Ed Dolan's Econ Blog

Can New Fiscal Rules Save the Euro? Three Details to Watch For

Yesterday  Angela Merkel and Nicolas Sarkozy announced a new set of fiscal rules, their latest idea to save the euro.  The new rules would replace the unworkable Stability and Growth Pact (SGP), which mandates a deficit of no more than 3 percent of GDP and debt of no more than 60 percent of GDP. Yesterday’s announcement was short on specifics, but here are three crucial things to watch for that will determine whether the new rules will have any chance of working.

1. Will deficit rules avoid procyclicality?

Sound fiscal rules must keep budgets in balance over the business cycle, but they must also allow deficits during recessions, balanced by surpluses during expansions. Any rule that forces austerity during a downturn is procyclical. It will do more harm than good.

The balanced budget amendment promoted by Republicans in the U.S. Congress is an example of how not to design a budget rule. The amendment would require strict annual balance for the U.S. federal budget, year in, year out. Keeping it in balance would require cutting expenditures or raising taxes during downturns, making the downturns worse. At the same time, it would provide inadequate incentive to run the surpluses that are needed during expansions in order to reduce previously accumulated debt.

To avoid procyclicality, any budget rule must,  at a minimum,  allow full operation of automatic stabilizers—those features of the budget that increase expenditures during recessions (such as unemployment benefits) and increase tax revenue during expansions (such as progressive income taxes). One way to allow full operation of automatic stabilizers is to require that each year’s budget be in structural balance, that is, that tax and expenditure laws  be written in a way that would produce balance if real GDP achieved its potential level. Chile’s growth-friendly fiscal discipline is based on such a structural balance rule.

Better yet would be a rule that requires balance over the business cycle but allows discretionary, countercyclical changes in taxes and expenditures. Sweden provides an example. Any such rule is more technically complex and requires a greater degree of political discipline, but it also provides significantly more flexibility.

The 3 percent maximum deficit of current EU rules allows some flexibility during downturns, but not enough. It can still require destabilizing austerity during a severe downturn, and at the same time, it does not provide an adequate incentive to run a surplus during expansions. A key test for any new EU rules will be whether they move away from the maximum deficit approach to one that emphasizes balance over the business cycle.

2. Will there be a credible system of rewards and penalties?

New rules will be no good if they do not include an appropriate set of rewards and penalties. The current EU rules, which call for procyclical fines against countries that exceed the maximum deficit limit, are completely unworkable. The current rules have never been enforced because everyone knows enforcing them would be counterproductive. If the rules are bad, making their enforcement automatic, as some are talking about, or turning enforcement over to the European Court of Justice, would only make them worse.

What might a workable set of rewards and penalties look like? One possibility would be financial penalties that are payable only during a subsequent expansion. They could take the form of increased contributions toward EU-wide funds or increased mandatory reductions in the offending country’s own debt.

An alternative would be rewards for good fiscal performance rather than penalties for violations. One idea that has been floated is to allow countries that meet fiscal policy guidelines to participate in issuing  jointly guaranteed eurobonds, thereby reducing their borrowing costs. Unfortunately, that particular idea will not work unless Germany agrees to put eurobonds back on the agenda.

Still another alternative would be noneconomic rewards and penalties. One form of noneconomic penalty could be a temporarily reduced voice in EU-wide decision-making bodies. An example of a noneconomic reward could be the right to reduced central monitoring of fiscal policy for countries that achieved a good record of compliance. Even symbolic rewards and penalties might help. Perhaps the leaders of noncompliant countries could be made to stand in the back row when ceremonial pictures are taken at summit meetings.

3. Who will monitor compliance?

Smart fiscal rules that call for structural balance and include delayed rewards and penalties will be technically more complex than the present 3/60 rule. It will be necessary to score each country’s budget proposals in advance of implementation. Doing so will require estimates of economic variables like potential GDP and output gaps that are not directly observable. Crunching the numbers to assess compliance is a job that must be assigned not to courts or politicians, but to competent experts who are as insulated as possible from political influence.

The United States has its nonpartisan Congressional Budget Office that fulfills this function with at least limited success. Sweden and Chile have comparable bodies that seem to function. Creating such a body for the EU as a whole, however, would pose special challenges. To be politically acceptable, it would have to avoid the appearance of domination by the largest member countries. To be workable, it would have to avoid the possibility of national veto. Forming such a body will be one of the most difficult parts of implementing any new rules.

Even the best rules to guarantee fiscal discipline may not be enough to save the euro at this point. Fiscal imbalances are far from the only problem of the euro area. There are trade imbalances, private sector financial imbalances, a fragile banking system, and a need for deep structural reforms. But better fiscal policy rules are a necessary condition. Let’s hope that EU leaders get the details right this time.

One Response to “Can New Fiscal Rules Save the Euro? Three Details to Watch For”

shiv139December 16th, 2011 at 7:57 pm

I also think that a balanced budget works best with a cyclically adjusted approach. However, a balanced budget over a cycle needs to also be supported with a balanced trade account. See what Germany is saying and it makes no sense. Germany had big trade surplus and so a lot of Euro's invested in places which cannot afford to re-pay it. So now Germany asks the borrower to deflate their economy, so that they can become competitive and export to create a surplus and thus repay them. But Germany with austerity is the buyer and they are not buying. Okay, so if Italy and Spain trade with an outside EZ partner, they end up creating a surplus with a trade deficit nation who may not be able to repay – it shifts and does not solve the problem. So really, the whole world needs to move towards balanced trade accounts!