creating a right balance between the short- and long-term goals.
Main supranational fiscal rules.
The fiscal rules of the Eurozone are mainly stablished around the Treaty of the Functioning of the European Union and the Stability and Growth Pact.
Concerning the TFEU, some of the articles stablish, in a general way, the principles underpinning the fiscal rules. The main examples of these are related with the explicit prohibition of monetary financing and privileged access to financial institutions by governments as well as the no-bailout clause, included in the Articles 123, 124 and 125 of the TFEU. In addition, the article 126 states that “Member States should avoid excessive government deficits” and defines the Excessive Deficit Procedure, explaining the circumstances under which this should be applied. As stated in the TFEU, the EDP is applicable if (1) a certain deficit threshold has been reached or it is at risk to be reached or (2) the “ratio of government debt to gross domestic product exceeds a reference value, unless the ratio is sufficiently diminishing and approaching the reference value at a satisfactory pace”. The TFEU also states that under exceptional circumstances beyond the control of the MS, the Union can grant financial assistance. The protocol No. 12 annexed to the Treaty stablishes that the reference values in respect to the deficit and debt-to-GDP are, respectively, 3% and 60%.
Regarding the SGP, it constitutes the main set of fiscal rules in the Eurozone. It entered into force in 1997 with the aim of ensure “sound government finances as a means of strengthening the conditions for price stability and for strong sustainable growth conducive to employment creation”. It is articulated through two legislations: the preventive arm, aimed to ensure sound budgetary policies over the medium term, avoiding excessive deficits, and the corrective arm, detailing the Excessive Deficit Procedure included in TFEU. Under the SGP MS “commit themselves to respect the medium-term budgetary objective of positions close to balance or in surplus”, which would “allow [...] to deal with normal cyclical fluctuations while keeping the government deficit within the reference value of 3% of GDP.”[2]
The generality embedded in the first formulation of the SGP legislation was addressed in 2005 with the definition of the Medium-Term Objective, a country specific numerical value defined in terms of the structural balance (cyclically adjusted and net of one-off and temporal measures). In addition, and, as a consequence of the procyclicality of fiscal policies, the nominal deficit targets were replaced by structural balances. This changes lead to the erosion of political consensus around the output-gap based rules as they were based around the estimation of potential GDP.
The second modification of the SGP in 2011 took place as a consequence of the period of market turmoil experienced right after the Great Financial Crisis. The main aim of the “six pack” reforms was to ensure the automatic creation of fiscal buffers in good economic times. In this regard, several changes were introduced. First, the preventive arm was strengthened through the introduction of an expenditure rule[3] to avoid the misuse of revenue windfalls during periods of economic booms. Secondly, the creation of a debt rule determined also that the pace at which the debt-to-GDP had to be reduced was 1/20th on average over 3 years. Thirdly, and, as a result of the competitiveness and macroeconomic imbalances that were built up in the first decade of the 2000s, the Excessive Imbalance Procedure was introduced as a surveillance and enforcement mechanism. If it is true that the scoreboard of the early warning system was mainly based on macroeconomic variables, the general government sector debt within a threshold of 60% was also considered. In case imbalances are expected to become large, the EU Commission and the Council can adopt preventive recommendations. In more serious, an EDP can be opened and forcing MS to submit and follow a plan of corrective actions under the supervision of the Commission. In case of compliance failure, sanctions can be imposed.
In the year 2013, the “two pack” entered into force as a complement to the changes in the SGP introduced with the “six pack”. The main aim of the “two pack” was to limit the potential spillover effects of budgetary policies through enhanced fiscal surveillance for those MS under the EDF or financial assistance. Regarding fiscal control, the main changes introduced by the “two pack” included the publication of the medium-term fiscal plans (Stability Programmes) and the drafts of the budgets for the following year. Following the publication of the documents, the Commission can give an opinion about these as well as propose corrective measures that can imply putting together a draft macro-economic adjustment programme.
