VoxEU Column Financial Markets

Fiscal rules for the Eurosystem: From “free talk” to effective incentive schemes

Another week, another set of crisis talks over the future of the euro. This column argues that the currency’s problem is one of incentives. It says that interventions since early 2010 have been completely ineffective and that most current proposals to foster budget discipline will fare no better. It calls for new decision-making mechanisms as a matter of urgency.

In a bid to save the euro, political leaders together with the European Central Bank have applied new fiscal instruments and have heavily intervened in financial markets since early 2010. To calm their critics, they have praised existing monitoring arrangements and proposed new fiscal schemes.

What about existing fiscal arrangements?
  • Stability and Growth Pact (SGP)

Created as part of the Maastricht Treaty, the SGP focuses on discipline in public budgets, primarily via a complicated excessive deficit procedure. It has never been executed and was loosened in 2005. National ministers deciding by qualified majority and having the final say have preferred a cooperative approach so far – as most students probably would if deciding collectively who will pass their exams. Currently the EU is finalising another SGP reform. There will be a new preventive part, but probably no automatic sanctions (Kafsack 2011).

  • Pact for the euro

Designed in March 2011, this instrument should foster national competitiveness, employment, stable public finance, and financial stability through, for example, improved national education systems, labour-market reforms, debt brakes, expenditure rules, and so on (Consilium 2011, Annex 1). Sceptics include The Economist (2011a) and observers such as Gros (2011) on this site who criticise the complete absence of means and sanctions for implementation.

  • Europe 2020

This strategy developed by the European Commission (2010) replaces the Lisbon Strategy for Europe between 2000-2010 that has basically failed. Europe 2020 presents precise targets for many national areas, e.g. higher employment rates, more R&D-spending, better environment, and less poverty. Here again though, precise sanction mechanisms are entirely missing.

  • European Semester

Introduced by the Council of the EU (2010) and first implemented in 2011, this annual early-warning system strives for long-term fiscal coordination. Based on a Commission report, the Council of Ministers and the European Parliament give political advice. Member states should then review their medium-term budgetary strategies and deliver reforms. For the national budget planning of the coming year, the European institutions provide political advice.

So far, the EU’s political recommendations are not legally binding. Heinen (2010) thinks their publication may put more peer pressure on national ministers and be interesting to bond markets. But within SGP, peer pressure and pure publication instruments have ultimately failed.

  • European summit in July 2011

Here, the Council of the EU (2011) was very precise on additional financial help for Greece and the European Financial Stability Facility. In terms of fiscal policy coordination, it just recapitulated the ongoing initiatives for stronger discipline and EU surveillance (Council of the EU 2011) without including additional ideas on how to enforce these targets.

In summary, none of the existing fiscal agreements is strict enough to change budget behaviour of national governments.

Which options for effective incentive schemes are under debate?
  • National debt brakes

These were proposed by Chancellor Merkel and President Sarkozy in August 2011 (see for instance Curtis 2011). Debt brakes are fashionable: - following the International Monetary Fund (2009, p. 7), national fiscal rules of any kind went up from seven in 1990 to about 80 in early 2009. However, they usually include exceptional clauses and will be executed in the future. A typical example is Germany’s constitutional debt brake. The problem of enforcing non-automatic rules are probably the most obvious in the case of the US’s legal debt ceiling which was raised for the 75th time in August 2011 (The Economist 2011b).

  • European economic government

Also suggested by Merkel and Sarkozy in August 2011 (see Curtis 2011), this still very blurry idea could comprise such things as taxation at the European level, Eurobonds or a European Commissioner of Finance.

French or Spanish governments have traditionally favoured a European economic government, whereas those from Germany or the United Kingdom, for example, have so far rejected this integrative step. It would require unanimous consent and a far-reaching self-disempowerment of national parliaments. It is extremely unpopular in Germany where, for instance, 76% of the population recently opposed Eurobonds (EU-Info Deutschland 2011). Finally, it would lack democratic legitimacy as there is yet no true European government elected by the European Parliament.

