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Journal ArticleDOI

A Simple and Flexible Alternative to Stability and Growth Pact Deficit Ceilings: Is it at Hand?

01 Mar 2012-European Journal of Political Economy (North-Holland)-Vol. 28, Iss: 1, pp 14-26

Abstract: We model a monetary union where fiscal discretion generates excessive debt accumulation in steady state and inefficiently delayed debt adjustment following shocks. By setting a debt target and raising the political cost of deviating from the optimal pace of debt reversal¸ institutional design induces fiscal policymakers to implement unbiased responses to shocks. This is partly achieved by increasing the transparency of the decision-making process. We therefore call for more focused supervision tasks for the European Commission and for parliamentary discussion whenever a disagreement arises between the Commission and a national government.
Topics: Debt adjustment (67%), Stability and Growth Pact (62%), European debt crisis (60%), Fiscal union (59%), Debt (56%)

Summary (2 min read)

1. Introduction

  • The Maastricht Treaty and the Stability and Growth Pact (SGP) provide the institutional framework that regulates fiscal policies within the European Monetary Union.
  • In this paper the authors review the working of the SGP after the 2005 reform and in the light of novel empirical evidence they advocate further reform.
  • In addition, the Greek debt buildup highlights a dramatic failure of both the surveillance framework and the pre-emptive arm of the Pact (Rehn, 2010).
  • The authors results call for the de facto demise of deficit ceilings, that cause inefficient stabilisation in the face of adverse shocks but in normal times allow countries to satisfy the ceiling even if policies are relatively undisciplined.
  • The European Commission would act as the “sound fiscal conscience” for national governments, and public debates in national Parliaments would trigger media coverage sufficient to provide adequate information to voters.

2. From the old to the new Pact

  • The Maastricht Treaty specifies that EU fiscal policies are run nationally, following EU-wide objectives defined for a three year period by the Council of Economic and Finance Ministers in the Broad Economic Policy Guidelines2 , and within the limits set by the SGP.
  • The MTO is expected to vary according to a country’s own initial debt-to-GDP ratio and to potential growth.
  • Hence the key commitment of the original SGP was to set the "… medium-term objective of budgetary positions close to balance or in surplus…" which "… will allow all Member States to deal with normal cyclical fluctuations while keeping the government deficit within the reference value of 3% of GDP".
  • The sanctions for breaking the 3% upper ceiling are detailed in the Excessive Deficit Procedure (EDP) which is specified by Council Regulation 1467/97 included in the SGP.
  • Several contributions pointed out that the old ‘corrective arm’ could not discipline procyclical fiscal in good times (Bean, 1998; CESifo, 2002; Canzoneri and Diba, 2001).

3. EMU fiscal policies in practice

  • There seems to be a general consensus that “a counter-cyclical response of discretionary fiscal policies seems to be the exception rather than the rule.”.
  • Estimates of changes in CAPB run separately for good and bad times reveal a pro-cyclical bias in good times and no bias in bad times.
  • The improvement of the overall balance for EMU countries since the adoption of the SGP actually masks unchanged (small countries) or deteriorating (large countries) cyclically adjusted primary balances with respect to the early post-Maastricht years.
  • Unlike the studies quoted above, the authors do not consider the pre-1999 period.
  • In Table 2 the authors present some basic correlations, confirming this analysis.

4. Theoretical underpinnings of a flexible debt targeting approach

  • The authors consider here a version of Jensen’s (1994) model of debt accumulation, extended to account for both supply shocks and the loss of monetary sovereignty that characterizes EMU membership.
  • In each country, the social welfare function is11 ststististi s sti s ti kGGkyL LW (3) where * is the discount factor, *, ~GG sti and *~ st denote public expenditure and inflation deviations from the socially optimal levels respectively.
  • The combination of idiosyncratic shocks and inflation targeting implies that sst *~ and allows to sharpen the analysis of fiscal policy12.
  • For sake of simplicity the authors therefore neglect this component of the budget constraint.
  • Thus, the term DDk sti ~,3 may be interpreted as follows: i) the target D~ defines the level of debt which would emerge if non-distortionary taxes were available in a world where bequest-constrained individuals affect politico-economic equilibria; ii) 3k represents the political cost of tolerating debt deviations from D~ 16.

4.3 The fiscal policy problem under a debt targeting rule

  • Furthermore, the model has a clear policy prescription, linking national deficits to country-specific cyclical conditions and to country-specific accumulation of debt.
  • In the next section the authors shall discuss how, in principle, EMU institutions could deliver that.

