Fiscal rules, what for?

5A fiscal rule can be defined as a constraint on a government’s fiscal policy by imposing numerical limits on public finance aggregates (expenditures, revenues, budget balance and/or public debt). Its two main objectives are the long term sustainability of public finances and the short term stabilization of economic activity.

6Between 1990 and 2015, the number of countries with national and/or supranational fiscal rules surged from 5 to 96. What is the rationale for such rules?

7First, most fiscal rules are in the form of a ceiling on aggregates, such as deficit, public debt or public spending, but not about the details of the components of the budget. A difficulty is that fiscal rules are a constraint on government policies but should not limit democratic choices. They should help to correct identified deficit biases and coordination failures in the complex decision-making process but should not appear as a bureaucratic constraint on democracy. We recognize that this arbitrage between rules and discretion is not an easy one especially in the European context where cultural and political histories have created different views on the balance between the two.

8The general rationale for such rules is to avoid political cycles in public finance which may distort short-term incentives to opt for high deficits today followed by future austerity. [1] Economists have focused on political biases that favour deficits. This is certainly valid in many countries. However, current political debates in some European countries, such as Germany, suggest that a bias favouring surplus may be at work. Fiscal rules are not a magic answer to these biases, but can go a long way in limiting their impact, if they are well designed and implemented. On the contrary, if not well designed and implemented, they can also be a source of instability in particular if they generate pro-cyclical fiscal policy.

The specific need of fiscal rules in the Eurozone

9In a monetary union like the euro area, additional arguments exist to justify the adoption of fiscal rules and the adoption of a common framework. The issue here is that governments do not internalize the long-term impact of their fiscal policy decisions on other European Monetary Union (EMU) members. The externalities go through the potential impact of too expansive (or too restrictive) fiscal policies and debt accumulation by one country on the others.

10Inflationary (deflationary) fiscal policy in one euro-area country could impact the average euro-area inflation targeted by the ECB and trigger a monetary tightening (easing) for everyone. [2] European involvement in the fiscal rule is also justified because fiscal policy has a role both in the build-up and the correction of wage/price divergences, especially in a non-optimal monetary union in which factor movements and purely market-based relative price adjustments across countries cannot efficiently compensate dis-equilibrating developments.

11There could be also a channel through interest rates: an increase in the deficit and debt of one country would lead to higher interest rates in other countries of the euro area. However, this channel has not been empirically relevant and in fact during the Eurozone crisis it may have gone in the opposite direction as investors fled countries with high debt and bought public debt of “safe haven” countries of EMU. This new effect may be an independent justification for fiscal rules to prevent such destabilizing movements in crisis period.

12The distinctive feature of the EMU comprised of sovereign countries is that debt restructuring or debt monetization that may be the consequence of excessive debt accumulation by one country heavily affects the other member countries. There is a risk that ECB may be pressured to use monetary policy to prevent a default in fiscally weak countries via debt monetization. This monetization, i.e. the implicit transfer to the country which public debt is purchased by the ECB, might generate an inflation tax on all EMU countries or lower transfers from central banks to governments. Such transfers are not voted by parliaments and may eventually backlash on the monetary union, as the amounts at stake are potentially very large. This was well understood at the time of the creation of the euro and Article 123 of the Treaty on the Functioning of the European Union (TFEU) expressly prohibits the ECB’ purchase of member countries’ public debt directly from public authorities. In addition, Article 125 of the TFEU prevents any form of liability of the EU for Member States debt obligations (no bailout clause). However, in a situation where there is a risk of a messy default and of a potential exit from the currency union, triggering contagion and collateral damage for all members, the cost of a bailout through financial assistance loans maybe lower than the cost of default and exit. [3] Therefore, the pressure for monetization and/or bailout through financial assistance loans is very strong, reducing the credibility of the no monetization/no bailout rules. [4]

13At various points during the Eurozone sovereign debt crisis, Greece, Ireland, Portugal, Spain and Cyprus had to ask for the support of the other member states in order to avoid a default or a collapse of their domestic banking sector and potentially an exit from the monetary union.

