How to Help European Fiscal Policy, A Commentary by Michael Deppler, Director, and Jörg Decressin, Deputy Division Chief, EU Policies Division, European Department, IMF

February 15, 2005

How to Help European Fiscal Policy
A Commentary by Michael Deppler, Director,
and Jörg Decressin, Deputy Division Chief, EU Policies Division
European Department, International Monetary Fund
Published in Financial Times
February 15, 2004

The process of reforming the Stability and Growth Pact—the set of rules governing fiscal policy for countries in the European Union—has reached the point where politicians must decide and agree on acceptable constraints on their room for fiscal manoeuvre. The signs are not propitious: there is a risk that the interplay between weak economic situations and electoral calendars would enshrine, rather than address, the pact's weaknesses.

Three factors account for the pact's travails: the failure of some countries to adjust their fiscal situations during good times; a largely unexpected weakening of potential growth; and an excessively mechanistic procedure for dealing with breaches of the 3 per cent deficit limit. While the third factor has generated controversy, the first two, which reveal inadequate policies in the face of shocks, are fundamental. The pact has simply performed its function as an alarm bell. The answer is not to mute the alarm but to adopt policies of fiscal consolidation and structural reform.

But the pact is more than an alarm bell. It is a necessary constraint on the powers of unchecked discretion in a monetary union and is intended to foster disciplined, forward-looking policies. As with monetary policy, it is now widely accepted that the tendency for governments to loosen fiscal discipline for political reasons is most effectively addressed through a rules-based framework that constrains policymakers' discretion. This is the core of the stability pact that needs protecting and strengthening. Like all rules, it ought to be operationally simple and transparent, all the more so for up to 25 member states. (A forthcoming IMF paper discusses these issues in greater detail.*)

By this yardstick the pact fares much better than is often suggested. Furthermore, it is more flexible than it receives credit for, has helped foster better budgetary policies than in the past and fits the long-term objectives and requirements of the eurozone. Indeed, of the possible changes to the pact under discussion, none is imperative, a few are desirable and many are problematic.

The desirable category includes allowing countries with excessive deficits more time to reduce them if they pursue strong fiscal consolidation but are suffering unexpectedly weak economic growth. It would also be desirable to give more weight to a country's level of indebtedness, as this would strengthen the focus on the medium term and limit gamesmanship with deficit figures.

Among the problematic proposals are: excluding certain expenditure from the deficit definition; introducing complex, country-specific budget targets that consider contingent, explicit or implicit liabilities or long-run potential output growth rates; or allowing for unknowable trade-offs between fiscal adjustment and structural reform. Such considerations would lead to endless manipulations. The present rules offer sufficient flexibility to accommodate country-specific concerns.

With the problems rooted in the policies, rather than in the pact, there is an urgent need to create more commitment to the pact's goals at a national level. One step proposed by the European Commission is to have national stability programmes debated by par liaments in the context of the national budgets. This is crucial. However, we would go further and urge the establishment of independent national fiscal councils that report to national parliaments on budgets and stability programmes.

Properly designed, such councils would help limit short-termism in budget policies and stem the transparency problems that have surfaced in various guises. These include overly optimistic economic growth or fiscal policy assumptions; reliance on one-off measures; creative accounting; and even misreporting. Although partially in place in some European countries, such institutions take time to establish. In the meantime, the goals of the pact would be well served if both the Commission and Eurostat, the European Union's statistics agency, were given more weight in vetting projections, assumptions and reporting practices.

As well as showing profligacy in good times, Europe's fiscal policies have been struggling with slowing potential growth. This problem looms larger with the onset of rapidly ageing populations. What is needed is complementary policies of fiscal consolidation and reform that boost potential growth. The stability pact, as an answer to the political forces of fiscal discretion, has worked well in this regard, if not perfectly. It needs to be sustained and strengthened through reforms that bring a more forward-looking perspective to national policy debates.

*"Reforming the Stability and Growth Pact", IMF policy discussion paper by Anthony Annett, Jorg Decressin and Michael Deppler.


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