At the last European Council meeting, Angela Merkel and Nicolas Sarkozy called on their Eurozone counterparts to sign up to a new pact for closer economic coordination. European countries are invited to improve their international competitiveness and to curb their burgeoning public debts through the introduction of a constitutional fiscal rule. At present there are no details on the last point, but it is likely that what Germany has in mind is a zero-structural-deficit rule, like the one that amended the German Constitution in 20091, in line with the medium-term objectives set by the European Commission.
The proposal is ambitious. It aims to complement the fiscal framework of the European Semester with a stronger commitment to fiscal sustainability at a national level. Even if the intricate national procedures necessary to amend a constitution make the proposal unfeasible in the short term, the plan could represent a turning-point for the stability of European public finances and for the survival of euro itself. But the proposal raises an important question. Is a German-style fiscal rule coherent with a constitutional status and with the political environment of the other European countries?
The constitutional status in the EU
From a juridical point of view, a constitutional rule is a complex one. Super-majorities, referendums, or waiting periods are required to amend a constitution. But the advantages are many.
- First, the complexity of these procedures make it credible that the law will be hardly changed under tempting situations.
- Second, the use of constitutional rules to achieve financial discipline signals that fiscal sustainability is an important goal of society.
- Third, it maximises the reputational costs for a government that does not respect it.
For these reasons, Drazen (2004) argues that raising the cost of deviating from a law (i.e. changing a law once it is given constitutional status) makes it more credible that the law will actually be followed, guaranteeing an effective commitment from the government. Moreover, a constitutional fiscal rule reduces the political costs of unpopular decisions that are necessary for fiscal sustainability. Since the target, like a zero-structural-deficit, is supposed to be shared by society at large, then the political debate could only concern the way to reach it.
But such a strong effectiveness comes at the cost of flexibility, because a constitutional rule cannot easily adapt to a changing environment. For countries such as Belgium, Italy, or Spain, characterised either by political instability or by huge internal contrasts, an ill-designed constitutional fiscal rule could be a burden, because amending the constitution a second time with a large majority would be tough. Therefore, a careful ex-ante design is essential.
The economic rationale
From an economic point of view, a zero-structural-deficit rule, one that will likely be proposed to the rest of Europe in the near future, is apparently simple and well-defined. It is enforced ex-post by the constitutional court, while adjustments for cyclical developments and exceptional events provide the rule with some flexibility.
But there are flaws as well.
- The structural budget balance is based on cyclically-adjusted figures whose estimation is rather problematic and imprecise.
- Moreover, it does not split current- and capital-account operations, even if the cost of the latter could be spread over several generations.
- Finally, and most important, a zero-structural-deficit rule turns out to be too tight, leading to the abolition of the public debt in the long run. But fiscal sustainability does not imply anything like that, since debt is a valuable source of funding for capital-account expenditures and the budget deficit is a useful tool for economic stabilisation (Franco and Zotteri 2010).
The political conflict
Therefore, policymakers should strike a balance between the juridical complexity of a constitutional rule and its design, not only for effectiveness reasons but also to prevent political tensions. Consider, for instance, the case of a country whose debt is around 100% of GDP. A German-style rule could be desirable for a short period of time in order to bring back the debt to a more sustainable level.
Once the country reaches the target, the zero-structural-deficit rule would still be binding, turning the debt negative in the long run. Since this result would not be attractive, the government should amend the constitution again. But opportunistic obstructionism, even by a small political group, which would be determinant for the amending procedures, could make the reform politically unfeasible. An amendment, indeed, would allow the majority in office to reallocate the resources devoted to the debt reduction to more productive uses, gaining in political support for re-election. For this reason, the minority could block it.
A stylised simulation
It would therefore be wiser to design a more flexible rule from the very beginning. An optimal fiscal rule does not exist in reality and its design depends on the needs of each country (Germany, for instance, resorted to its rule for problems of fiscal coordination between different levels of government, see Bauman et al. 2008. For a deep analysis on the design of a fiscal rule refer to the European Commission 2010 and Koptis and Symansky 1998).
However, for the sake of the argument and to gain some useful insights, let's imagine combining a zero structural deficit rule with a reasonable debt target, like 60% of GDP. Figure 1 reports a simulation with some heroic hypothesis for Italy, whose public debt is 118.5% of GDP and the structural deficit 3.4% of GDP (so a very extreme case). We bravely assume an exogenous 2% real GDP growth, an elasticity of the financial balance to GDP at 0.5% (Bénassy-Quéré et al. 2010), and a positive output-gap from 2017 onwards.
The simulation takes the following three steps:
- Step 1: The transition. The structural budget converges to a zero balance in 2017 through an annual 0.5% of GDP improvement. In Figure 1, the debt (on the left axis) increases and then decreases in this lapse of time.
- Step 2: Zero structural deficit target. From 2017 onwards, the zero structural deficit becomes a binding constraint as long as the debt converges to 60% of GDP in 2037. Step 1 and step 2 follow the rationale of the German rule. But in that case the debt target would be asymptotically zero or negative (green lines in the figure).
- Step 3: Debt target. In 2037 the 60% debt target starts being binding, while the structural budget freely moves. This way fiscal policy would become more flexible. Without macroeconomic shocks and because of our optimistic growth assumptions, the equilibrium structural balance coherent with the debt target would be negative and equal to 2.18% of GDP. Therefore, the rule could require the structural deficit to be invested in durable goods, a sort of golden rule, and it could include an escape clause for acute economic slowdowns to avoid pro-cyclical effects (European Commission 2010).
Summing up, like a German-style rule, the above one, that is far from being optimal, would guarantee fiscal sustainability. A combined rule, on the other hand, would make fiscal policy more flexible in the long run, preserving the budget balance as stabilisation tool and avoiding political tensions for amending the constitution.
Figure 1. A German-style rule with debt target
Introducing constitutional fiscal rules across Europe would be an important step towards fiscal sustainability. However, the rigidity that derives from the constitutional status of the rule should be offset by a more flexible economic design. Last but not least, a flexible rule would make the German and French proposal more appealing and, hence, politically more feasible.
Author's note: The opinions expressed in this column should be attributed to the author only. They are not meant to represent the positions or opinions of the Italian Parliament or any of its members.
Drazen, Allan (2004), "Fiscal Rules From A Political Economic Perspective", in G Kopits (ed.), Rules-Based Fiscal Policy in Emerging Markets: Background, Analysis and Prospects, Palgrave Macmillan.
Baumann, Elke, Elmar Doennebrink and Christian Kastrop (2008), “A Concept for a New Budget Rule for Germany”, CESifo Forum 2/2008.
Bénassy-Quéré, Agnès, Benoit Coeuré. Pierre Jacquet and Jean Pisani-Ferry (2010), Economic Policy: Theory and Practice, Oxford University Press.
European Commission (2010), "Public Finances in EMU -2010, European Economy”.
Franco, Daniele and Stefania Zotteri (2010), "Fiscal Rules: What Lessons from Germany?", mimeo, Bank of Italy.
Koptis, G and S Symansky (1998), "Fiscal Policy Rules", IMF Occasional Paper 162.
1 The German rule envisages a 0.35% structural budget deficit for the federal government by 2016 and a structural balanced budget for the Länders by 2020.