14In addition, expected bailouts may also have reduced market discipline in the sense that the cost of borrowing for some countries may have been too low in the period before the crisis. This may also have reduced the incentive for fiscal prudence such as in Greece in the 2000s. Note therefore that debt sustainability not public deficit per se should be the core objective in the EMU. Note also that macroprudential rules that limit vulnerability of financial institutions are a necessary complement to fiscal rules as we have seen (for example in Ireland and Spain) that bank debts can rapidly be transformed into public debts. [5]

15Finally, because countries in a monetary union loose the monetary instrument to stabilize the economy against asymmetric shocks, the fiscal instrument is a key countercyclical policy tool. Hence, fiscal rules in the EMU, more than in countries with independent monetary policy, must play a countercyclical role.

Proposal for a new public expenditure rule

32Recent contributions advocate the introduction of a fiscal rule based on the growth rate of public expenditure. [14] One advantage of such a rule is that its basic principle is easy to describe: nominal expenditures should not grow faster than long term nominal income, and they should grow at a slower pace in countries with excessive levels of debt. Unlike the cyclically adjusted deficit, public expenditures are observable in real time and are directly controlled by the government. Furthermore, expenditure rules embed countercyclical stabilisation both because cyclical revenue increases have no effect on the expenditure ceiling –inducing stronger fiscal discipline in good times compared to the current rules– and because they do not require cyclical revenue shortfalls to be offset by lower expenditure. This characteristic will be analysed in the next section reporting simulations of such a rule.

33This translates into a two-pillar approach, consisting of a long-term target debt level, such as 60% of GDP; and an expenditure-based operational rule to achieve the anchor. This would work as follows in practice.

34Each year, the government proposes a rolling medium-term (e. g. five-year-ahead) target of reduction on the debt to GDP ratio. This could be part of the existing Stability Program provided each year by member states to the European Commission. Both the national independent fiscal council and the euro area fiscal watchdog are consulted and provide a public assessment of the target in terms of both feasibility and ambition. A discussion follows with the European Commission. The discussion should be based on an economic analysis where the important parameters would be the distance between the actual debt-to-GDP ratio and the long-term target of 60% (the higher the gap, the more ambitious the adjustment); a broader analysis of fiscal sustainability (in particular, to give credit to countries that undertake solvency-improving entitlement reforms, or major reforms expected to raise potential growth); and an economic analysis of the economic situation and the relevant path of debt reduction. As a result, the medium-term debt reduction pace should not be determined by a formula. The Commission then presents its conclusion for the debt reduction targets for each country to the Council that can vote against it by a reverse qualified majority.

35The national fiscal council would prepare a medium-term nominal GDP growth projection based on expected potential output growth; expected inflation; and a possible cyclical correction, in case initial conditions depart markedly from long-run equilibrium. Given the medium-term target on debt reduction, the national fiscal council provides a consistent medium-term nominal public expenditure path and uses it to set a nominal expenditure ceiling for the coming year, for use in the preparation of the corresponding budget.

36Nominal expenditures are calculated net of interest payments, of unemployment spending (except when these are due to discretionary changes to unemployment benefits), and of the estimated impact of any new discretionary revenue measures (changes in tax rates and tax bases). The first two adjustments allow for more counter-cyclicality, while excluding the effect of expenditure-increasing structural measures. The last adjustment is meant to preclude the manipulation of tax rules (for example, tax cuts ahead of an election) that are not compensated by offsetting expenditure measures. But it also allows elected governments to make fiscal policy choices (implying different but consistent long-term levels of expenditures and taxes) that reflect political preferences. For instance, a government that decides a permanent increase of 2 percentage points of GDP of income tax revenues would be allowed by the rule to increase permanently the level of spending by the same amount. This would temporarily increase the growth rate of spending allowed by the rule.

37Limited deviations between actual and budgeted spending could be absorbed by an ‘adjustment account’ that would be credited if expenditures net of discretionary tax cuts run below the expenditure rule, and debited if they exceed it. These types of accounts exist in Germany and Switzerland. If a country passes a budget with no excessive spending but realised spending is above the target, the overrun could be financed without breach of the rule, provided that the deficit in the adjustment account does not exceed a pre-determined threshold (e.g. 1% of GDP). If the threshold has been breached, the country violates the fiscal rule.

