How to redesign the EU’s approach to public debt sustainability

The European Union should abandon the fiscal rules intended to put constraints on national budgetary policies in favour of fiscal standards – qualitative prescriptions that leave room for judgment together with a process to decide whether the standards are met.

That is the central conclusion of a new research report by Olivier Blanchard (Peterson Institute for International Economics), Alvaro Leandro (CaixaBank Research) and Jeromin Zettelmeyer (International Monetary Fund). The authors note that their proposals would mark a major departure from the status quo, requiring Treaty change.

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Central to the process of shifting from fiscal rules to fiscal standards would be country-specific assessments of the sustainability of public debt led by the European Commission. Violations of the standard should preferably be adjudicated by an independent institution, such as the European Court of Justice (ECJ), rather than by the European Council.

But in an environment in which the Covid-19 crisis has already led to the suspension of fiscal rules at least until the end of 2021, as well as common and national fiscal action that was previously unthinkable, the opportunity to rethink the EU fiscal framework in a fundamental way should not be squandered. ‘Successive waves of reform have not made much of a difference’, they conclude: ‘It is time to question the premises of the framework itself.’

The EU’s fiscal rules were designed to achieve low debt levels in an environment of positive interest rates. The post-Covid-19 reality is one of high debt levels but very low interest rates that are likely to persist for some time to come. The new study asks: if and when the rules are reinstated, what should they look like?

European fiscal rules were conceived in the early 1990s as a way of addressing adverse debt externalities arising across members of the euro area. Externalities of this type could arise both because debt accumulation might put pressure on the European Central Bank to inflate, and because of adverse spillovers from one country to others in the event of a debt crisis. The fiscal rules were meant to maintain public debt at safe levels while giving members adequate space to conduct fiscal stabilisation policy.

Almost 30 years later, there is a wide consensus among economists and policy-makers in the EU that the fiscal rules have not been very successful and require reform. One approach would be incremental reform, perhaps with an adjustment of the target debt level, or at least an adjustment of the speed at which it should be reached, together with a simplification of the general framework and a more prominent role for an expenditure rule.

The other, which is proposed here, would be more ambitious. Going back to first principles, the authors argue that incremental reform will not be enough. Indeed, the attempt to write down rules is bound to be a fool’s errand. Whether debt is at risk of becoming unsustainable does not just depend on debt and deficit levels, but on a host of uncertain economic and political factors. Fiscal rules, even complex ones, cannot account for this uncertainty, because it is impossible to predict and specify the relevant contingencies ex ante. Rules are bound to lead to mistakes, constraining fiscal policy either too much or too little.

The alternative to rules is standards. Unlike rules, standards distinguish good behaviour from bad behaviour in qualitative rather than numerical terms. Whether the standard is satisfied is determined ex post, at the point of application. This allows an adjudicator to draw on a much larger set of information than typically enters rules. It also allows room for judgment.

Article 126(1) of the European Treaty, in which the fiscal rules are anchored, already establishes a fiscal standard: ‘Member states shall avoid excessive government deficits’. Rather than inventing a complex system of rules to determine what is excessive, the European Commission should analyse the fiscal position of members using ‘stochastic debt sustainability analysis’. If it finds that a member state’s debt is not sustainable with high probability, it would ask for fiscal adjustment, at a speed that balances the output costs of adjustment with the risks of delay.

To be successful, standards require an effective enforcement process. Ideally, this would take the form of adjudication of disputes between the European Commission and member states by an independent body, such as the ECJ or a specialised EU-level court. Alternatively, the existing enforcement mechanism, in which the Council is in the role of the adjudicator, could be strengthened, by allowing the Commission to challenge budgets that do not comply with the fiscal standards.

‘Redesigning EU Fiscal Rules: From Rules to Standards’

Authors:

Olivier Blanchard (Peterson Institute for International Economics)

Alvaro Leandro (CaixaBank Research)

Jeromin Zettelmeyer (International Economics Monetary Fund)