27-30 January 2003 Santiago de Chile XV Seminario Regional de Pol

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27-30 January 2003 Santiago de ChileXV
Seminario Regional de Política Fiscal Daniele
Franco
The Debate on EMU Fiscal Rules
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OUTLINE
a) EU fiscal rules b) Fiscal outcomes in
1992-2001 c) Criticisms of EU rulesd)
Challenges to EU fiscal policies
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1992 European Union countries decide to create
a monetary union (Treaty of Maastricht) 1999
exchange rates of eleven countries irreversibly
locked (Greece joins in 2001) 2002 euro coins
and banknotes replace national currencies New
development many sovereign countries share a
common currency and retain fiscal
responsibility ? extensive implications for
fiscal policy
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The need for EU fiscal rules
Budgetary discipline widely recognised as
essential condition for EMU success Fiscal
rules considered necessary to? prevent moral
hazard? avoid externalities of deficits and
debts? avoid pressures on European Central
Bank for ex-ante ex-post bail-out
Rules necessary also for contingent reasons ?
obtain radical changes in policies ? rapidly
ensure credibility of EMU ? select EMU Member
States
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The development of EU rules
Gradual development of rules 1992 Treaty of
Maastricht set deficit (3) and debt (60)
conditions for access to EMU, but left open
issues 1997 Stability and Growth Pact (SGP)
defined rules to accompany EMU on a
permanent basis 1999? specification of
operational aspects (e.g., target year for
reaching balanced budget)
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Main aspects of EU rules
1) deficit should not exceed 3 of GDP unless
? exceptional events ? excess is temporary
? excess is limited 2) close-to-balance or
surplus target over the cycle 3) multilateral
surveillance (stability programs,
notifications) 4) excessive deficit procedure
(from recommendations to sanctions) 5)
common statistical framework
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EU rules vs federal countries rules
EU approach is stricter ? rules defined with
reference to numerical parameters ? ex-ante
and also ex-post compliance required ? non-comp
liance triggers predefined pecuniary
sanctions ? flexibility margins defined ex-ante
for exceptional factors ? no special
provision for investment spending Multinational
dimension requires formal predefined solutions
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Why these rules?
1) Multinational context limited available
solutions cannot have implicit rules
applying to many sovereign countries
2) Solutions influenced by contingent
factors(i) problematic fiscal developments
? high deficits and rising debts ? rising tax
burden ? pro-cyclical policies? need to
obtain radical changes in policies? need to
rapidly ensure credibility of EMU (ii) need to
select EMU members? rules for selection applied
in steady state
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EU rules vs Kopits-Symansky criteria
Ideal fiscal rule EU fiscal
rules Well-defined Transparent
Simple Flexible
Adequate relative to final goal
Enforceable Consistent
Underpinned by structural reforms
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EU rules vs Inman criteria
Criteria Strong rule EU rules Timing for
review Ex post Ex post Override by majority
rule Not allowed Not allowed Enforcement Enforce
r Independent Partisan Access Open
Closed Penalties Large Large Amendment Pro
cess Difficult Difficult
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Fiscal outcomes up to 2000
? EU rules successful up to 1998 (deficit
declines 6.4 ? 1.7) ? 1999-2000 EU
governments introduced tax cuts, without spending
cuts (deficit about stable 0.8 ? 0.7) ? EU
and US similar deficit levels in early 1990s,
but US improve budget balance faster and
longer ? Fiscal consolidation
expenditure-based in EU, spending-and-tax-based
in US 1993-2000 GP/GDP T/GDP USA -3.4
2.4 EU -4.7 0.7
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Fiscal outcomes 2000-2002
? EU reaction to downturn milder than US
Budget balance 2000 2002 EU -0.7
? -1.7 US 1.5 ? -2.6 GP/GDP
T/GDP USA 1.7 -1.8 EU 1.5
-0.5 ? Four EU countries close or above 3
deficit limit. - either avoid discretionary
anti-cyclical policies / adopt pro-cyclical
policies - or neglect rules ? loss of
credibility ? New discussion on EU rules
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Conflicting views
"The stability pact is a vote of no confidence
by the European authorities in the strength of
the democratic institutions in the member
countries. It is quite surprising that
EU-countries have allowed this to happen, and
that they have agreed to be subjected to control
by European institutions that even the IMF does
not impose on banana republics. Paul de Grauwe,
Financial Times, 25 July 2002"Of course, the
stability pact restricts the room for manoeuvre
enjoyed by national fiscal policymakers. But this
is the price that must be paid for a common
currency. Historically, stability between
currencies has been possible only when countries
have been prepared to relinquish some national
sovereignty. H. Siebert, Financial Times, 6
Aug. 2002
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Criticisms 1 There is no need for fiscal rules
Rules lead to sub-optimal solutions. Better rely
on discretionary decisions? Either rely on wise
governments or on effective financial
marketsHigh deficit ? high interest rates ?