38The simulations conducted for this Note by CEPREMAP and the French Economic Observatory –Observatoire français des conjonctures économiques (OFCE)– suggest that during a very large crisis, the fiscal rule may be too stringent. Hence, this militates, as is the case presently, in favour of an escape clause that would allow countries to deviate from the rule in case of ‘exceptional circumstances’. The activation of such a clause would have to be agreed by the Eurogroup, after consultation with the euro area fiscal watchdog.

39We argued that structural budget balance estimates are subject to large revisions, partly due to the uncertain estimates of the output gap. Based on that finding, one might argue that the medium-term potential growth estimates, which are the basis of our proposed expenditure rule, could be also subject to large revisions –but this is not the case. With the exception of the year 2008, even European Commission estimates were subject to rather small revisions. [15] For example, for the EU15 Core countries, the typical revision is about 0.15 percentage points per year. A 0.15 percentage point downward revision in medium-term potential growth estimate would imply that if in spring 2018 a country is allowed to increase expenditures by 3.0 percent, in spring 2019 the allowed growth rate of expenditures is revised downward to 2.85 percent per year. Given that public expenditures amount to about half of GDP, a 0.15 percent revision in expenditures implies a 0.075 percent of GDP impact on the budget balance, which is rather small and well below the impact of revisions in the structural balance. [16]

40Recommendation 1. Adopt a new fiscal rule targeting the growth rate of nominal public expenditures. The growth rate should be constrained by the potential GDP growth rate, the expected inflation rate as well as a debt reduction objective specific to each country. The public spending trajectory must be consistent with the rolling medium-term (e. g. five-year-ahead) target of reduction on the debt to GDP ratio which European countries agree upon.

Simulations of an expenditure rule

41In order to assess the consequences of an application of an expenditure rule, several quantitative simulations done by the OFCE are shown in this note. The structural model providing these simulations is based on the iAGS project, to which OFCE participates. [17] The following form of expenditure rule is simulated: the growth rate of nominal public spending (net of interest payments and of unemployment spending) for country i in year t is the sum of real potential growth, expected inflation [18] minus a debt brake term which takes into account the difference between the observed ratio of debt to GDP and the long term target which we take to be 60%. The parameter associated with the debt brake is important as it drives the speed at which the country converges to its long-term debt target. It should be computed to be consistent with the debt reduction objective at a five-year horizon and should therefore be different among countries. [19]

42A public spending rule with a constant and homogenous debt brake parameter to reach the 60% target does not generate realistic fiscal policy recommendations for certain European countries. In countries with debt level significantly higher than the 60% of GDP, the necessary initial budgetary effort is unrealistically high if, for example, the debt brake parameter is chosen to fit France or Germany. This is the reason we recommend an expenditure rule based on a 5-year country specific debt reduction target.

43This is what is simulated in the technical focus by OFCE: a sequence of budgetary efforts is computed every year in order to reach a debt reduction objective over a five years horizon. [20] The sequence is revised every year based on the new debt level. Debt reduction objectives vary across countries depending on the level of their debt. In this way, the necessary effort is concentrated in the first years and tends to zero with time. Examples of the simulations run by OFCE of France’s debt dynamics and real public expenditures growth rates under three objectives (– 2%; – 4% and – 6% decrease in debt over GDP at a five-year horizon), suggest that depending on the degree of ambition on the 5-year debt reduction target, an expenditure rule can generate debt reduction dynamics that are similar or less stringent than the MTO rule. In all cases of the proposed expenditure, the real growth rate of expenditures for France would converge to a bit less than 1% (therefore less than the potential growth rate assumed to be 1.1%) but with more front loading of the adjustment in the first years. CEPREMAP simulations also show that in order to obtain, on a five-year horizon, a 5 percentage point reduction of the public debt to GDP ratio, an inflection point is necessary early on that itself requires a front loading of fiscal adjustment with a negative impact on growth. [21]

44Next, we analyze the cyclical properties of the rule. This analysis is based on a rule calibrated for France. The rule has good countercyclical properties for unexpected demand shocks. First, the nominal growth rate of expenditures is not affected by the shock and automatic stabilization is at work due to lower revenues and higher deficits. Second, a negative demand shock generates inflation below expectations. As the growth rate of nominal public spending is based on expected inflation, such a shock induces a higher real growth rate of public expenditure and therefore a positive fiscal impulse. [22] Concerning supply shocks, such as oil price shocks generating a fall in output and an increase in inflation, the expenditure rule is still stabilizing because it induces a budget deficit but the higher unexpected inflation slightly reduces its stabilizing properties (relative to the current rule). Overall, if, as is mostly believed, demand shocks are predominant in the Eurozone, we conclude that the expenditure rule has a better cyclical properties than the current rule.

