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

TL;DR: In this article, the authors model a monetary union where fiscal discretion generates excessive debt accumulation in steady state and inefficiently delayed debt adjustment following shocks, and 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.

About: This article is published in European Journal of Political Economy.The article was published on 2012-03-01 and is currently open access. It has received 66 citations till now. The article focuses on the topics: Debt adjustment & Stability and Growth Pact.

Summary

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.

Figures

Figure 3 vividly illustrates the faltering performance of fiscal policies under the SGP regime. The change in the cyclically-adjusted balance-to-GDP ratios (CAPB) is in the negative when favourable cyclical conditions (output gap - YGAP) prevail, while discretionary fiscal policy tightens only when adverse cyclical conditions bring the actual deficit close the 3% ceiling.

Table 2

Fig. 9 Fig. 9 EMU countries 2005-2008

Fig. 8 EMU countries 1999-2004

Fig. 7 EMU countries 1999-2008

Fig. 10 OECD-non EMU countries 1999-2008

Fig. 6 US 1999-2008

Frequently asked questions

Q1. What contributions have the authors mentioned in the paper "A simple and flexible alternative to the stability and growth pact deficit ceilings. is it at hand?" ?

The authors 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. 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. 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. 

Q2. What are the future works in "A simple and flexible alternative to the stability and growth pact deficit ceilings. is it at hand?" ?

21 Note that 0ˆ/1ˆ is a necessary condition for stability, and that the stability condition r 1ˆ can be reinterpreted as a ceiling to the proportion of adjustment shifted onto the future.