Wednesday, March 16, 2011

Enforcing the unenforceable

European Union countries are coming up with new proposals to provide a stricter framework for fiscal policy. EU members have lived for more than a decade under the rules of the Maastricht Treaty and the Stability and Growth pact that set numerical limits on government deficits (3%) and debt (60%). While numerical rules are attractive (they are simple and transparent) the experience of EU countries has shown that, by themselves, they are not very good at providing fiscal policy discipline.

There are many reasons why these rules have not worked as well as expected: they do not provide enough discipline when it is most needed (during economic booms), the enforcement mechanism is decided by the offenders (ministers of finance), etc. In addition, even if the rules are supposed to be objective and transparent, they have always been subject to different interpretations. In particular, the limit on government debt (60%) has been consistently violated by many countries - today most countries are above this limit. They have all used as an excuse a clause that allowed deviations if the ratio was sufficiently diminishing toward the 60% level. But what does it mean to "sufficiently diminish toward the 60% level"?

The current proposal by the European Commission (you can read it here) attempts to make the 60% limit more operational and enforceable. Here is the summary of the new proposed guidelines:

"The debt criterion of the EDP is to be made operational, notably through the adoption of a numerical benchmark to gauge whether the debt ratio is sufficiently diminishing toward the 60% of GDP threshold. Specifically, a debt-to-GDP ratio above 60% is to be considered sufficiently diminishing if its distance with respect to the 60% of GDP reference value has reduced over the previous three years at a rate of the order of one-twentieth per year. Non- compliance with this numerical benchmark is not, however, necessarily expected to result in the country concerned being placed in excessive deficit, as this decision would need to take into account all the factors that are relevant, in particular for the assessment of debt developments, such as whether very low nominal growth is hampering debt reduction, together with risk factors linked to the debt structure, private sector indebtedness and implicit liabilities related to ageing. In line with the greater emphasis on debt, more consideration should be given to relevant factors in the event of non-compliance with the deficit criterion, if a country has a debt below the 60% of GDP threshold."

Maybe I am too pessimistic but the number of potential excuses that are being introduced in this paragraph makes me think that this is not going to work either. I have written a few papers on this issue, the difficulty of enforcing strict numerical fiscal policy rules and the failure of the Euro experience (Here is one example, and here is another oner). Some of the other proposed changes (e.g. establishing national fiscal frameworks of quality) are more promising, but if they keep relying on strict and asymmetric numerical targets, I doubt they will achieve the necessary level of fiscal policy discipline.

Finally, here is a very interesting presentation on this issue from the perspective of the Chile experience by Andres Velasco, former finance minister ( via Phil Lane and the Irish Economy Blog).

Antonio Fatás
on March 16, 2011 |   Edit