Editors' note: This column is a lead commentary in the VoxEU debate on euro area reform
The EU’s fiscal rules have been suspended until at least the end of 2021. When they are reinstated, they will need to be modified, if only because of the high levels of debt. Proposals have been made suggesting various changes and simplifications. The gist of most proposals is to retain the 60% debt ratio as a long-term debt anchor and a dividing line between the fiscal rules that apply for countries with debts above and below, while replacing the plethora of existing rules and procedures with an expenditure rule that allows fluctuations in the deficit driven by cyclical changes in revenue.1
In a new paper (Blanchard et al. 2021), we argue for a more ambitious approach. No quantitative rule can hope to come close to fitting the diversity of possible country-time situations. Simplicity is attractive, but not feasible. This leads us to propose the abandonment of fiscal rules in favour of fiscal standards – qualitative prescriptions that leave room for judgement – together with a process to enforce the standards.
The limits to incremental reform
The role of EU-level fiscal rules is fundamentally different from that of national fiscal rules. National fiscal rules exist to help countries reach their preferred fiscal policy objectives. Some countries may want to actively use fiscal policy to smooth cyclical fluctuations, while others may not. Some may want to favour future generations and aim for low or even negative net public debt. In contrast, the only purpose of EU fiscal rules or standards should be to contain adverse debt-related externalities across members, by ensuring that each country’s debt is indeed sustainable. So long as this is the case, member countries should be free to pursue their preferred fiscal policy.
The problem with not just past and current EU fiscal rules, but any set of fiscal rules built around country-invariant debt and deficit ceilings is that they are an extremely poor proxy for debt sustainability, for at least four reasons. First, sustainability does not just depend on debt levels – or even debt and deficit levels – but also on future primary balances, interest rates, and growth. Second, there is significant uncertainty around the difference between future interest and growth rates: while this relationship is currently expected to be negative far into the future, implying that even high debt is consistent with a primary deficit, this could change. Third, the primary balance that a country can achieve depends on many additional factors. These include its starting level, the starting level of taxes, the type of government, and the willingness of the population to support fiscal adjustment. Fourth, investor confidence matters. While the ECB may be able to rule out extreme ‘bad equilibria’ in which lack of investor confidence becomes self-fulfilling – as very high interest rates feed into higher debt – it cannot eliminate cross-country differences in the credibility of fiscal policy. This makes it harder for some countries to adjust even if they want to, and consequently lowers the debt level that might be considered sustainable.
These difficulties do not imply that it is impossible to come up with a well-founded assessment of whether debt is sustainable or not. But they do imply that such an assessment requires taking into account many factors, including expected growth, expected interest rates, the country’s fiscal track record, and political and institutional factors. Fiscal rules that treat all countries the same cannot possibly achieve that.
At the same time, such fiscal rules can impose constraints that seriously hamper fiscal policy as a stabilisation tool. The Covid-19 crisis has clearly made that point: it required large deficits which conflicted with the rules, leading to their temporary suspension. But even after the crisis has passed, fiscal policy will remain an essential stabilisation tool for some time. One reason is the ECB’s ‘one size fits all’ monetary policy. This can get it right on average, but not for every member of the euro area. Furthermore, while the ECB is constrained by an effective lower bound on interest rates, it may have difficulties in playing its stabilisation role even for the euro area on average.
Bringing the rules closer to the optimal trade-off between allowing stabilisation policy and limiting the risk of unsustainable debt would require a vastly more complex set of contingencies. But this would make the rules even more complex – the opposite of what most recent proposals are trying to achieve. More importantly, even highly complex rules are unlikely to get it right. The reason for this is what economists call ‘Knightian uncertainty’: many relevant contingences, the probabilities associated with them, and the right way to map them into a rule are impossible to identify ex ante.
From fiscal rules to fiscal standards
To escape this dilemma, the EU needs to move away from fiscal rules. Rather than attempting to codify the trade-off between debt risks and output stabilisation ex-ante, this trade-off should be evaluated case by case, using all relevant information.
The legal literature refers to this approach as applying standards as opposed to rules.2 Standards lay out an objective, but without fully spelling out how it is to be met. “Do not drive faster than 55 miles an hour” constitutes a pure rule; “do not drive at excessive speed” is a pure standard. What speed is considered ‘excessive’ depends on the situation, and will be based on judgment, social norms, and legal precedent.
Most legal norms lie between these extreme cases. Rules may include exceptions or state contingencies; standards may list criteria that adjudicators must consider when deciding whether the standard was met.
Standards are commonplace in national and EU law. Article 126(1) of the Treaty on the Functioning of the European Union (TFEU), “Member States shall avoid excessive government deficits,” is an example for a pure standard. Large swaths of EU law, such as competition law, are based on standards. And while legal frameworks that seek to constrain fiscal policy tend to be based on rules, there are exceptions, such as New Zealand’s “principles of responsible fiscal management” (New Zealand Treasury 2015, 2019).
Rules have the advantage of providing greater clarity ex ante. But a case-by-case approach guided by standards is preferable when it is very difficult to design satisfactory rules. For the reasons explained above, this is true for EU fiscal rules today.
