Fiscal rules: Hazardous to your health?

As Eurozone leaders move towards fiscal integration, critics say the focus on fiscal rules will entrench pro-cyclical fiscal austerity. This criticism, a knee-jerk reaction to the fact that Germany advocates both new fiscal rules and immediate austerity in peripheral countries, is misguided on a number of levels.

First, we all know it would be nice to boost government spending across the board to fuel growth today; but we did that already in 2009. Now some countries find themselves with public finances so shaky that they have no alternative but to tighten fiscal policy; and as growth is already slowing, this is indeed pro-cyclical. But this has nothing to do with fiscal rules; it is the consequence of current market pressure and past government profligacy.

The fiscal rules agreed at the 8-9 December EU summit are defined on “structural” fiscal balances. The structural fiscal balance is meant to correct exactly for the impact of the economic cycle. It is obtained by calculating where government revenues and expenditures would be if output were at potential level, to get a better gauge of the fiscal stance. When output is below potential, the economy is weak, revenues tend to be lower while some social expenditures (such as unemployment benefits) tend to be higher; the corresponding widening in the deficit just reflects the natural impact of a weaker economy, which the so-called automatic stabilisers mobilise to support. Conversely, when output is above potential, higher tax revenues reflect a stronger economy, not a more rapacious government.

Fiscal rules defined on a structural basis are, by design, counter-cyclical. They recognise that in a recession the budget deficit will naturally widen and should be allowed to. At the same time though, they ask to set aside the windfall revenues which accrue during a boom – exactly what most Eurozone countries did not do in the pre-crisis period.

As Figure 1 shows, most Eurozone countries improved their structural fiscal balances as they strived to meet the Maastricht criteria and qualify for Eurozone membership (the fiscal targets had to be met in 1997) and kept the virtuous momentum going into 1999, the year monetary union was launched. In 1991, Italy and Greece had a structural deficit of 12% of GDP; by 1999 Greece’s was less than 2% and Italy’s just 1.5%. Then complacency set in, they relaxed and let their structural fiscal position weaken – all of them, except Spain. During 2001-7, structural deficits averaged close to 7% of GDP in Greece, over 5% in Ireland, and around 4.5% in Portugal and Italy; only Spain’s remained stable at just over 1% of GDP, performing better than France and Germany. Under the new fiscal rules, those deficits would have had to be kept at less than 0.5% of GDP, which would have left these countries in a much stronger fiscal position by the time the financial crisis hit in 2008.

Figure 1. Structural fiscal balances (% of potential GDP)

Source: IMF

The new fiscal rules would have forced Eurozone countries to run a tighter fiscal policy while robust growth was being fuelled by the credit boom, leaving more room for fiscal stimulus once the post-Lehman recession set in. They would have made fiscal policy countercyclical, not pro-cyclical. The true weakness of this rule is that calculations of the structural fiscal balance depend on potential output, which is notoriously difficult to estimate; but the rule is definitely not pro-cyclical.

This, incidentally, is in line with the spirit of the much-maligned Stability and Growth Pact. It is worth making a brief digression here. The problem with the SGP was not that the design of the targets was flawed, as many have argued; it was that it lacked binding enforcement mechanisms, and was therefore systematically violated, including by Germany and France. The SGP stipulated that the budget should be kept in balance or surplus over the medium term – this was interpreted as ruling out deficits systematically larger than 0.5% of GDP over the cycle (see Annett et al. 2005), exactly the structural deficit ceiling envisioned in the new rules – and that the deficit should never exceed 3% of GDP.

The idea was that if a country kept its budget in balance when output was at potential, it could then let it deteriorate by 3% of GDP in times of recession – and 3% was estimated as a sufficient margin for the full play of automatic stabilisers in a recession, based on historical experience. The numbers were not arbitrary – together with the 60% of GDP debt ceiling, they were designed to ensure debt sustainability under reasonable growth assumptions. Since the numerical, sanction-triggering limit was defined on the non-cyclically adjusted fiscal balance, however, countries simply focused on that. They often ran sizable deficits even during economic booms, effectively treating the 3% as the numerical deficit ceiling regardless of growth performance, and ignored the medium-term balanced-budget prescription. Unsurprisingly, this made it harder to stay under the 3% deficit ceiling in recessions. The new fiscal rules would now (i) shift the explicit numerical target to the structural balance; and (ii) bolster the enforcement mechanisms, especially by requiring the rules to be included in primary national law (constitution or equivalent).

Another criticism raised against fiscal rules is that some countries got into trouble because of excess private spending even as they ran prudent fiscal policies. Ireland and Spain are cited as examples. Between 2001 and 2007, they ran an average budget surplus of 0.5% and 0.9% of GDP respectively. In the case of Ireland however, we saw earlier that this corresponded to a structural deficit of 5% of GDP – in other words, the new fiscal rule would have rung the alarm loud and clear. Ireland was clearly overheating, despite its apparent fiscal probity. In the case of Spain, the alarm would have been much softer, so arguably the new fiscal rules would not have been enough. However, Spain has proven to be the least vulnerable of the "peripheral’ countries, in large part thanks to its prudent fiscal policy that meant it entered the crisis with a low public debt ratio.

Most importantly, the fact that private excesses can cause a crisis in the face of prudent fiscal policy proves that we also need better monitoring of private sector imbalances, not that we should disregard public sector deficits. There is no easy way out of this. Some argue that rather than fiscal balances, we should be monitoring the current account, which combines both public and private sector imbalances. But Italy’s current-account deficit averaged just 1% of GDP in the pre-crisis EMU period, a figure that would not have raised concern – and yet Italy is now at the epicentre of the crisis. There is no single metric we can rely on. We need to monitor fiscal balances, public and private sector debt levels, current-account balances and credit trends, among other variables. But the fact that a single metric is not sufficient does not imply it is useless.

Annett, Anthony, Jörg Decressin, and Michael Deppler (2005), “Reforming the Stability and Growth Pact”, IMF Working Paper, February.