5. Turning the SGP into a flexible debt targeting regime

  • Taken at face value, the new SGP is consistent with their proposal of endorsing a long-term debt target.
  • Third, the new SGP acknowledges the role of past debt in assessing a country’s budgetary objectives ex-ante, but fails to condition deficits on past debt: deviations from MTOs are corrected in a fixed proportion of GDP and faster adjustment is typically enforced on countries characterized by relatively low debt ratios (see their discussion in section 3 above).
  • The Commission’s recommendation was certainly consistent with the SGP provisions.
  • To obtain this, new provisions should require that, in case of disagreement with the Commission, the government would then be required to report to national Parliament, publicly motivating its decisions.
  • In New Zealand the government chooses the inflation target.

6. Conclusions

  • Compared to the SGP, even in its ‘new’ post-2005 form, their proposal scores better with respect to the twin goals of long-term public finance sustainability and economic stabilization in the face of adverse shocks.
  • In their view, their comparison with fiscal policies implemented in non-EMU countries once more confirms that the SGP binds when it should not.
  • The sensitivity of expenditures to the current debt burden (equation 13) may be interpreted as follows.
  • The policymaker’s reluctance to tolerate debt deviations from the target works in the opposite direction: the larger is coefficient 3k , the less sensitive is the deficit to shock.
  • The authors wish to thank for very useful comments Enzo Dia and Jacques Melitz.

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DEPARTMENT OF ECONOMICS
UNIVERSITY OF MILAN - BICOCCA
WORKING PAPER SERIES
A simple and flexible alternative to the
Stability and Growth Pact deficit ceilings. Is
it at hand?
V. Anton Muscatelli, Piergiovanna Natale, Patrizio
Tirelli
No. 195 – July 2010
Dipartimento di Economia Politica
Università degli Studi di Milano - Bicocca
http://dipeco.economia.unimib.it

A simple and flexible alternative to the Stability and Growth Pact deficit ceilings. Is it at hand?
*
V. Anton Muscatelli
(University of Glasgow and CESifo, Munich)
Piergiovanna Natale
(Università di Milano Bicocca)
Patrizio Tirelli
(Università di Milano Bicocca)
This version:
4 May 2010
Abstract
We use a simple theoretical model of a monetary union where myopic discretionary fiscal policies
generate excessive debt accumulation in steady state and inefficiently delayed debt adjustment
following a shock. We advocate the adoption of a flexible debt targeting approach. By setting a
long-term debt target and by raising the political cost associated to deviations from the optimal pace
of debt reversal following a shock¸ institutional design induces the fiscal policymaker to implement
unbiased discretionary responses to shocks. Since the power to discipline fiscal policymakers rests
in the hands of national voters, this outcome can be achieved by increasing the transparency of the
decision-making process, where national voters understand the long-term consequences of fiscal
policies. In practice, we call for clearer and more focused supervision tasks for the European
Commission and for a more active role of national Parliaments whenever a disagreement arises
between the Commission and a national government.
JEL Codes: E52, E61, E63
Corresponding author
Piergiovanna Natale
Università di Milano Bicocca
Piazza dell’Ateneo Nuovo 1
20126 Milano
piergiovanna.natale@unimib.it
tel. +390264483095
fax +390264483085
*
This is a completely revised version of CESifo Working Paper n. 1006. The authors wish to thank for very useful
comments Enzo Dia and Jacques Melitz.

1
1. Introduction
The Maastricht Treaty and the Stability and Growth Pact (SGP) provide the institutional framework
that regulates fiscal policies within the European Monetary Union. Adopted in 1997, the SGP
stipulated that countries should aim for public budgets close to balance or in surplus, and set a
ceiling to national deficits as a proportion of GDP (3%), making exception only for large adverse
shocks. Shortly after its adoption, the SGP architecture was put under severe strain. Between 2001
and 2004 several countries breached the 3% deficit ceiling. In November 2003, the European
Council refused to endorse a recommendation by the Commission, requiring France and Germany
to cut their budget deficits for 2004. Following a request by the European Council, in September
2004 the European Commission presented a set of changes to the Pact’s provisions. Six months of
heated debates and tough negotiations led to the adoption of a reformed SGP in March 2005. In the
aftermath of the 2008 financial crisis, the new SGP allowed for budget deficits well beyond the 3%
deficit ceiling. Unfortunately, the crisis unveiled another weakness of the EMU institutional
framework. In fact, it turned out that official figures for the Greek deficits had been systematically
cooked before and after the country joined EMU in 2001 (Almunia, 2004). In 2009 the actual
budget deficit was close to 13% of GDP, more than doubling the government forecasts in 2008.
This triggered fears that a Greek default could destabilise the Euro area. In this paper we review the
working of the SGP after the 2005 reform and in the light of novel empirical evidence we advocate
further reform.
The reformed SGP allows for greater discretion in the face of cyclical downturns, puts more
emphasis on the long-term accumulation of debt and explicitly refers to structural deficits as a
measure of long-term fiscal discipline. Early analyses of the reform pointed out that the new Pact
would simply provide excessive flexibility (Buiter, 2005; Calmfors, 2005; Coeré and Pisani-Ferry,
2005). More recently, in the wake of the financial crisis that hit the world economy, EMU fiscal
policies have been criticized for being too timid (IMF 2009). The empirical evidence presented in
the paper points out that, despite its apparent flexibility, the new Pact has been associated with