45To illustrate how better are the countercyclical properties of the expenditure rule, the graphs below show the observed growth rate of primary public spending in France and of the fiscal impulse and a counterfactual simulation performed by OFCE of these two series as generated by an expenditure rule. Both graphs below suggest that the rule would be more countercyclical than what was observed in France. During good years the growth rate of public expenditure as well as the fiscal impulse would have been lower. Vice versa, in the period 2011-2013 French fiscal policy would have been less restrictive. Note that the variance in the growth rate of expenditures as generated by the rule appears high in these simulations. One reason is that the expenditure rule is net of discretionary changes in fiscal revenues : for example in 2011-2013, tax rates and revenues were increased so that the rule would gave allowed for a large increase in spending. Our counter-factual simulations take as given tax changes. This is rather hypothetical. Had our rule been in place and followed, no such tax rate increase would have been necessary and thereby the year-to-year expenditure growth rate limit would have not been as erratic as in the simulation. In any case, our rule requires a careful consideration of revenue-side measures. Note however that in 2009, the rule would have implied less fiscal stimulus and this is the reason we advocate to keep an escape clause in case of exceptional circumstances.

2

Nominal growth rate of primary public spending in France for the period 1998-2017, in %, current euro

Nominal growth rate of primary public spending in France for the period 1998-2017, in %, current euro

3

Fiscal impulse in France for the period 1998-2017, in % of potential GDP

Fiscal impulse in France for the period 1998-2017, in % of potential GDP

Reading: The simulation consider actual tax measures as given, like tax cut in 1999 and the tax inceases in 2011-2013

46To summarize, based on our simulations, the advantage we see in the expenditure rule are:

• A country-specific public expenditure rule delivers realistic path for debt reduction, within explicit debt reduction targets;
• The policy prescriptions are simpler to implement as the final recommendations concern nominal public expenditures directly controlled by the government;
• The cyclical properties are generally better than the current rule, in particular in the case of demand shocks.

Creating the right institutions

47A recent literature on fiscal discipline emphasizes the complementary role of fiscal rules and the establishment of national independent fiscal institutions (IFIs) or fiscal councils. [23] Building such institutions is not enough to improve trust in public governance but it is a necessary ingredient.

48The ability of a fiscal council to identify biases of governments’ fiscal and economic forecasts, and to provide competent macroeconomic analysis is essential to its effectiveness. They can provide macroeconomic forecasts for the budget preparation that do not suffer from the optimistic biases often found in official government forecasts. This is even more important because euro area countries appear to have responded to the 3% limit imposed by the Stability and Growth Pact by offering over-optimistic forecasts when they are most in danger of breaching the limit. [24] This is the reason we believe that independent growth forecasts are key especially in the presence of fiscal rules.

49The OECD identifies six conditions to effective independence of such councils:

• Appropriation in the national fiscal framework (integration into the national budget process with evaluation of the medium-term sustainability of public finances, realization of budget estimates on behalf of the government, counter-expertise and analysis economic and fiscal scenarios of the government, information of parliamentary debate…);
• Adequacy of the human and financial resources with the mandate;
• Access to relevant information at all times (this means establishing formal information exchange systems with national administrations and the national government);
• Credible communication in real time;
• Impartial stance and accountability of the Independent Fiscal Institutions (IFI) based on past records;
• Strong links with Parliament (set up regular hearings of the National Budget Board Executive Board in Parliament, as well as technical sessions with parliamentary budget committee).

How to enforce the rules?

60Introducing a new expenditure based fiscal rule is a necessary yet not sufficient step for an effective fiscal framework. The actual enforcement of the rule is crucial. The traditional view is that this should be done by increasing the cost, both economic and political, of non-compliance. This is certainly part of the solution but there is no silver bullet here in particular because political sensibilities, history, culture and beliefs shapes the views on the optimal trade-off between rules versus discretion. Experience suggests that enforcing compliance through penalties imposed by what is seen in many countries as Brussels bureaucracy or Berlin political might has its own deficiencies. European fiscal rules were sometimes used as a scapegoat by national governments, which preferred to blame them for a necessary fiscal adjustment rather than past profligacy.

