VoxEU Column EU policies

Golden rule or golden straightjacket?

Europe’s Fiscal Compact is being widely sold as the essence of prudent fiscal management. But this column argues that the rules in the Fiscal Compact severely restrict a country’s ability to use fiscal policy to stabilise its economy and will often require debt levels far below those considered sensible. The rules should be changed before they become a straightjacket.

Economists have long debated the question of whether macroeconomic policy should be set on the basis of a pre-specified set of rules or whether policymakers should be allowed discretion to set policy as they see fit. Personally, I am a sceptic regarding legally binding macroeconomic rules.

As a professional macroeconomist, I think it is important to admit the limits of our knowledge. Governments can face policy challenges that even the most complex rules may fail to anticipate. We should also acknowledge that our understanding of how the macroeconomy works is, at best, incomplete.

For these reasons, macroeconomic rules that constitute ‘frontier macroeconomic thinking’ at one time can end up being viewed later as overly rigid and outdated. The adherence of international policy makers to the Gold Standard during the 1930s provides a good example (see Eichengreen and Temin 2010).

What is noteworthy about the new EU Fiscal Compact, however, is that it does not even correspond to current mainstream thinking among economists as to how an ideal fiscal policy framework should operate.

I suspect most economists would agree that such a framework should have two key elements.

  • First, it should guide an economy towards a moderate and sustainable level of public debt.
  • Second, it should keep public debt fluctuating around this moderate level in a countercyclical fashion, with higher-than-usual deficits in times of recession being offset by improvements in the fiscal position during expansions.

In relation to the first element, moderate debt levels, the compact emphasises the need for an explicit trajectory whereby countries can return towards a 60% debt-to-GDP ratio. I think this addition to the Stability and Growth Pact is a positive one and one could make an argument for placing it on a formal EU-treaty footing.

Far less positive, however, is the so-called golden rule setting a legally binding maximum structural deficit of a 0.5% of GDP when a country has a debt ratio above 60% and a maximum of 1% when a country has a debt ratio lower than 60%. In addition, independent of the ‘cyclical adjustments’ that are factored in to structural deficits, the maximum actual deficit shall be 3% of GDP.

The idea of the desirability of balancing the national budget may appear self-evident to its designers, embodying as it does the wisdom the famous Swabian housewife. However, an economy is not a single household and, as we know from the paradox of thrift, these comforting comparisons can be highly misleading when applied at an aggregate level.

The truth is that, far from golden, this rule is a poor one that doesn’t correspond to either of the principles of good fiscal policy just mentioned.

In relation to long-run debt levels, this rule, if followed over time, will lead to debt ratios well below those considered sustainable and moderate. An economy’s debt-to-GDP ratio tends to converge towards the ratio of the average deficit percentage to the average growth rate of nominal GDP (see Whelan 2012). So, for example, an economy with an average growth rate of nominal GDP of say, 4%, following a policy in which average deficits are a maximum of 1%, will end up with a maximum debt-to-GDP ratio of 25%, far below what is required to operate a sensible and stabilising fiscal policy.

These rules will also severely limit the ability to use fiscal policies for stabilisation purposes in a manner consistent with moderate long-run debt levels.

For example, a deficit of 2.4% per year would, over time, stabilise the debt-GDP ratio at 60% in an economy in which nominal GDP grew at an average 4% pace. Cyclical deviations of 2 or 3 percentage points around such an average deficit of 2.4% would also be possible without endangering fiscal stability. However, the 3% maximum deficit rule severely limits the ability to run countercyclical policies of this type that would still be consistent with moderate levels of debt.

Because Eurozone member states cannot set their own exchange rates or interest rates and do not receive any federal transfers, these severe restrictions on the only available macroeconomic policy tool are likely to be particularly damaging to macroeconomic stability in the Eurozone. Indeed, they may contribute to its long-run failure rather than help to keep it together.

Finally, the legal invocation of the concept of a structural deficit is unfortunate. This is a theoretical concept and empirical measures of it can differ widely depending on how the analysis is done. Legally binding rules that rely on impossible-to-measure quantities are likely to run into trouble sooner or later.

Without doubt, the political realities of the post-ESM Eurozone require a greater commitment to fiscal responsibility but Europe could have achieved this goal with a far better set of rules than were arrived at in this hastily drawn-up treaty.

At least those who inflicted damage on the world economy by sticking to the Gold Standard in the 1930s can claim to have been following prevailing economic thinking. The politicians who have designed these rules will have no such defence.

Ideally, debate about this treaty in all European countries should move beyond misleading analogies about the prudence of households balancing their books to focus on its actual long-run implications. Once passed into treaty form, it will be extremely difficult for European citizens to change these rules. Hopefully, it is not too late to prevent the golden rule from becoming a golden straightjacket.


Eichengreen, Barry and Peter Temin (2010), "Fetters of gold and paper", Oxford Review of Economic Policy 26(3): 370–84.

Whelan, Karl (2012), “Simple Analytics of the Debt-GDP Ratio”, Irish Economy, 23 February.

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