pressure on government ? consolidationbut (i)
sufficient information? (ii) timely reaction
of markets? (iii) timely reaction of
governments? ? a risky solution with 12 (? 25)
sovereign countries
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Criticism 2 rules are necessary but there are
better rules
Core issue What rules would we want if we
could start again from scratch? Are there
rules clearly more intelligent than the SGP?
Critical aspects of EU fiscal rules? reduce
budgetary flexibility? work asymmetrically? di
sregard aggregate fiscal stance? discourage
public investment? focus on short term
commitments and disregard structural reforms
? too demanding for countries in sound
positions
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Fiscal stabilisation
? EU rules designed to combine a sound
fiscal position (3 deficit limit) and
budgetary flexibility in recessions
(structural balanced budget)? Deficit
fluctuates over cycle (automatic stabilisers
can operate - contrary to past EU experience)
? But (i) problems in the initial
transition to balanced structural budget
(ii) asymmetric structure of incentives
sanctions for deficits ? 3 but no
incentive to avoid loosening in
upswings? Need policy-makers with medium or
long-term views
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Fiscal co-ordination
? No explicit co-ordination procedure.
Implicit rule-based co-ordination let
stabilisers work over the cycle ? In some
circumstances aggregation of national fiscal
policies may not result in optimal area fiscal
stance - free-riding in stabilisation in bad
times? - pro-cyclical policies in good times?
? However, supranational co-ordination
would be problematic - different cycles
policy views - forecasting timing problems
- enforceability of decisions? Does the EU
need a federal budget?
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Public investment
Balanced budget ? tax-finance for public
investment Risk reduction of capital
accumulation Transition period problematic pay
for new investment and pay back debt Exclude
public investments from deficit rule (golden rule
or dual budget)? but what is capital
spending? bias in favour of physical capital
contrasting evidence on effects of public
investments on growth multilateral
surveillance more complex (e.g., evaluation of
depreciation) bigger role of private sector
in infrastructure development
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Long-term fiscal sustainability
? no reference to long-term indicators in EU
rules. Outcomes are assessed on a yearly basis
? this can discourage some tax and pension
reforms (PAYG ? funding) involving a temporary
deficit ? but the use of sustainability
indicators (e.g., projections, generational
accounting) would be problematic (e.g.,
comparability) ? moreover, balanced budget
forces reforms and determines fast debt
reduction
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Alternatives to the SGP?