Monitoring and enforcing fiscal standards
The obvious concern about the shift proposed here is that all EU member governments would argue that their fiscal conduct does indeed meet the standard. And without the benefit of clear rules that identify violations, it would be difficult to prove them wrong. Accordingly, fiscal standards must lay out criteria that reduce discretion and guide judgment. In addition, there must be an effective fiscal surveillance and enforcement process:
- Criteria and methods that guide judgement. The existing fiscal standard, “Member States shall avoid excessive government deficits,” would remain as the starting point. EU secondary legislation would then lay out a general standard for when deficits would be considered excessive: namely, when debt is not sustainable with high probability, conditional on current and projected policies. It would also adopt a definition of ‘debt sustainability with high probability’ (including what probability is deemed is ‘high’), and identify methods that can contribute to assessing it. Such methods already exist.3 EU legislation could also state criteria that would inform the minimum speed of fiscal adjustment in the event that debt is not considered sustainable with high probability, including the state of the economic cycle, market conditions, and the level of interest rates.
- Surveillance with ‘teeth’. National independent fiscal institutions (IFIs) (Wyplosz 2005, 2019) and/or the European Commission or European Fiscal Board, in some combination, would be given the task to regularly monitor debt sustainability risks, much like the Commission already does (European Commission 2021). If debt is not sustainable with high probability, the Commission and/or IFI would propose remedial action, guided by the criteria laid out in EU secondary legislation, which the member would be expected to reflect both in its next draft budgetary plan and its medium-term fiscal plan. If the Commission and/or IFI deem these to be inconsistent with maintaining debt sustainable with high probability, they would be put on hold, pending final adjudication. This is more than the Commission is currently allowed to do: while it can request revisions to the draft budgetary plans, it cannot delay the implementation of a budget that it considers inadequate.
- Independent adjudication. In the event of a disagreement between a member and a surveillance institution, an EU institution would need to adjudicate (within a few months). Our preferred approach would be to assign this role to a judicial body – such as a new and specialised chamber of the European Court of Justice. This would allow the creation of a fiscal standards jurisprudence that is not encumbered by political considerations. If this is not feasible, the existing procedure laid out in Article 126 (3)-(11) TFEU could be maintained, which assigns the role of adjudicator and enforcer to the Council of the EU.
So, would this require treaty change?
Giving the adjudication role to the European Court of Justice or another judicial entity would require treaty change, since it would require (at a minimum) amending Article 126 TFEU, which currently assigns this role to the Council.
If the current process is maintained, treaty change may or may not be required. Article 126(2) allows member states to exceed the 3% deficit and 60% debt-to-GDP reference values under some conditions (namely, if “the excess over the [deficit] reference value is only exceptional and temporary and the ratio remains close to the reference value” and the debt ratio is “sufficiently diminishing and approaching the reference value at a satisfactory pace”). EU secondary legislation would need to state that these conditions are considered to be met so long as debt remains sustainable with high probability. Whether or not such legislation would survive legal challenge is beyond our expertise.
Our proposals would mark a large departure from the status quo. Fiscal rules would be replaced by standards. Independent fiscal institutions and/or the European Commission would obtain a stronger role in the budgetary approval process. Putting a judicial body in charge of adjudication would require a treaty change.
Even with the requisite political support, these changes could not be implemented overnight. Many details remain to be worked out. An interim reform of the fiscal rules could be required as a bridging measure. But reforms should not stop there. In an environment in which the Covid-19 crisis has already led to the suspension of such rules as well as to common and national fiscal action that was previously unthinkable, the opportunity to fundamentally rethink the EU fiscal framework in should not be squandered. Successive waves of reform have not made much of a difference. It is time to question the premises of the framework itself.
Authors’ note: The views expressed in this column are those of the authors and do not necessarily represent the views of either the IMF or CaixaBank.
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Bénassy-Quéré, A, M K Brunnermeier, H Enderlein, E Farhi, M Fratzscher, C Fuest, P-O Gourinchas, P Martin, J Pisani-Ferry, H Rey, I Schnabel, N Véron, B Weder di Mauro and J Zettelmeyer (2018), “Reconciling Risk Sharing with Market Discipline: A Constructive Approach to Euro Area Reform”, Policy Insight No. 91, London: Centre for Economic Policy Research.
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IMF (2021), “Review of the Debt Sustainability Framework for Market Access Countries”, Policy Paper No. 2021/003, Washington: International Monetary Fund.
Kaplow, L (1992), “Rules versus Standards: An Economic Analysis”, Duke Law Journal 42: 557–629.
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1 See, among others, Andrle et al. (2015), Claeys et al. (2016), Beetsma et al. (2018), Bénassy-Quéré et al. (2018), Darvas et al. (2018), Feld et al. (2018), EFB (2019), Constâncio (2020) and Gaspar (2020).
2 See, among others, Sunstein (1995), Kaplow (1992), Schlag (1985) and Ehrlich and Posner (1974).
3 See Bouabdallah et al. (2017), Debrun et al. (2019), Eichengreen et al. (2018), European Commission (2014), and IMF (2021).