The Economics of Fiscal Rules and Debt Sustainability

DOI: 10.1007/s10272-022-1021-1 Forum Intereconomics, 2022, 57(1), 11-15 JEL: E62, H6 Roel Beetsma* The Economics of Fiscal Rules and Debt Sustainability Because they exert cross-border spillover effects, fiscal policies of individual EU member states are a common concern for the entire EU. An expansionary fiscal stance in one country raises imports from other countries, thereby stimulating their economies (Beetsma et al., 2006; Alcidi et al., 2015). But it also pushes up the country’s public debt and magnifies solvency risk, which may spill over to other member states or force them to come to the financial rescue. These spillovers provide the main rationale for the EU’s Stability and Growth Pact (SGP), the most visible elements of which are the 3% of GDP reference value for the deficit and the 60% reference value for the public debt.1 The SGP strengthens the EU Treaty’s “no-bailout” clause by which countries or EU institutions are forbidden to bail out a country in financial difficulty. The rationale behind the clause is that a credible no-bailout policy limits moral hazard on the side of governments. Knowing that no other party may come to the rescue, they will behave responsibly; otherwise, financial markets will force them to do so. In effect, the SGP is the answer to the fear that markets cannot adequately fulfil this role, creating a risk that the no-bailout clause will be tested, which is exactly what has happened. The advice of the European Fiscal Board In the year before the eruption of the coronavirus crisis, the European Fiscal Board (EFB, 2019) offered President Juncker of the European Commission advice. It concluded that high debt ratios had not been sufficiently reduced, especially in periods when this was opportune; that national fiscal policies were too often procyclical; and that the flexibility in the rules had not prevented governments from cutting back on public investment or, more broadly, growth-friendly 1 See Buti and Gaspar (2021) on the history of these reference values. In the following, we will refer to these as “ceilings”, although they are not absolute ceilings that can never be exceeded. © The Author(s) 2022. Open Access: This article is distributed under the terms of the Creative Commons Attribution 4.0 International License (https://creativecommons.org/licenses/by/4.0/). spending. Failure to take advantage of good times by building buffers resulted in unwarranted budgetary contraction during bad times, the most pronounced example being the period 2011-2013, when countries recorded large improvements in their structural balance at a time of highly negative output gaps. Expenditure slippages went into higher current spending, not into investment. The SGP had numerous ailments: (i) rules were complex and opaque, based on unobservable indicators, while the use of multiple indicators allowed cherry-picking so as to give countries the benefit of the doubt when needed; (ii) medium-term planning was weak, while planned adjustment was back-loaded; and (iii) political considerations interfered with economic assessment, while surveillance was becoming increasingly bilateral between the Commission and the country surveyed. The EFB (2019) essentially reiterated the revision proposed in its Annual Report 2018 (EFB, 2018). First, the EFB (2019) suggested imposing one fiscal anchor, a debt ceiling at 60% of GDP: the focus would be on sustainability, while its advantage would be its simplicity and observability. Second, it recommended the creation of an expenditure benchmark as a single operating indicator, which is under the control of the government, imposing a ceiling on primary expenditure growth equal to potential output growth,2 with a correction factor to bring excessive debt down to 60% (in 15 years).3 This would create a built-in stabilising effect: In periods with actual growth below potential growth, spending growth would exceed actual GDP growth, thereby providing economic stimulus and vice versa in periods with actual growth exceeding potential growth. The spending ceiling would be fixed over the coming three years, after which it would be recalculated. This medium-term orientation would avoid un- 2 Open Access funding provided by ZBW – Leibniz Information Centre for Economics. * The author thanks Michel Heijdra for comments on an earlier version of this paper. The views in this paper are the author’s personal views and should not be attributed to any institution he is affiliated with. Roel Beetsma, University of Amsterdam, Netherlands; and European Fiscal Board, Brussels, Belgium. ZBW – Leibniz Information Centre for Economics 3 As is the case for the output gap and the structural balance, potential output growth is not directly observable either. Measurement error is smaller because by taking growth rates, measurement error in the assessment of the level of potential output largely washes out. Claeys et al. (2016) point to the smaller revision errors in medium-term potential growth estimates when compared to changes in the structural balance. However, Barnes and Casey (2019) demonstrate a positive pass-through from revisions in actual to revisions in potential output, which could lead to pro-cyclicality of a spending rule linked to potential output growth. Long-term debt anchors in combination with an intermediate spending ceiling have been proposed by others as well, for example Bénassy-Quéré et al. (2018) and Darvas et al. (2018). The ceiling would correct for discretionary revenue measures and cyclical spending (on unemployment benefits). This way the ceiling gives room to the automatic stabilisers on both the spending and revenue side. A ceiling based on nominal growth would allow additional room for stabilisation if demand shocks dominate: when demand is low, actual inflation undershoots its forecast and spending is allowed to grow even faster relative to actual output. 11 Forum due policy fluctuations. Third, the EFB recommended introducing a single escape clause replacing all existing flexibility provisions. This would do away with the current “complete contract” approach. And finally, it suggested demarcating policy decisions from economic analysis. The escape clause would be triggered by an independent analysis leading to independent advice that decision-makers at the political level would either follow or deviate from with a motivation. Figure 1 Debt developments by country group Gross government debt, % of GDP 140 BE, EL, ES, FR, IT, CY, PT 120 100 DE, IE, HR, HU, MT, NL, AT, SI 80 60 40 The COVID-19 crisis has strengthened the case for reform BG, CZ, DK, EE, LV, LT, LU, PL, RO, SK, FI, SE 20 The crisis has made a revision of the SGP even more urgent. Ideally, the time before the deactivation of the SED clause would be used to design a reform of the pact and get countries to agree on the reform, a position also taken by EU Independent Fiscal Institutions (2021).4 However, due to the expectation that the SED clause will be l (...truncated)