1) fiscal co-ordination at EU level 1a) one
EU fiscal policy 1b) co-ordination of national
policies 1c) a market for deficit
permits 2) fiscal institutions and
procedures 2a) national budgetary procedures
2b) institutional reform (Fiscal Policy
Committee) 3) different numerical rules
3a) golden rule 3b) expenditure
rule 3c) permanent balance rule 3d) debt
sustainability pact
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EU rules a preliminary conclusion - 1
? EU without rules new experiment. Will have
to rely on financial market discipline. Leap
in the dark? ? Greater EU integration would
allow more flexibility, but unlikely in
medium- term ? EU rules related to
traditional solutions balanced budget with
exception for cyclical and exceptional events
(but not for investment) ? EU rules present
some problems, but no alternative solutions
clearly superior ? Rules-based co-ordination
necessarily somewhat inflexible (implicit
mistrust of other countries behaviour)
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EU rules a preliminary conclusion - 2

• EU enlargement if current EU members do not
  respect rules, can EU ask new members to do
  so?? Radical changes of rules are very
  difficult (need unanimity). Risk revisions can
  reduce credibility ? Can EU rules survive
  the current slowdown? If not, can monetary
  union survive (with up to 25 countries)??
  If rules survive, there is room for
  improvement country differentiation,
  pro- cyclical bias in good times, transparency?
  Rules can be effective and not harmful only
  if governments endorse their spirit and are
  prepared to make efforts

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Are fiscal rules the problem?
the debate on EU rules may divert attention away
from more relevant issues EU economic
performance is unsatisfactory in terms of
growth, activity and employment rates
EU USAGDP growth rate 1985-1990 3.
2 3.4 1991-2000 2.1 3.3Unemployment
rate 1991 8.1 6.8 2000 8.1 4.0 Labour
market participation rate 2000 69 78
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Fiscal challenges
? EU large public sectors and high tax
burdens induce distortions
inflexibility? economic integration increase
tax competition and revenue losses reduces
? greater burden on less mobile bases ?
inequity, distortions? the ageing process
increases spending 2000 2050 EU12
18.0 24.5 USA 11.2 16.7? ? need
for structural reforms ? a tight budget
constraint may increase the pressure to
introduce expenditure reforms and accelerate
debt reduction
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Fiscal co-ordination - 1
1a) Move to single EU fiscal policy one money ?
one fiscal policy Solve flexibility and fiscal
stance problems but are we ready for a federal
country? 1b) Co-ordinate aggregate fiscal
stanceHave an aggregate stability programme 3
limit applies to area deficit (or can even scrap
limit). Political allocation of deficit permits
Solve flexibility and fiscal stance problems
but ? national sovereignty problem
? different cycles policy views? conflicts in
allocation of deficits ? forecasting timing
problems ? enforceability of decisions (regions,
etc)
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Fiscal co-ordination - 2
1c) A market for deficit permits Set total
volume of deficit permits let countries
trade(A. Casella - drawing from markets for
pollution rights)Solve flexibility
aggregation problems but initial
allotment of rights? small number of
traders different countries ? different
externalities who can predict cycle and
set amount of rights?
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Fiscal institutions and procedures - 1
2a) Reform national budget procedures Introduce
institutions and procedures conducive to
responsible fiscal policy ? attack deficit bias
at roots e.g. rules about presentation,
adoption and execution of budgets. Hierarchical
procedures more conducive to fiscal discipline
than collegial procedures. But full
agreement on solutions? national sovereignty
problem reforms difficult to monitor what
if (apparently) correct solutions do not deliver
results? need time for testing
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Fiscal institutions and procedures - 2
2b) Introduce Fiscal Policy CommitteeAssign to
FPC (accountable to Parliament) management of
stabilisation policies on the basis of predefined
mandate and judgement FPC responsible for
setting the budget balance within debt
sustainability constraint defined over a number
of yearsFPC expected to deliver both long-term
sustainability and short-term stabilisationProbl
ems (i) difficult to separate stabilisation
from allocation distribution(ii) government
interference (appointments)(iii) need time for
testing
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Numerical fiscal rules - 1
Given multinational context and need for rapid
results ? permanent numerical constraints on
domestic fiscal policy in terms of indicator of
overall fiscal performance simpler to
evaluate compliance easier to grasp by
public opinion and policy-makers solution
based on long debate on budgetary rulesWhat
rule? golden rule, expenditure rule, debt rule
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Numerical fiscal rules - 2
3a) Exclude public investments from budget
balance (golden rule) Solution adopted in some