61Under the current fiscal framework, non-compliance is theoretically subject to fines, amounting to up to 0.5% of a member state’s GDP. Large fines are not credible, as they do not pursue an economic purpose apart from penalty, and might exacerbate an already fragile fiscal stance. This creates a time consistency problem: ex ante everyone agrees that credible sanctions are important to enforce the SGP, but once the SGP is violated, imposing that sanction may do more political and economic harm than good. In addition, the recent literature emphasises the political economy deadlock of such a compliance mechanism in the EU. As fines are voted at the majority of the European Council, a bad coalition may arise: one Minister might prove reluctant to vote in favour of sanctions against another member state, in order not to be voted against should a similar situation arise for him: we should not rely on Finance Ministers to impose discipline on each other. The introduction of reversed qualified majority following the Eurozone crisis did not break the status quo. An alternative to monetary fines paid by member states to the EU would be conditioning EU budget payments to member states on respecting fiscal rules: such a system would face exactly the same problems as the problems of current fines described above. Moreover, EU budget payments serve EU goals and therefore suspending them would harm EU goals.

62We believe that the European fiscal framework is stuck in a corner solution where all the weight of compliance has been put on rules and fines and not enough on domestic institutions and market discipline. In our view, a mix of rules, domestic institutions and market discipline can help although each has their own costs and advantages. On top of the institutional surveillance described above, the reform should focus in two main aspects: sticks and carrots.

63Rewards. One possibility is to relate the enforcement of fiscal rules to the creation of a fiscal capacity for the Eurozone. In a sense, this also shifts the mechanism from using sticks to offering carrots. For example, the participation in a fiscastabilisation scheme that offers one-off transfers in case of large downturns could be made conditional on the compliance with fiscal rules. The same condition can apply to the right to benefit from low-cost ESM lending for prequalified countries (lending even when countries have not lost market access and when there is no imminent financial stability risk to the euro area as a whole). The access to this ‘flexible’ ESM facility could be made conditional on compliance with fiscal rules, as proposed by the “Fourteen economists report” [26] and the June 2018 Council declaration.

64Sanctions. Market discipline should also be part of the package even if it has not worked well in the past. In the 2000s, markets did not discipline countries that were running imprudent fiscal policies –or imprudent financial policies that gene rated excessive private leverage– and during the euro crisis market discipline over-reacted with mechanisms of self-fulfilling expectations where the fear of default and exit were pushing the cost of financing of several countries to levels that were driving them towards default. Steps have already been taken to guide market discipline. For example, the introductions of collective action clauses to government bonds will likely help to avoid the pre-2007 market complacency. This has to be accompanied by instruments that reduce the danger that default risk transforms itself into redenomination risk. This is one objective the Outright Monetary Transactions (OMT) instrument by the ECB and it is important to keep this instrument in the toolbox to help to contain self-fulfilling expectations. Market discipline that prices default risk should not be eliminated. Redenomination risk is different in nature and should not be allowed to destabilize the Eurozone.

65One can go one step further to guide market discipline towards giving the right incentive for fiscal prudence. One possibility is the proposal to force countries that violate the fiscal rule to issue junior bonds to finance expenditures in excess of the fiscal rule. [27] The advantage of this proposal is that it applies not on the stock of existing debt but on a portion of the flow of the new debt necessary to finance excessive expenditures. Hence, discipline is applied where it is most useful in terms of incentives, i.e. at the margin to increase the marginal cost of financing excessive expenditure flows. Governments that decide to spend in excess of the spending rule would have to explain their economic and political rational to do so and the marginal cost of such spending would depend on the motives and credibility of the government plans.

66In case of repeated deviation to the rule, issuing junior bonds can also protect existing bondholders, by creating a buffer of junior sovereign debt that will be restructured first. This is akin to debt covenants protecting the interests of creditors in privately issued debt, and could in fact lower the average cost of debt issuance. The proposal has been criticised in particular because there is no experience of countries issuing such junior debt and that this creates a precedent that acknowledges the possibility that Eurozone countries may default on some of their debt. However, only countries that repeatedly violate the fiscal rule would accumulate a large amount of junior debt. Also, the cost of issuing junior sovereign bonds may depend on market conditions largely outside the control of the government such as monetary conditions or general risk appetite. This is however a characteristic of governments financing that also applies to senior sovereign debt. In addition, the issuance of junior bond may not be automatic but imposed after some analysis showing that this issuance is not destabilizing. This path towards enhanced market discipline requires futher analysis.

