## A Call for New Fiscal Rules

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**Canonical URL:** [A Call for New Fiscal Rules](https://www.imf.org/-/media/files/publications/fandd/article/2022/march/fraga.pdf)

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### Context and problem
- Authors (Mario Draghi and Emmanuel Macron) argued for reforming the EU’s fiscal rules to mobilize large-scale investment for existential challenges such as climate change and pandemics.
- Their position: pandemic was well managed macroeconomically and debt-to-GDP ratios were no longer growing, yet new fiscal rules are needed that would not stand in the way of investment.
- Counterpoint: government indebtedness must be brought down—but not through higher taxes, cuts in social spending, or fiscal adjustment; instead, growth-enhancing structural reforms and new fiscal rules were advocated.

### Why the old rules failed
- Maastricht rules largely demanded:
  - debt-to-GDP ratio below 60 percent, and
  - nominal public deficit of no more than 3 percent of GDP.
- Outcomes cited:
  - France’s debt ratio was 98 percent by 2019.
  - Italy’s debt ratio was 135 percent by 2019.
  - Post-pandemic, these ratios are about 20 percentage points higher.
  - The 3 percent ceiling for budget deficits was, for the most part, treated as a floor.
- Interest rate environment that enabled fiscal slippage:
  - 10-year Bund yields were above 6 percent at the time Maastricht was signed; now they are near zero.
  - Spreads on Italian bonds versus Bunds at the time of writing: 136 basis points.
  - France’s spreads to Germany remain very low despite a debt ratio 43 percentage points higher.

### Advanced economies versus emerging market economies
- IMF Fiscal Monitor data cited:
  - general government debt in emerging market economies averages 64 percent of GDP.
  - advanced economies average 122 percent of GDP.
- Bond yield environment for more stable emerging markets:
  - Brazil, India, Indonesia, Mexico, Russia, and South Africa had 10-year local currency bond yields of about 7 percent at one point.
  - Russia is now at 8 percent; the others are at or below 7 percent but still higher than advanced economies.

### Brazil case study: fiscal slippage and dynamics
- Brazil’s debt experience:
  - Debt ratio was 53 percent in 2014.
  - Debt ratio peaked at 89 percent in 2020.
  - Debt ratio is now at 83 percent (at the time of writing).
- Fiscal balance swings:
  - Overall swing in the primary balance from surplus to deficit reached nearly 6 percentage points of GDP after the 2014 fiscal collapse.
  - Since 2015 Brazil has run primary deficits.
- Interest-rate and inflation context:
  - 10-year inflation-linked government bonds in Brazil yield over 5 percent (a 6 percent difference over US Treasury Inflation-Protected Securities).
  - Nominal 10-year paper yields more than 10 percent.
- Causes and consequences:
  - Recession-driven low interest rates and unexpectedly high inflation temporarily reduced the debt ratio to 83 percent, but rising interest rates imply the debt ratio will resume an upward and unsustainable climb.
  - A formerly effective fiscal responsibility law (enacted in 2000) and a subsequent constitutional freeze on government expenditures in real terms have lost credibility and effectiveness.
  - Low per capita growth combined with high yields produces ominous debt dynamics.

### Four pillars proposed for a new fiscal regime
- Pillars proposed for Brazil (author argues applicability to advanced economies as well):
  1. Public debt should be sized to allow for access to financing (usually under stress), at a reasonable cost, in case a fiscal expansion is needed.
  2. The primary balance should be set so that, in normal times, the debt-to-GDP ratio remains stable.
  3. If for whatever reason the debt ratio deviates from its target level, the primary balance should be adjusted to gradually bring the debt ratio back to the target.
  4. The average debt maturity should be long, with limited concentration at the short end, to match long-term government horizons and lower the risk of run-like financial or currency crises driven by sudden stops in financing.
- Relationship to IMF recommendations:
  - The IMF Fiscal Monitor’s three desirable features for a fiscal framework: “(1) sustainability of public finances; (2) stabilization of the economy through countercyclical fiscal policy, when appropriate; and (3) for fiscal rules in particular, simplicity.” The author adds resilience as a fourth priority and maps the four pillars to these features.
- Design notes:
  - The debt-ratio target of pillar 1 is subjective and depends on economic, political, institutional, and historical factors.
  - Targets in pillars 1 and 2 should be periodically revised, but not too frequently and at preannounced dates, to minimize short-term political temptations.
  - The adaptive reaction function of pillar 3 is highlighted as the most important pillar.

### Expected outcomes and risk management
- A fiscal regime based on these pillars would:
  - provide a resilient and possibly durable anchor for both advanced and emerging market economies.
  - be adjustable across countries because key parameters (debt spreads and growth) differ across nations, though the same logic applies.
- Caution about current conditions:
  - Current ultra-low interest rates in advanced economies ought not to be taken as permanent.
  - Markets are prone to booms and busts; blind faith in low rates is poor risk management.

*Source: fraga (FINANCE & DEVELOPMENT, March 2022).*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2022/march/fraga.pdf_