countries and decentralised governments Dual
budget (current capital) old issue (Musgrave,
1939) long debated (Sweden) Main
pro spreading cost of durables over time
(analogy to private sector finance) But wha
t is capital spending? (opportunistic
behaviour) bias in favour of physical
capital unlimited borrowing ? low attention
for projects
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Numerical fiscal rules - 3
Moreover, dual budget discussed but little
used contrasting evidence on effects of
public investments on growth bigger role of
private sector in infrastructure development
multilateral surveillance more complex
(e.g., evaluation of depreciation) in
developed countries small net investment
(Germany 1980-1999 0.6)
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Numerical fiscal rules - 4
3b) Expenditure rule Introduce comprehensive
expenditure target (all primary items central
local) Solution adopted in some
countries Benefits spending can be controlled
by government monitoring easier medium term
framework But problematic in multinational
context cannot have uniform EU rule, must
rely on countries programmes cannot commit
future governments deficit debt may
increase because of tax cuts
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Numerical fiscal rules - 5
3c) Permanent Balance Rule Buiter Grafe
(2002) PBR would ensure sustainability while
considering country differences Permanent budget
in balance or in surplus difference of future
values of tax revenue and spending (strong form
of tax smoothing tax rates constant with G
depending on cycle, interest tates, structural
factors) Implementation problems estimates of
permanent value of tax and spending ? take into
account future preferences
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Numerical fiscal rules - 6
3d) Debt Sustainability Pact Pisani-Ferry
(2002) countries (i) with debts ?50 and (ii)
publishing comprehensive fiscal accounts can opt
out of EDP and embrace a DSP Countries indicate
five-year target for debt ratio have greater
flexibility in short term Avoid excessive
tightening on sound countries. But can we fully
overlook the deficit level? Better fiscal
accounting would provide more discipline by the
financial markets. Estimate of future
liabilities problematic uncertainty related to
macroeconomic, demographic and behavioural
scenarios
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Old-age dependency ratios 2000-2050 (baseline
scenario)
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DIFFERENT MEDIUM TERM TARGETS
? Fix medium term targets also on the basis of
debt level and future budgetary trends If debt
and contingent liabilities are low allow
deficit up to minimal benchmarks ? This would
allow funding of net investment without
distortions and monitoring problems ? Need
transparent fiscal accounting and accurate
long-term projections
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IMPROVE TRANSPARENCY
? Transparency can increase credibility of
rules and allow greater flexibility in
implementation ? Current framework
problematic (i) one- off measures, (ii) delays
in data provision, (iii) limited data on
off-budget liabilities (i) Publicise one-offs,
lower danger threshold for early warnings, net
one-off in computing structural
balances (ii) Make greater use of cash data and
debt (more timely and less subject to
estimates). More independent statistical
authorities (iii) Have regular and transparent
estimates of off-budget liabilities, net asset
positions long term budgetary trends
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MISBEHAVIOUR IN GOOD TIMES
? Try to have some sanctions for slippages in
good times and facilitate countries to behave
prudently (i) Use early warning procedures in
goods times when deficit diverge from
structural target (ii) Allow the use of
rainy-day funds surplus in good times can
increase room for manoeuvre in bad times
Rainy-day funds require a change in ESA
accounting transfer should affect deficit
(now they would be considered financial
transactions)
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IMPLEMENTATION OF RULES
? Now enforcement is partisan national
authorities apply the rules to themselves.
This may also reduce the incentive to behave
well in good times ? Solution give more
responsibilities to the Commission -
Commission responsible for technical
assessment of compliance to the rules
(excessive deficit) - Council decides what
measures to require to countries in excessive
deficit - Council decides sanctions on the
basis of Commission recommendation
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Total primary expenditure ( of GDP)
General government tax and non tax receipts ( of
GDP)
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The old debate on fiscal rules
Fiscal policy usually based on rules
either implicit (conventional wisdom) or
explicit (laws) Theoretical case for
formal rules at national level ambiguous
results - counter deficit bias, ?
transparency - induce distortions, lack of
flexibility Traditional solutions budget
balance with three main exceptions -
capital expenditures - extraordinary finance
- effects of the cycle budget balance
over business cycle full employment
balance functional finance
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A comparison
EU USAGDP growth rate 1985-1990 3.2 3.
