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Summary of "European fiscal rules require a major overhaul"

Core Content

This policy contribution argues that the current European fiscal rules need a major overhaul to better support fiscal sustainability and macroeconomic stabilisation in the euro area. The authors, Zsolt Darvas, Philippe Martin, and Xavier Ragot, highlight the flaws in the existing framework and propose a simplified fiscal rule that would allow for more flexible and effective fiscal policy.

Main Viewpoints

1. Need for Fiscal Rules in the Euro Area

• Fiscal rules are necessary in the euro area to ensure debt sustainability, especially given the lack of a credible no-bail-out clause.
• The euro area's monetary union structure means that fiscal policy can significantly impact other members, particularly in the context of potential defaults or exits from the union.
• The rules should support countercyclical fiscal policy, as countries in a monetary union lack the ability to use monetary instruments to stabilise their economies during asymmetric shocks.

2. Deficiencies of the Current Framework

• Complexity: The current fiscal framework is overly complex, leading to a lack of transparency and making it difficult for policymakers to internalise the rules.
• Measurement Issues: Structural budget balance, a key component of the rules, is not directly observable and is subject to large estimation errors. Output gap and potential growth estimates are particularly uncertain.
• Pro-cyclicality: The existing rules have led to pro-cyclical fiscal tightening, which exacerbated the economic downturn following the 2008 crisis.
• Non-compliance: Compliance with the rules has been weak, with many countries frequently exceeding the 3% deficit threshold and failing to meet debt reduction targets.
• Lack of Enforcement: There is no effective enforcement mechanism, and flexibility has been misused to avoid sanctions.

3. Proposed Reform

• A new fiscal rule is proposed: nominal expenditures should not grow faster than long-term nominal income, with a slower growth rate in countries with excessive debt levels.
• This rule is designed to be transparent, simple, and flexible, allowing for countercyclical policy during downturns and promoting fiscal discipline during good times.
• The rule should be implemented within a national and European institutional framework, involving consultation with independent fiscal councils and the European Commission.

Key Information

Current Fiscal Rules

• Budget deficit: Must be below 3% of GDP.
• Public debt: Must be below 60% of GDP, with annual reduction if above.
• Structural budget balance: Must be above the country-specific medium-term objective (MTO), which is at least -0.5% of GDP for EMU countries.
• Real expenditure growth: Cannot exceed potential growth if the structural balance is at or above the MTO.

Issues with Structural Budget Balance

• Structural balance estimates are highly uncertain due to output gap and potential growth miscalculations.
• Revisions of structural balance estimates can be as large as the initial estimates, undermining policy credibility and effectiveness.

Example: France

• The authors suggest improving the role of the French independent fiscal council (Haut-Conseil des finances publiques) by expanding its mandate to include endorsement of fiscal forecasts and debt sustainability analysis.
• This would help ensure better alignment between fiscal policy and long-term economic goals.

Institutional Framework for Reform

• A two-pillar approach is recommended: a long-term debt target (e.g., 60% of GDP) and a nominal expenditure rule.
• The European Commission should play a role in reviewing and approving debt reduction targets, with the Council of the EU able to vote against them.
• Adjustment accounts could be used to manage limited deviations from the expenditure rule, provided they do not exceed a pre-determined threshold (e.g., 1% of GDP).
• An escape clause should be introduced to allow for flexibility during major crises, with activation requiring agreement from the Eurogroup and the euro-area fiscal watchdog.

Conclusion

• The authors stress that fiscal rules are not a substitute for national democratic debate but should help frame it.
• A simplified, transparent, and countercyclical fiscal rule is needed to enhance the credibility and effectiveness of the European fiscal framework.
• The proposed reform aims to reconcile fiscal prudence with macroeconomic stabilisation, ensuring that the euro area can better manage both good and bad economic times.