The EU new fiscal flexibility guidelines: An assessment

Paolo Manasse 27 January 2015

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On 13 January the European Commission issued new  guidelines to the European Parliament, the EU Council, the ECB, the EIB, the Economic and Social Committee, and the Committee of the Regions for "making the best use of the flexibility within the existing rules of the Stability and Growth Pact" (SGP). The report underlines that the existing rules apply with no modifications, and that the guidelines aim at reducing the scope for discretion in their application – a complaint often made by smaller EU members.

The guidelines were eagerly awaited for political and technical reasons. From a political point of view, Prime Minister Renzi and President Hollande had much invested in promoting an exchange of "structural reforms" for "less austerity", and promoting an active role of the EU in fostering investment and growth (the Juncker plan). Technically, the layers of revisions and additions to the SGP had raised the matter of the complexity of the European rules to the EU exegetes, so that a clarification and simplification was due. In fact the  Communiqué acknowledges that "The Commission now gives Member States additional certainty on how it will apply the Pact. Equal treatment of all Member States and predictability of the rules are at the core of the Pact".

The guidelines cover three issues: the structural reform clause, the investment clause and the cyclical conditions.

Structural reforms

The exchange of structural reforms for less austerity works as follows. Consider a country implementing (or credibly committing to) a "major" reform that has positive growth and budgetary effects. Then there are three cases.

  • The country is not under an excessive deficit procedure (EDP). Then it may be granted a temporary deviation from the adjustment path toward the Medium term objectives (MTO), for at most 0.5% of GDP. The MTO is supposed to be reached within four years anyway, and the country must not violate the 3% deficit limit.
  • The country is in the process of falling into an EDP. Then it may be granted extra time for reaching the MTO.
  • The country is already in the EDP. In this case it may get extra time, conditional on having respected previous fiscal commitments.

Case 1 is tailor-made for Renzi's Job act, and gives legitimacy to the present Italian deviation from the MTO in exchange for the labor market reform. Case 3 may help France, Spain, Portugal, Ireland, and Poland, which are under the EDP scrutiny (see Table 1) although it is unclear whether all these countries may qualify for extra-time (France may not). Notice that the "structural reforms" clause rewards past fiscal discipline by giving countries not in the EDP a better bargain.

Table 1. Ongoing Excessive deficit procedures

Source: http://ec.europa.eu/economy_finance/economic_governance/sgp/corrective_arm/index_en.htm

Investment

The Communiqué clarifies that a country’s contributions to the new European Fund for Strategic Investment – the vehicle for the Juncker investment plan – will not be counted for the deficit and debt criterion. Moreover, an ‘investment clause’ specifies some extra-room for investment in case of recession. A country is allowed to deviate from the adjustment path toward the  MTO provided:

  • The investment has a measurable positive effect on growth and public finances,
  • The country is not under an EDP,
  • The country is in recession (defined as negative growth or  output below 1.5% of  potential),
  • The deviation is temporary (e.g. it is compensated within the time framework agreed in the convergence plan and does not lead to violation of the 3% deficit limit), or 
  • The investment is co-financed by EU institutions.

The conditions for getting extra-space for investment are quit stringent, and yet the investment clause may be exploited by a relatively large number of countries. Table 1 and 2 show that countries that satisfy the second and third conditions include Austria, Belgium, Czech Republic, Denmark, Estonia, Finland, Iceland , Italy, and the Netherlands. Again, not being part of the EDP club has quite a few privileges.

Table 2. Potential output and GDP

Cyclical conditions

This part of the document is quite important, given the widespread criticisms that the current framework fosters pro-cyclical policies and leads to divergence in Europe.1 Nothing changes for countries in the EDP club, for which the consequences of bad cyclical conditions will be taken into account by focusing on structural balances. For "fiscal responsible countries", two contingencies will determine the adjustment pace to the MTO: cyclical conditions and debt sustainability. Here things get rather complicated, since there are no less than four variables which pin down the size of the required fiscal adjustment:

  • Real GDP growth,
  • The output gap (the percentage deviation of GDP from potential output as a fraction of the latter),
  • The growth rate of potential output, and
  • The debt-to-GDP ratio.