4 1991-2000 2.1 3.3Unemployment
rate 1991 8.1 6.8 2000 8.1 4.0 Labour
market participation rate 2000 68 79Budget
balance 1996-2000 -2.0 -0.1
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Rules vs discretion
Debate reflects the old discussion on rules
counter deficit bias increase transparency
but induce distortions lack of
flexibilityConflicting views"The stability
pact is a vote of no confidence by the European
authorities in the strength of the democratic
institutions in the member countries. Paul de
Grauwe, Financial Times, 25 July 2002"Of
course, the stability pact restricts the room for
manoeuvre enjoyed by national fiscal
policymakers. But this is the price that must be
paid for a common currency. H. Siebert,
Financial Times, 6 Aug. 2002Predominant view
monetary union without fiscal rules would be a
risky experiment (a leap in the dark)
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Rules vs discretion
Debate reflects the old discussion on rules
counter deficit bias increase transparency
but induce distortions lack of
flexibilityConflicting views"The stability
pact is a vote of no confidence by the European
authorities in the strength of the democratic
institutions in the member countries. Paul de
Grauwe, Financial Times, 25 July 2002"Of
course, the stability pact restricts the room for
manoeuvre enjoyed by national fiscal
policymakers. But this is the price that must be
paid for a common currency. H. Siebert,
Financial Times, 6 Aug. 2002Predominant view
monetary union without fiscal rules would be a
risky experiment (a leap in the dark)
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Fiscal stabilisation
EU rules aim at combining a sound fiscal stance
(3 limit) with budgetary flexibility in
recessions (structural balanced
budget) ? Deficit fluctuates over cycle
(automatic stabilisers can operate) The
asymmetric structure of incentives is quite
problematic in this regard. It has been widely
recognised that, ideally, the SGP should be
complemented by fiscal policy guidelines
encouraging EMU members to avoid fiscal laxity in
periods of upswing and buoyant activity
SURPLUS
0
3
DEFICIT

BAD TIMES GOOD TIMES


LENGTH OF CYCLE
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EARLY LESSONS
? One-off measures and new accounting and
financial operations extensively used to meet
targets ? EMU FRAMEWORK SUCCESSFUL IN REDUCING
DEFICIT AND DEBT ? 3 PERCEIVED AS HARD
CEILING? GRADUAL CONVERGENCE TO
CLOSE-TO-BALANCE BUT IN 2000 NO PROGRESS IN
STRUCTURAL TERMS PROGRAMMES FOR 2001
IMPROVEMENTS DUE TO CYCLE AND INTEREST PAYMENTS
SLOWDOWN IN GDP TARGETS MISSED IN SEVERAL
COUNTRIES?