  • Independent institution for fiscal supervision

These initiatives run under different labels, for instance “independent fiscal councils” (The Economist 2011b). All have one thing in common: they would be more credible and more able to enforce fiscal rules than politicians under a re-election constraint. But who would represent this independent body? National politicians or civil servants appointed in mutual consent by the heads of state, or government as in case of the ECB’s executive board? Members of the European Commission? As long as they could be re-appointed (as in the case of Commissioners), as long as they would be young enough to continue their career elsewhere (as in the case of ECB members and Commissioners) and as long as they would have close links to their national government (as in the case of both again), the institution would not be completely impartial.

  • Withdrawal of voting rights in the Council of Ministers

This idea has been popular for many years with regard to a reinforced SGP. Of course, it would not solve the fundamental problem. If one applies again the analogy of students deciding by themselves who will pass the exam, the performing students could hesitate to let their peers fail, as they would fear becoming an underperformer themselves in the next round.

  • Credit against collateral from insolvent euro members

Following a Finnish initiative (see for instance Mußler 2011), proposals ranging from national gold reserves to public holdings of company’s shares are now publicly debated (Spiegel 2011). But will there be sufficient collateral for every lender to cover the entire credit risk? Presumably not. Are gold reserves managed by the central banks? Probably yes. So far, these independent national organisations have no incentive to give their reserves away. But they could be forced to do so by the ECB to compensate it’s purchases of government bonds.

In summary, the main initiatives under debate, even if implemented before long, lack incentives to reduce public debt in the Eurosystem. The only fairly realistic and credible approach is to pass national collateral, especially gold, from the borrowers to the lenders.

Effective incentive schemes for fiscal discipline

They would comprise automatisms and other politically independent decision-making. Here are some examples (for details see Kuhn 2011):

  • A completely independent fiscal institution chaired by an expert no younger than 60 years and coming from outside the EU.
  • Completely automatic sanctions based on an IT system fed with the relevant macroeconomic data by Eurostat.
  • Fewer or no more subsidies from EU funds for countries violating the rules.
  • A temporary loss of seats in the Council of Ministers, the Commission and the European Parliament, i.e. severe political instead of economic sanctions.
  • Automatic euro-exit for countries not fulfilling the Maastricht criteria during at least three years.
  • Rewards to performing countries, for example bonuses from the EU-budget, more seats in the European institutions, powerful positions such as President of the European Commission or of the ECB, and finally a publicly celebrated “medal of discipline” for the top three.

Consilium (2011), “Conclusions of the heads of state or government of the Eurozone of 11 March”.
Council of the EU (2010), “Economic Policy Coordination – European Semester”, Press Release 13161/10, 7 September, p. 6.
Council of the EU (2011), “Statement by the heads of state or government of the Eurozone and EU institutions”, 21 July.
Curtis, Polly (2011), “Sarkozy and Merkel call for 'true economic government' to save Eurozone“, Guardian.co.uk, 16 August.
EU-Info Deutschland (2011), “Umfrage: Drei Viertel der Bundesbürger gegen Eurobonds“, 18 August.
European Commission (2010), “EUROPE 2020 – A European strategy for smart, sustainable and inclusive growth, Annex 1 – Europe 2020: An Overview“, 3 March, p. 30.
Gros, Daniel (2011), “Pact for the euro: Tough talk, soft conditions?”, VoxEU.org, 14 March.
Heinen, Nicolaus (2010), “The European Semester: What does it mean?”, Euroactiv.com, 6 October.
International Monetary Fund (2009), “Fiscal Rules – Anchoring Expectations for Sustainable Public Finances”, 16 December.
Kafsack, Hendrik (2011), “Durchbruch bei Verhandlungen über Stabilitätspakt“, FAZ.NET, 7 September.
Kuhn, Britta (2011), “Eurokrise: Budgetregeln mit Biss“, oekonomenstimme.org, 2 September.
Mußler, H (2011), “Finnland ringt Griechenland Geld ab“, FAZ.NET, 18 August.
Spiegel (2011), “Von der Leyen will Gold als Sicherheit für euro-Hilfe“, Spiegel Online Wirtschaft, 23 August.
The Economist (2011a), “The divisiveness pact – Plans for closer economic integration in the euro zone could cause trouble”, Economist.com, 10 March.
The Economist (2011b), “Ties that sometimes bind”, Economist.com, 12 May.

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