The idea is to account both for the state of the economy (the level out the output gap – the adjustment is smaller, the more negative the gap), and for its rate of growth (the adjustment is larger when GDP grows faster than potential output), together with debt sustainability (more tightening for debt/GDP exceeding 60%). All this is exemplified by the ‘matrix’ reported below. The rows describe how far the economy is from potential output – the columns differentiate low from high debt countries. Growth considerations in each cell determine the size of the required adjustment.

Figure 3. Matrix for specifying the annual fiscal adjustment towards the medium-term objective (MTO) under the preventive arm of the pact

Definitions:

  • Fiscal adjustment: improvement in the general government fiscal balance measured in structural terms (ie cyclically adjusted and without one-off measures).
  • Growth potential: estimated rate of growth if the economy is at its potential output.
  • Output gap: difference between the level of actual and potential output (expressed in percentage points compared to the potential output).
  • Potential output: a summary indicator of the economy's capacity to generate sustainable, non-inflationary output.

It helps to show the rule on a graph. On the vertical axis of Figure 1 I plot the required adjustment to the MTO as a fraction of GDP; the output gap is on the x-axis and increases moving from left to right, the difference between the actual and the potential growth, the width of the box, increases moving upward.2 The picture refers to countries with debt-to-GDP ratio in excess of 60% (most of EU members).

Figure 1. The cyclical conditions and the fiscal adjustment

The graph shows a few characteristics of the rule. First, when the output gap times leaves ‘exceptionally bad times’, above the value of -4%,  we have a first hike in the fiscal adjustment, from 0 to .25% of GDP.  Moreover, as soon as we enter ‘normal times’, a gap between -1.5 and +1.5%, the fiscal adjustment jumps up even more. Actually the fiscal effort starts rising even before, in ‘bad times’ when the gap is between -3 and -1.5%, provided the difference between actual and potential growth has turned positive. Finally, in good times – with a gap above 1.5% – the size of the step increases rapidly with the excess of growth over potential. Thus even under the new interpretation, the SGP is confirmed to be quite restrictive, and the step-wise nature of the fiscal  rule  implies that very similar cyclical conditions may be treated with very different doses of austerity, which is hard to justify.

Finally, limiting the matrix applicability to countries who comply with the 3% limit prevents many countries in deep recession (Greece, Portugal, Spain, Ireland, and Slovenia) from benefiting from the austerity discount, and leaves only two countries with a zero required adjustment in 2015 – Italy and Estonia.3

Conclusions

The new guidelines have three merits:

  • They improve the transparency of the rules,
  • They establish the principle that fiscal adjustment should not be the same for everyone, and
  • They give incentives for fiscal discipline and structural reforms.

The drawback is that they operate within the existing rules, and therefore share the limits of the fiscal framework: its austerity bias and the complexities of potential outputs, output gaps, structural unemployment rates, non-accelerating wage rates, and cyclically adjusted balances. Moreover, the rule may impose quite different adjustment efforts to countries in very similar conditions. Finally, the exclusion of countries with an excessive deficit procedure implies that the overall impact on the EU economy may be rather limited since these are exactly the countries where cyclical conditions are worse, also as a result of front-loaded consolidation, and where investment and reforms are most needed.

Footnotes

1 Paolo Manasse (2015) "Time to scrap the Stability and Growth Pact", www.voxeu.org http://www.voxeu.org/article/time-scrap-stability-and-growth-pact.

2 In order to draw the box I made a few assumptions. For example I assumed that the fiscal adjustment rises linearly between ‘normal’ and ‘good’ times. I also assumed that growth is negative only when the output gap is below -4% so that I can effectively ignore the condition on negative growth (unfortunately I cannot plot a graph in 4D).

3 Italy is in ‘exceptionally bad times’ (row one, column one), and Estonia is in ‘bad times’, with "debt below 60% of GDP" and "growth below potential" (row three, column two). Other ‘beneficiaries’, with only 0.25% adjustment, are Austria and Slovenia (in ‘very bad times’ with high debt – row two, column two), Finland and Netherlands (in ‘bad time’, with growth below potential and high debt – column three, row two). Conversely, Slovakia, Poland and Germany get a standard 0.5% adjustment (row four, column one) while countries with high debt and ‘normal times’ – Belgium, Hungary, and the UK – should adjust by more than 0.5%.

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Topics:  Europe's nations and regions Macroeconomic policy

Tags:  fiscal policy, austerity, eurozone

Professor of Macroeconomics and International Economic Policy, University of Bologna

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