2
procyclical policies that reduced debt when business cycle conditions were deteriorating. Perhaps
this could be justified as the hard price to be paid after the profligacy of the early EMU years.
However, despite the new emphasis on debt control, observed rates of change in national debt
levels are uncorrelated with debt-to-GDP ratios accumulated in 2004. Nor do we find any evidence
for a reduction in the dispersion of national debt ratios after 2005. In addition, the Greek debt build-
up highlights a dramatic failure of both the surveillance framework and the pre-emptive arm of the
Pact (Rehn, 2010). These apparent shortcomings suggest that further amendments should be
introduced in the Pact.
Our analysis is based on a simple theoretical model of a monetary union where myopic
discretionary fiscal policies generate excessive debt accumulation in steady state and inefficiently
delayed debt adjustment following a shock. Borrowing from the literature on monetary policy
games (Svensson, 1997), we advocate the adoption of a flexible debt targeting approach. We show
that, by setting a long-term debt target and by raising the political cost associated to deviations from
the optimal pace of debt reversal following a shock¸ institutional design induces the fiscal
policymaker to implement unbiased discretionary responses to shocks. Even when left with full
discretion to decide the initial policy action, the fiscal policymaker will never choose an
“excessive” deficit if he will then be induced to reverse it at the optimal speed.
Our results call for the de facto demise of deficit ceilings, that cause inefficient stabilisation
in the face of adverse shocks but in normal times allow countries to satisfy the ceiling even if
policies are relatively undisciplined. The numerical rule introduced in 2005 and requiring a uniform
pace of deficits reversal (at least 0,5% of GDP per annum) should also be dismissed, as it enforces
stronger discipline on those who need it less, i.e. low-debt countries. Can these arrangements be
replaced by more efficient ones? It should be made clear we are not proposing just to adopt a
different numerical rule for the pace of debt reversal, to be enforced as the SGP. In fact, such
numerical rules are inevitably bound to introduce excessive rigidity in an uncertain macroeconomic
environment. In our view, since fiscal policy decisions lie at the heart of the electoral competition in

3
modern democracies, the power to discipline policymakers ultimately rests in the hands of national
voters. Institutional design should therefore raise the political cost of implementing inefficient
policies. This can be achieved by increasing the transparency of the decision-making process,
making it easier for national voters to understand the long-term consequences of fiscal policies. In
practice, we call for a substantial strengthening of the Pact pre-emptive arm, relying on clearer and
more focused supervision tasks for the European Commission and for a more active role of national
Parliaments whenever a disagreement arises between the Commission and a national government.
Had these proposed changes been introduced in the 2005 reform, Greek policies would have been
more tightly disciplined at the right time, during the fast-growth period that preceded the 2008
crisis. By contrast, we are sceptical of proposals that rely on a stronger corrective arm, such as
negating the right to vote within the European Council
1
. In fact, the curse of the SGP is that
sanctions have been unable to discipline governments in good times and have often been
renegotiated or become irrelevant ex-post.
In a nutshell, the key aspects of our proposal are summarized as follows. The Commission
should evaluate fiscal policies, irrespective of the current deficit size, taking into account both their
short-term impact on the economy and their long-term consequences for debt accumulation. In case
of disagreement with the government, the latter would then be required to report to the national
Parliament, publicly motivating its decisions. This simple, transparency-enhancing proposal would
raise the political cost of disregarding the Commission’s advice. The European Commission would
act as the “sound fiscal conscience” for national governments, and public debates in national
Parliaments would trigger media coverage sufficient to provide adequate information to voters. Just
as our modelling approach is inspired to the theoretical analysis of flexible inflation targeting
schemes, our proposal borrows from empirical evidence on the behaviour of central banks that
adopted inflation targets and carefully designed their communication strategies as a device to
1
See the proposal advanced in a recent interview by the German chancellor, Angela Merkel (FT, 1
st
of May 2010).

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