This column is a lead commentary in the VoxEU Debate "Euro Area Reform"
The ECB has played a critical role in saving the monetary union at the height of the crisis in 2012 and subsequently in supporting European recovery through a very accommodative monetary stance. If another major economic shock were to hit the euro area in the near future, euro area monetary policy may be overburdened to effectively smooth activity. Hence, it is critical that fiscal policy at the national level has enough room for manoeuvre to smooth the cycle when the next crisis hits, in the absence of a common fiscal capacity (OECD 2018).
A pre-condition is that member states use the current favourable economic situation to improve their fiscal position and not spend windfall revenues, especially in countries where there are fiscal sustainability issues (e.g. a high level of public debt or contingent liabilities). In the past, fiscal policy has frequently been pro-cyclical, with fiscal easing when the output gap was positive or reciprocally (see Figure 1). The European fiscal framework should provide sufficient incentives for that purpose.
Figure 1 The euro area fiscal stance is not sufficiently counter-cyclical
Source: OECD (2018), OECD Economic Outlook: Statistics and Projections (database).
Raising national awareness that fiscal consolidation is desirable in good times would pave a political way forward, ensuring that governments and their citizens are not tempted to spend windfall revenues immediately. This is where national fiscal councils could play a more active role, as long as they are properly staffed and financed, and communicate effectively to a wider audience, which is not always the case. In parallel, the European Fiscal Board could support such activities. For example, the European Fiscal Board noted that the euro area fiscal stance in 2016 was broadly appropriate, but that the geographical composition was not optimal (EFB 2017a). The European Fiscal Board could go one step further by providing an assessment on the appropriate fiscal stance for each country in line with the appropriate stance at the European level (OECD 2018).
Incentives to tighten fiscal policy in good times are also needed, for example through a better implementation of current fiscal rules of the Stability and Growth Pact (SGP). In that vein, the EFB proposed in 2017 that countries under the corrective arm of the SGP (i.e. countries in excessive deficit procedure) would see their nominal fiscal deficit target brought forward in case of better economic conditions (EFB 2017b). For countries under the preventive arm (i.e. countries outside the excessive deficit procedure), the EFB suggests a revised and faster convergence path of the fiscal balance towards the medium-term objective (MTO), which is defined in structural terms, in case of past deviations from the required path.
Although the EFB’s suggestions to make the rules less pro-cyclical in good times are valuable and worth exploring, they face two difficulties. For countries still under the corrective arm, it would be politically difficult to request that they reach their nominal deficit target faster even if growth is above potential, because spending needs remain high after several years of underinvestment and in view of rising inequality during the recession years. For countries that are under the preventive arm, meeting the MTO objectives earlier would add more complexity without necessarily being very effective. It has proved too complicated for politicians to explain the MTO concept to the general public. It is also a very imperfect instrument, as uncertainties regarding the level of the output gap – key to assess the structural fiscal balance – make it difficult to use in a fiscal rule. It is striking that the output gap continues to be revised several years after the publication of the first estimates (and lack of consensus among experts), reducing its relevance to assess consolidation efforts.
To avoid these difficulties, European rules should be revised. Two options could be considered.
First, positive incentives in the form of rewards rather than sanctions should be reinforced (Eyraud et al. 2017). Sanctions have proved not to be an effective tool and can backfire politically, reducing goodwill for fiscal adjustment. The Commission has recently proposed to provide budgetary incentives for countries achieving agreed structural reforms (European Commission 2017c). A similar idea could be explored regarding fiscal efforts (OECD 2018).
Second, rules could be simplified. Current rules are complex and it is difficult to assess the adequate fiscal stance based on the numerous fiscal indicators produced at the European level (EFB 2017b). The rules could be simplified by adopting an expenditure rule ensuring a sustainable debt-to-GDP ratio, an idea suggested by several authors (e.g. Benassy and al. 2018, Claeys 2017, Darvas and al. 2018, Eyraud and Wu 2015, Feld and al. 2018). To foster fiscal sustainability, the expenditure path should be set in a way that achieves a public debt-to-GDP ratio converging towards sustainable levels in the medium term. For example, the framework could be similar to the Swiss debt brake rule, which includes a notional account to compensate for past deviations, but with no link to a structural balance target (Debrun 2008).