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THE COMPOSITION OF FISCAL ADJUSTMENT
EMU RULES DO NOT CONSIDER ? COMPOSITION OF
FISCAL ADJUSTMENT ? SIZE OF
GOVERNMENT SUBSIDIARITY REASONS SEVERAL
STUDIES ROLE OF COMPOSITION OF ADJUSTMENT
(SUSTAINABILITY, ETC) EURO-AREA 1992-1993
REVENUE BASED 1994-1997 EXPENDITURE
BASED 1998-2004 EXPENDITURE BASED (CONSOLIDATION
TAX CUTS)
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LONG-TERM SUSTAINABILITY - 2
CHALLENGE OF AGEING PENSION EXPEND. ? 3 to 5
OF GDP TOTAL EXPENDIT. ? 5 to 8 OF GDP CAN
CURRENT REVENUE LEVELS BE MAINTAINED IN AN
INTEGRATED ECONOMY? BUT FAST DEBT REDUCTION
OFFSETS PRESSURES OF AGEING INCREASING ROLE OF
LONG-TERM ISSUES IN EU SURVEILLANCE RECOMMENDATIO
NS, PROJECTIONS
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FISCAL RULES -1
Conventional wisdom against borrowing And
thou shalt lend unto many nations, but thou shalt
not borrow - Deuteronomy The budget should be
balanced,the treasury should be refilled,public
debt should be reduced ... - CiceroOur modern
expedient is to mortgage the public revenues a
practice which appears ruinous - David Hume
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FISCAL RULES -2
For a long time the orthodox view of economists
reflected such common wisdom What is prudence
in the conduct of every private family, can
scarcely be folly in that of a great kingdom -
Smith borrowing allows governments to
conceive gigantic projects that lead sometimes to
disgrace, sometimes to glory, but always to a
state of financial exhaustion - Say debt is
one of the most terrible scourges which was ever
invented to afflict a nation, a system which
tends to make us less thrifty, to blind us to our
real situation - Ricardo
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FISCAL DISCIPLINE AND FLEXIBILITY
Fiscal stabilisation recognised as a fundamental
function area cycles asymmetric
shocks deficit ceiling close-to-balance target
? balance fluctuates over the cycle
stabilisers can operate freely Problems ?
transition to close to balance ? fiscal policy
in good times (lack of sticks and carrots) ?
lack of consensus on estimation of cyclically
adjusted balances
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TECHNICAL CRITICISMS - 1
? SGP reduces budgetary flexibility it may
require pro-cyclical policies or may prevent
discretionary action (i) true in transition
(ii) unlikely in steady state safety margins
sufficient to cope with most recessions
exceptionality clause? SGP disregards
aggregate fiscal stance aggregation of national
fiscal policies may not result in optimal area
fiscal stance possible, but - if
stabilisers work, no problem in most cases -
coordination of national policies problematic -
close-to-balance better than past situations,
when high deficit constrained policies
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TECHNICAL CRITICISMS - 2
? SGP discourages public investment no longer
be possible to spread the cost of an investment
project over all the generations of taxpayers
who benefit from it true, but - GR
problematic distortions, monitoring - net
investment not big in several countries? SGP
focuses on short term commitments and disregards
structural reforms true, but - long term
indicators operationally problematic -
close to balance ? ? debt ? ageing
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TECHNICAL CRITICISMS - 3
? SGP works asymmetrically does not curb
incentives to cut revenue or increase
expenditure in good times true need peer
pressure, long-term views? SGP does not
sanction politically- motivated fiscal policies
unlike 1997 convergence, sticking to rules do
not pay politically true need peer
pressure, long-term views ? SGP too demanding
for countries in sound positions SGP treats
equally countries with different long-term
prospects and debt levels true
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Fiscal outcomes
? EU rules successful up to 1997 (Deficit
declines 6 ? 2.5) ? Balanced budgets
targeted for 2002 ? But, once monetary union
was started, governments introduced tax cuts
(without spending cuts) ? 2002 four countries
constrained by the 3 deficit limit. Either -
avoid discretionary anti-cyclical policies or
adopt pro-cyclical policies - or neglect rules
(loss of credibility) ? New discussion on rules
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Criticisms 2 EU rules now hamper stabilisation
policies
? Short-term approach? But solutions to
current policy dilemma depend on views about SGP
in steady state - if rules are unnecessary
or SGP inferior to other solutions, why
bother? - if rules necessary and no solution
clearly superior to SGP, better retain it
and bear some adjustment costs
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Critical views of EU rules - 1
Three main arguments? There is no need for
fiscal rules. Rules lead to sub-optimal
solutions. Better rely on discretionary ad hoc
decisions ? EU rules may be fine in
principle, but they are now an obstacle to
adequate stabilisation policies ? Rules are
necessary, but we could have more intelligent
rules than the EU rules