Today’s Eurozone fiscal discipline is the amalgamation of reforms implemented over ten years, with the latest and largest changes agreed in crisis settings. This column argues that the result fosters neither growth nor stability since actual fiscal policy has been powerfully procyclical. The focus on intermediate targets has distracted attention from the final objectives – debt sustainability and economic convergence. A drastic simplification of the current rules is proposed.
In recent years the European fiscal framework has undergone important reforms (see Frayne and Riso 2013). In 2005, the Stability and Growth Pact was amended in order to take country-specific considerations and economic conditions into account.
- In the ‘preventive’ arm of the Pact, targets expressed in terms of nominal balances were replaced by country-specific structural balances, and reference was made to countries’ debts and ageing populations.
- In the ‘corrective’ arm, consideration was given to business cycle conditions, and some allowance was made for structural reforms, as long as they improved fiscal sustainability.
In 2011, with the ‘six pack’, the ‘preventive’ arm was strengthened by adding a benchmark for public expenditures and by introducing a criterion for triggering fiscal adjustment. Moreover, in the ‘corrective’ arm, the required correction was scaled to deviation of the debt to GDP ratio from the 60% objective, so as to make sure that high-debt countries would adjust more. Sanctions were reinforced and extended to the preventive arm.
Most recently, in 2012, 25 EU countries signed an intergovernmental treaty containing the ‘fiscal compact’ – domestic institutions, rules, and procedures should be shaped so as to ensure compliance with the European obligations, for example by introducing a balanced budget rule in the constitution and creating independent fiscal watchdogs.
On the whole, the European fiscal framework has become more restrictive (and more cumbersome), presumably in order to prevent ‘moral hazard’ problems that may arise from the new institutions (European Stability Mechanism, Banking Union) designed to lessen ex post the consequences of poor fiscal discipline. This column evaluates how the EU fiscal framework has worked during the current crisis 2008-2014 and concludes that it should be scrapped.
Figure 1 shows a familiar picture. Following a first severe recession in 2008, fiscal policy in the Eurozone was initially countercyclical, as the average cyclically adjusted balance fell from -4.1% to -5.4% of potential output. In 2009 the EZ average growth rate rebounded (see the purple line), but at the same time an unprecedented fiscal consolidation began – between 2009 and 2014 the average cyclically adjusted balance ratio climbed from -5.4 to -1.3% (see the red line in Figure 1).
Unsurprisingly, the EZ economy plunged again in 2012, showing only weak signs of recovery as of 2014, while the consolidation effort ebbed away. Europe-wide GDP is today about 10% below the pre-crisis level, with unemployment and output gaps at record levels. Notice that the ensuing fall in the rate of inflation (blue line), together with the negative GDP growth rates destabilised debt dynamics – the average net debt ratio in the EZ climbed from 40% to 60% of GDP (green line) during the crisis.
Figure 1. Average net debt/GDP, cyclically adjusted balance (red line), inflation, and growth
An estimated fiscal reaction function
One way to describe the EZ policy rule implicit in the data is to estimate a ‘fiscal reaction function’ (see Gavin and Perotti 1997). For a panel of 18 EZ countries for the period 2008-2014, I regress the change in the cyclically adjusted primary balance (DCAPB) as a ratio of potential output – a measure of discretionary policy – on the past net debt to GDP ratio (DEBT), on the previous year’s primary balance (CAPB), and on the past GDP growth rate (GROWTH). The model includes time and country fixed effects. The coefficient of the lagged primary balance is expected to be negative, as a larger surplus this year should require a lower tightening next year to ensure debt stability. For the same reason, the coefficient of lagged net debt is expected to be positive – lower debt this year should reduce the required tightening next year. Finally, tax-smoothing/automatic stabilisers considerations would imply a positive coefficient on the GDP growth rate, as policy should tighten in good times and loosen in bad times. Consistent with the previous picture, on average the primary balance tightens by more than half a percentage point when the previous year’s balance loosens by one point of potential output (significant coefficient of -.55) – a strong reaction towards a balanced budget.
