Future of Fiscal Rules in the Euro Area
IMF News, January 28, 2020
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- Published: January 28, 2020
Rationale for Fiscal Rules in the Euro Area
- Fiscal rules are necessary to offset deficit and debt biases in day-to-day politics and to preserve sound public finances.
- In a monetary union, sovereign bonds become closer substitutes; absent risk reduction, market discipline may be too slow, weak, or sudden and disruptive.
- Maastricht Treaty design reflected upper-limit rules, “no bail-out”, and prohibition of monetary financing to contain spillovers and encourage discipline.
- Lamfalussy (1989) made two key points:
- The EU’s small budget implies Union-wide fiscal stance must rely on coordination of national budgets.
- Financial markets alone are insufficient to ensure fiscal discipline.
Lessons from Three Decades of Euro-Area Fiscal Rules
- Evolution and complexity:
- Fiscal rules have become more complex and opaque through successive substantial changes.
- Frequent revisions and layering of rules have undermined commitment and clarity.
- Compliance and effectiveness (simplified comparisons from Eyraud et al., 2017 and related analysis):
- The MTO was violated in 80 percent of observations.
- Almost two-thirds of countries exceeded MTOs in every single year.
- In 2009:
- The MTO rule was violated by 90 percent of countries.
- The debt ceiling was violated by 50 percent of countries.
- The deficit ceiling was violated by 85 percent of countries.
- The required fiscal effort was violated by 75 percent of countries.
- The share of countries with a debt ratio greater than 60 percent increased from 35 percent in 1999 to 75 percent in 2015.
- For the 3-percent deficit rule over a three-year planning horizon:
- Execution slippages led to a median upward deviation from the ceiling of up to 2 percent of GDP at the end of the third year.
- Behavioral effects:
- The 3-percent deficit ceiling acted more as a target or “magnet” than as a strict upper bound, increasing observations around the threshold and reducing both large deficits and surpluses.
- Cyclicality and stabilization:
- Despite attempts to strengthen counter-cyclicality, fiscal outcomes were mainly pro-cyclical; almost 60 percent of country-year observations of structural primary balances fell in procyclical quadrants.
- Divergent country experiences:
- Over the last twenty years (relative to the speech date), Germany had strong real per capita GDP growth (at U.S. level), while Italy’s real per capita GDP was almost at the same level as twenty years earlier.
- Between 2010 and 2019:
- Italy’s gross debt-to-GDP ratio increased by about 18 percentage points.
- Germany’s gross debt declined by 24 percentage points of GDP.
- Average structural primary surplus: Italy 1½ percent of potential GDP; Germany 0.9 percent of potential GDP.
- Low growth and high cost of debt are primary reasons Italy remains in a high-debt vicious circle; Germany benefits from favorable interest rate-growth differential due to record-low and negative interest rates.
Macroeconomic Context and New Challenges
- Three crucial unfinished elements for euro-area architecture:
- Completion of the banking union (including a European Deposit Insurance Scheme).
- Integrated single European capital market (improvements in transparency, insolvency regimes, withholding tax rules).
- Central fiscal capacity at the euro-area level to complement monetary policy in area-wide downturns.
- Low nominal interest rate environment:
- Nominal interest rates have fallen significantly and negative rates are common across major advanced economies.
- The relevance of constraints on policy interest rates (effective lower bound) reinforces the role of fiscal policy.
- Interest rate-growth differentials are not unusually favorable in a long-term perspective; lower nominal rates do not automatically imply more fiscal space because nominal GDP growth and interest rates move together.
- Public sector balance sheets and transformation needs:
- EU Green Deal: outline presented by the Commission on December 11, 2019 with a list of 50 initiatives to achieve carbon neutrality by 2050; transition requires substantial investments.
- IMF database on public sector balance sheets shows median general government net worth moved from positive 20 percent of GDP in 2000 to negative 20 percent of GDP in 2016.
- Significant differences exist between changes in net worth and increases in gross debt; many countries have shortcomings in public asset data.
- Aging societies increase present value of future commitments; low interest rates raise the present value of future cash-flow commitments and make pre-funding pensions more expensive.
Key Analytical Findings and Empirical Results
- Debt is the most important predictor of crises and exhibits strong nonlinearities (Moreno Badia, Medas, Gupta and Xiang, 2020).
- Beyond certain debt levels, crisis likelihood increases sharply regardless of the interest-growth differential.
- Interest rate-growth differentials are not higher prior to sovereign defaults than in normal times (Mauro and Zhou, 2019).
- Expenditure rules can balance flexibility and simplicity but require correction mechanisms to deliver a debt anchor.
- Golden-rule experiences have been disappointing; the Public Sector Balance Sheet (PSBS) approach offers complementary insights by accounting for public assets and long-term liabilities.
Policy Options and Recommendations
- Guiding principle: simplicity.
- Three main directions for reform:
- Consolidation of preventive and corrective arms of the fiscal framework.
- Shift to a single fiscal anchor and a single operational target.
- Option highlighted: use public debt-to-GDP ratio as the anchor and an expenditure growth rule as the operational target.
- Tie real expenditure growth to the economy’s potential growth rate to support stabilization and debt sustainability.
- Implement a debt correction mechanism to better link the operational rule to the debt anchor.
- Establishment of a central fiscal capacity at the euro-area level to strengthen counter-cyclical response.
- Expenditure rules:
- Offer clearer operational guidance that is easier to measure, communicate, and monitor, but can be sensitive to initial conditions.
- Public Sector Balance Sheet (PSBS) approach:
- Use accrual accounting and balance-sheet metrics to capture assets created by public investments and fiscal exposure from SOEs, PPPs, pensions, guarantees.
- PSBS complements debt and deficit metrics and addresses shortcomings of golden-rule implementations.
- Strengthen fiscal institutions and expertise:
- Reinforce the role of fiscal councils; tasks could include producing macroeconomic forecasts for the budget and costing fiscal measures.
- Fiscal councils could be made fully independent.
- The European Fiscal Board could be made fully independent and placed at the center of a system of independent national fiscal councils.
- Fiscal councils in the euro area currently differ in independence and most do not prepare forecasts or provide costing of fiscal measures.
Concluding Priorities
- Complete the euro-area architecture by:
- Completing the banking union, including a European Deposit Insurance Scheme.
- Completing the capital markets union to improve resilience.
- Establishing a central fiscal capacity to complement monetary policy in severe area-wide downturns.
- Simplify fiscal rules by moving to a single debt anchor and a single operational nominal spending target.
- Respond to constraints on policy rates and transformational pressures via:
- Better information using accrual accounting and PSBS.
- A reinforced system of independent national fiscal councils with an independent European Fiscal Council at its center.
Keynote Address by Vitor Gaspar, Director, Fiscal Affairs Department; Workshop on “Fiscal Rules in Europe: Design and Enforcement”, DG ECFIN, Brussels, Belgium, January 28, 2020.
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