In addition to the “two pack”, the “fiscal compact”[4], was also put in place as a consequence of the increased market pressure that the most vulnerable MS were suffering. The main goal of the intergovernmental agreement was to reinforce the budgetary discipline of the Euro area countries through the introduction of budget balance rules as a way to ensure that national budgets are balanced or in surplus. The rules limit the annual structural deficits to a -0.5% of GDP for those MS whose debt-to-GDP is higher than 60%. For the MS whose debt-to-GDP is less than 60% the annual structural deficit can be as high as -1% of GDP. Apart from the budget balance rules, automatic correction mechanisms in response of departures from the budget rules were introduced. The Treaty also stated that in case of exceptional circumstances (such as a severe economic downturn), MS were allowed to be temporary exempted from the budget balance rules.
During the year 2015, as a result of the adjustment fatigue and the low growth figures, new changes in the SGP were introduced. The preventive arm was modified in order to allow MS to lower the structural adjustments in exchange of structural reforms and additional public investment. Furthermore, a matrix of structural efforts was introduced for countries in which the MTO was not achieved.
In 2018 the SGP introduced the last modifications. These last set of changes allowed for a more flexible and discretionary implementation of the fiscal rules, lowering the necessary adjustments required by the matrix of structural efforts. The main reason behind the revision of the SGP was related with the output gaps underlying the structural adjustment. As argued by some authors[5] the output gaps were understating the weakness of countries macro conditions.
Underpinning of the fiscal rules.
The debt and deficit limits stablished in the Maastricht treaty do not have solid ground in either theory or empirical evidence. When it comes to the debt limit, the 60% stablished roughly corresponds to the average debt level in the euro area during the year 1989. Concerning the deficit cap, the value of 3% is obtained through the following expression:
∆b = d – gb
The expression is obtained through the government budget constraint. Concerning its components, b is the debt-to GDP ratio; d refers to the overall deficit as a percentage of GDP; and g is the nominal growth of GDP. The sum of real GDP growth and inflation give us, approximately, g.
If we take into consideration some assumptions regarding real growth and inflation, the 3% deficit value can be obtained. The assumptions that were considered were based on the levels of real growth and inflation observed during the time in which the Maastricht Treaty was being negotiated. Taking into account the expression and, considering a 5% real growth rate and a 2% rate of inflation and a 3% deficit, the debt-to-GDP ratio that we obtain is 60%. From this, it is possible to say that the complying with the deficit limit was a sufficient and necessary condition to comply with the debt rule.
Apart from the simple arithmetic used to calculate these values, some other political considerations were included in the negotiations. Because of the high levels of public debt of some member states at that time, the 60% level of public debt was not considered an absolute limit. It is because of this that the fiscal architecture derived from the Maastricht Treaty allows for a debt ration above 60%, as long as the ratio is moving towards the value fast enough.
When it comes to the deficit cap some authors argue that, apart from the results derived from the debt accumulation equation, the political consensus prevailing in France during the 1980s also influenced the decision process around the 3% limit. According to some authors[6] during the early 80s the French President François Mitterrand was looking “for an easy rule, that sound(ed) as coming from an economist, and [could] be opposed to the ministers that walk(ed) into his office asking for money.” According to a person involved in the preparations at that time, they “came up with this number in less than an hour [...] without any theoretical reflection”.
[1] Although national governments are in charge of structural policies, there is a soft form of coordination and surveillance with some of the EU supranational bodies.
[2] See: “Resolution of the European Council on the Stability and Growth Pact Amsterdam.” (European Council, 1997).
[3] As shown in “EU Economic governance "Six-Pack" enters into force.” (European Commission, 2011), the expenditure rule introduced with the “six pack” reforms “places a cap on the annual growth of public expenditure according to a medium-term rate of growth”.
[4] “Fiscal compact” was the name that was commonly used to talk about the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union.
[5] See: “Taking Stock of the Functioning of the EU Fiscal Rules and Options for Reform.” (Kamps, C., & Leiner-Killinger, N. 2019).
[6] See reference 5.