The results (see the Annex for details) suggest:
- A 1% fall in the rate of growth is associated with a primary balance tightening of almost one fourth of a percentage point of GDP.
Thus, the estimates indicate that the current EZ fiscal framework is delivering a strongly procyclical, i.e. restrictive, impulse.
- The coefficient on the debt ratio is positive, as required by debt sustainability, but very imprecisely estimated, possibly due to the fact that the tightening has adverse consequences on debt dynamics.
A country-by-country disaggregated view adds interesting elements to the picture. On the one hand, the strong policy reaction has accelerated the convergence of budgetary positions across the EZ countries. In Figure 2, each country is a point. On the horizontal axis, I plot the cyclically adjusted balance as a percentage of potential output in 2008; on the vertical axis I plot the change in the balance ratio between 2008 and 2014.
The fact that the dots lie on a negatively sloped line means that countries that in 2008 had a larger deficit position (on the left of the horizontal axis) were those who most improved their budgets (up on the vertical axis). Note, however, that with the exception of Finland and Luxembourg, all the dots (countries) have positive y-coordinates – everybody tightened between 2008 and 2014.
Figure 2. Convergence in structural balances
Figure 3. Divergence in GDP growth
The policy of differentiated and coordinated tightening, together with different supply-side conditions (see Manasse and Rota Baldini 2013) resulted in diverging growth rates (Figure 3), diverging debt ratios (Figure 4), and diverging Inflation rates (Figure 5). Thus the asymmetries that lie at the roots of the EZ problems are today more pronounced than when the crisis began.
Figure 4. Divergence in net debts
Figure 5. Divergence in inflation rates
The actual fiscal framework that resulted from successive stratifications is based on a set of complicated rules and indicators (potential outputs, output gaps, structural unemployment rates, non-accelerating wage rates, cyclically adjusted balances etc.). These are subject to unpredictable revisions (see Tereanu et al. 2014) and have far-reaching implications for policy. By focusing strictly on intermediate targets, such as cyclically adjusted balances, the framework has lost sight of the final objectives, debt sustainability and economic convergence.
What is required is a drastic simplification of the current rules along two directions:
- The ‘corrective arm’ should focus only on the dynamics of a very small number of final targets over a period of, say, three years.
These targets should a) be comprehensible for voters and b) have strong externalities for member countries. Domestic and external debt would suffice.
- Fiscal surveillance, the ‘preventive arm’, should monitor budget deficits merely as early warning indicators of solvency problems along the road (see Manasse and Roubini 2009).
If debt is abated, say, by privatisation rather than by budget tightening, that should be perfectly fine.
If the proof of the pudding is in the eating, it is about time to scrap the current European fiscal framework – before it scraps the Eurozone.
Frayne, C and S Riso (2013), “Vade mecum on the Stability and Growth Pact“, European Commission European Economy Occasional Paper 151, May.
Gavin, M and R Perotti (1997), “Fiscal Policy in Latin America“, in B S Bernanke and J Rotemberg (eds.), NBER Macroeconomics Annual 1997, Volume 12, Cambridge, MA: MIT Press: 11-72.
Manasse, P and I Rota Baldini (2013), “What’s wrong with Europe?“, VoxEU.org, 4 November.
Manasse, P and N Roubini (2009), “‘Rules of thumb’ for sovereign debt crises“, Journal of International Economics 78(2): 192-205.
Tereanu, E, A Tuladhar, and A Simone (2014), “Structural Balance Targeting and Output Gap Uncertainty“, IMF Working Paper 14/107, June.
The regression results discussed in the text are presented here in more detail.
Table 1. Regression results
[95% confidence interval]
 In the analysis I consider the following EZ countries: Austria, Belgium, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Slovenia, Spain, Cyprus, Latvia, Malta, and the Slovak Republic, for the years 2008-2014. The data sources are the IMF and the OECD.