Sanctions whose threat has been ineffective should be abandoned and replaced by market-driven incentives for fiscal prudence. One avenue could be to request countries wishing to deviate from their fiscal targets that they do it through GDP-linked bonds (OECD 2018). This will give countries more flexibility in managing their budget while at the same time introducing a market mechanism to encourage member states to meet or remain close to their fiscal targets. The issuance cost of such bonds would likely entail a premium, which would act as a disciplining device.
Recently, 14 French and German economists made a similar proposal by suggesting the issuance of junior bonds to finance fiscal slippages (Bénassy-Quéré et al. 2018). The advantage of GDP-linked bonds compared to junior bonds is that they would not require a debt restructuring – a rare and unlikely event owing to its high political and economic costs (see notably Tabellini 2018) – to improve debt sustainability in case of a major economic slowdown. With GDP-linked bonds, such a mechanism would be continuous and non-discrete – debt payments would be reduced as soon as economic growth falls below a pre-defined threshold. Reciprocally, investors would get higher revenues if growth surprises on the upside, which would be an attractive feature for investors.
Hence, GDP-linked bonds could bring substantial benefits in terms of stabilising debt-to-GDP dynamics by reducing restructuring risks especially in euro area economies where the high public debt ratio prevails (Blanchard et al. 2016, Benford et al. 2016, Carnot and Pamies Sumner 2017, Fournier and Lehr 2018). It should be noted that the impact would vary importantly across countries depending on the features of their economy, the positive impact on sustainability being potentially much smaller in some countries (Acalin 2018 and here). Some estimates suggest, however, that debt-stabilising effects could already be significant when GDP-linked bonds represent about 20% of the total debt stock (Shiller et al. 2018).
Overall, the fiscal sustainability benefits of GDP-linked bonds will depend on two conditions: (i) the issuance of GDP-linked bonds reaching a minimum threshold, and (ii) the interest paid on GDP-linked bonds not being too high. Linking the issuance of GDP-linked bonds to European fiscal rules could help satisfy those conditions.
To assess if the issuance of GDP-linked bound could be sizeable enough, we calculated the potential amount of GDP bonds that would have been issued during 2013-2017, based on the European Commission assessment of member states’ deviations from fiscal rules. This period is expected to provide a conservative estimate of the amount of GDP-linked bonds potentially issued, since it has been a recovery period when meeting fiscal rules was relatively easier. We find that many euro area countries would have issued GDP-linked bonds during this period, with such bonds reaching on average 13% of the total new issuances. This is lower than the 20% target mentioned above as it only concerns new issuances and will impact the total stock of debt only progressively, but the effect would be sufficiently significant to help kick-off a market for such bonds.
Table 1 How many GDP-linked bonds could countries issue for not meeting EU rules?
Source: author’s computation based on the European Commission’s assessments of member states’ stability programmes.
Note: Column 3 is obtained by dividing the cumulated amount of slippages during 2014-17 (column 2) by the cumulated amount of financing needs over the same period of time, assuming all slippages are financed through GDP-linked bonds.
The second condition on the level of interest to be paid is difficult to assess. The premium on GDP-linked bonds compared to standard bonds is set to increase with risks related to novelty, liquidity and growth, while a lower expected default risk should reduce this premium (Blanchard et al. 2016). Linking the issuance of GDP-linked bonds to fiscal rules should help reduce the influence of novelty and liquidity risks, however. The novelty risk should decrease relatively fast since many euro area countries are likely to issue such bonds, reinforcing investor confidence. Similarly, the liquidity risk should be smaller compared to the situation where countries issue GDP-linked bonds independently of fiscal rules, since deviations from the rules are likely to help create a sizeable market more rapidly (see Table 1 above). A rapid reduction in the novelty and liquidity risks is crucial since it would enable GDP-linked bonds to ensure debt-stabilization properties even in countries where specific economic features require a smaller premium for that purpose.
One operational challenge would be the assessment of deviations that would require or not the issuance of GDP-linked bonds. This role could be given to an independent institution, such as national fiscal councils.
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