67Recommendation 4. Transfer surveillance to well-equipped national fiscal councils, coordinated and overseen by a European fiscal council. Subject the access to a “flexible” ESM credit line and the participation in euro area-wide fiscal stabilisation instrument to compliance with the fiscal rule.

68A further “stick” would be to increase the political cost of deviating from the fiscal rule, in line with objective to renationalize the fiscal debates. For example, whenever the national fiscal council concludes that the rule is not respected, it should hold a press conference and the Minister of Finance should testify in front of the national parliament. When the European Fiscal Council concludes that the deviation from rule is major, the Minister of Finance should also testify in front of the European Parliament.

69Recommendation 5. In case of non-compliance with fiscal rules, as concluded by the national fiscal council introduce national “comply or explain” procedures for the Minister of Finance in front of the parliament and the press in member states, and in front of the European Parliament in the case of a major deviation as concluded by the European fiscal council.

Legislative changes needed to introduce our proposal

70The EU fiscal framework is based on three types of laws: the TFEU, the SGP and the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union (TSCG), an intergovernmental treaty signed by 26 countries, [28] which is frequently called Fiscal Compact.

71We presume that the EU Treaty will not be changed soon, because that would require complicated negotiations and a difficult ratification process. The 6-Pack and 2-Pack regulations (SGP) could be changed by the co-decision of the Council and the European Parliament, which should be feasible. A change in TSCG is probably much easier than changing the EU Treaty, yet that would also necessitate national ratification, which in some countries requires a referendum.

72Article 126 of TFEU says that “Member States shall avoid excessive government deficits” and includes two indicators to assess such a situation: the budget deficit should not exceed 3% of GDP (unless the excess is small and temporary), and the public debt should be below 60% of GDP, or if larger “the ratio is sufficiently diminishing and approaching the reference value at a satisfactory pace” (the 3% and 60% reference values are defined in the annex of the TFEU).

73Our proposed expenditure rule is fully in line with the public debt criterion of the Treaty, since a major aim of our proposed rule is to reduce public debt. However, our proposed rule does not necessarily comply with the 3% deficit threshold which if it was breached would not necessitate an immediate fiscal adjustment to reduce the deficit below 3%. Yet such a situation would not violate the Treaty, because Article 126 of TFEU gives the right to the Council to decide about the period by when the excessive deficit will have to be addressed. Thereby the Council could consider the opinion of the European Fiscal Council about the timing and the measures, a process which respects the requirements of the proposed expenditure rule.

74There could also be cases when both the 3% deficit and our proposed expenditure rules are violated, and it is also possible that the expenditure rule is violated, while the deficit does not breach the 3% of GDP reference value. Therefore, there are three possible cases of violations: the 3% deficit rule is violated but the expenditure rule is obeyed; both the 3% deficit rule and the expenditure rule are violated; or the 3% deficit rule is obeyed but the expenditure rule is violated. Such situations are different and require different interventions. In the first case, we recommend a ‘light’ EDP, whereby the Commission carefully considers the opinion of the European Fiscal Council. When our proposed expenditure rule is violated (cases 2 and 3), the ‘normal’ level of the EDP should be applied and we should consider the positive and negative incentives discussed previously.

75Finally, The Fiscal Compact is mostly in line with the new rule we propose. The two most relevant regulations of the Fiscal Compact are the minimum requirement for the medium term objective of the structural balance for Eurozone countries (– 0.5 or – 1.0%) and the 1/20^th debt reduction rule from the 6-Pack.

76The concrete MTO values are not in contradiction with our proposed rule, because that would lead to a close to balance budget in the long term. Therefore, keeping these numerical requirements as long run requirements (if no specific annual changes in the structural balance is required) would not be in contradiction with our proposed rule. But the 1/20^th debt reduction rule is in contraction with our proposed rule, since we argued for a moving 5-year debt reduction target, which might be lighter (but also tighter) than the 1/20^th rule. Therefore, the Fiscal Compact should be revised along with the SGP (6-Pack regulations).