Reference: Balassone, Fabrizio & Franco, Daniele, 2003. “EMU fiscal rules: a new answer to an old question?,” Sede de la CEPAL en Santiago (Estudios e Investigaciones) 34909, Naciones Unidas Comisión Económica para América Latina y el Caribe (CEPAL).

Balanced budget policies less popular than in the pre-WWII era; importance of allowing fiscal policy to be used to stabilize output

In EMU, concern to allow freedom for fiscal stabilization policy in part to reduce the need for the EMU-wide monetary policy to counteract shocks in member countries, leading to a desire to avoid very strict rules for fiscal deficits

At the same time, there was a long tradition throughout the 19th and early 20th century of viewing government spending in general as displacing productive private sector spending, and was therefore to be carefully considered and minimized as much as possible. This line of thought held that government borrowing was generally a bad idea and useful only for things like investment, althought he division between “current consumption” and “investment” was difficult to draw in practice. Particularly challenging is how to categorize government spending on intangible human capital and welfare categories such as health expenditure and education expenditure.

The fiscal framework of EMU was developed gradually.

The Treaty of Maastricht in 1992 set the fiscal criteria to be met for joining Monetary Union. The Stability and Growth Pact (SGP), adopted by the European Council in Amsterdam in June 1997, developed these criteria with a view to permanently restraining deficit and debt levels while allowing room for fiscal stabilisation.

The Pact also strengthened the monitoring procedures complementing the quantitative rules.

The Treaty of Maastricht stated that budget deficits cannot be larger than 3 per cent of GDP unless (a) under exceptional circumstances, such as deep recessions, (b) they remain close to 3 per cent, (c) the excess only lasts for a limited period of time.

If the deficit exceeds the 3 per cent limit when the above three conditions are not met, the deficit is deemed “excessive” and it sets off a procedure intended to force corrective measures by the deviating country.

If such measures are not taken the Treaty foresees monetary sanctions which increase as situations of excessive deficit persist

The Stability and Growth Pact commits EMU member states to a medium term objective of budgetary position close to balance or in surplus.

The main rationale for such a target is that its attainment will allow member states to deal with normal cyclical fluctuations while keeping the government deficit within the value of 3% of GDP set in the Treaty of Maastricht2. Compliance with this threshold, and with the 60 per cent ceiling for the debt to GDP ratio, will prevent the public finances of EMU member states from taking unsustainable paths.

The Stability and Growth Pact specified what is meant by “exceptional” and “limited period” in the clauses allowing a deficit greater than 3 per cent of GDP not to be considered “excessive”. A recession is considered exceptional if real GDP diminishes by 2 per cent. Milder recession (where the reduction in real GDP is of at least 0.75 per cent) may also be considered exceptional if, for example, they are abrupt. The excess above 3 per cent must be reabsorbed as soon as the “exceptional circumstances” allowing it are over.

The Pact also specified that each country should aim for a medium term objective of a budgetary position “close to balance or in surplus”. According to the guidelines provided by the European Council, the choice of the medium term target should take into account both the budgetary risks of recessions and those linked to fluctuations of other economic factors (e.g. interest rates).

Countries with debt ratios above 60 per cent of GDP should also take into account the need to decrease such ratio, at a satisfactory pace, towards the threshold. Moreover, an increase in the debt

According to the European Council, compliance with the Pact should be assessed considering the cyclical position of the economy.

In practice, EMU fiscal rules require that each member state choose a budgetary target in cyclically adjusted terms and let automatic stabilisers or discretionary action operate symmetrically around it. The lower this budget balance with respect to the 3 per cent threshold, the wider the margins for counter cyclical policy without running the risk of an excessive deficit.

Each member state must submit its budgetary targets officially in multi-year budgetary documents (Stability Programmes); these documents are updated annually and are subject to a review by the European Commission aimed at assessing their consistency with EMU fiscal rules.

Overall, the approach taken by the EU can be characterised as less flexible than the solutions adopted in some federally structured countries:

the rules are defined on the basis of established numerical parameters;

ex post compliance with the parameters is required each year; overshoots must be rapidly dealt with;

margins of flexibility are envisaged only in connection with exceptional cyclical events (established ex ante as a decline in GDP) or in any case events beyond the governments’ control;

no special provision is made for investment expenditure;

monitoring procedures are envisaged, whereby peer pressure is strengthened by the European Council’s power to make formal representations to governments of the need to adopt corrective measures during the year and by the application of pre-established monetary sanctions.

With European Monetary Union for the first time the need for fiscal rules arises in a multinational context.

The arrangements adopted are deeply embedded in the long-lasting debate on budgetary rules. The novel features of EMU guided the choice between alternative solutions and required the introduction of some innovations.

The need to reconcile fiscal soundness and budgetary flexibility led to combine different approaches:

setting a predetermined upper bound for the deficit is a new pragmatic solution;

balancing the budget over the cycle is a precept derived from the keynesian approach. In 1951 a report by the United Nations, commenting the 1937 Swedish reform, points out that “while counter - cyclical budgeting introduced an element of flexibility in the fiscal policy of Government, the concept of ‘financial soundness’ has been retained”;

prudence when fixing the average target to be achieved over the cycle (“close to balance or in surplus”) has a classical flavour. In 1927 Bastable argued that “the safest rule for practice is that which lays down the expedience of estimating for a moderate surplus, by which the possibility of a deficit will be reduced to a minimum”

The stress on fiscal soundness motivates the rejection of a dual budget approach and of any distinction between ordinary and extraordinary finance. However, pragmatism called for the allowance of margins for exceptional circumstances, this rests on the idea that “in some circumstances, indeed, a balanced budget is a pedantic luxury, which a community, hard pressed by sudden and exceptional misfortune, can ill afford” Dalton (1934, p. 12).

The asymmetry in EMU between the monetary regime, with the single currency and a single monetary authority, and the political landscape, lacking an authority of federal rank, gave prominence to moral hazard issues.

It is probably at the roots of the rejection of both the dual budget and the distinction between ordinary and extra-ordinary finance.

It motivated the adoption of a detailed multilateral surveillance procedure and the introduction of a predetermined limit for the annual deficit in a framework that envisages the targeting of a balanced budget over the cycle.

EMU may be termed a “radical federation”, where in the absence of fiscal rules member states enjoy absolute autonomy in matters of public expenditure and taxation and recourse to debt. In this context, the stability of monetary and financial conditions represents a public good to which all local governments contribute by maintaining sustainable budget positions.

There is an incentive for each local government to exploit the benefits accruing from the discipline of others without itself complying with the rules. This creates a double cost for the other entities: the free-rider’s excessive indebtedness can put pressure on interest rates to rise; it can also result in bankruptcies requiring bail-outs

The need for monitoring was felt also in earlier days. For instance, Durrell (1917) argues that : “the public and the Parliament should be satisfied that … there is some authority which … will give timely warning if that expenditure or those obligations are either outrunning the revenue provided for the year or engaging the nation too deeply in the future” (p. 242). However the monitoring procedure adopted for EMU is novel with respect to its scale, complexity and tightness

Until now [at the time of the article’s writing] the chosen mix of approaches has been successful in securing a reduction in budget deficits and debt across EMU member states. It remains to be seen whether it will also be successful in maintaining fiscal discipline once at regime. Unfavourable economic developments will put to test EMU’s fiscal constitution and the issue of legitimacy of rules in a democracy pointed out by Blinder and Solow may come to the fore again

Fiscal rules can be successful over a long period only if public opinion considers them a valuable contribution to policy making. In the words of Bastable (1927): “it but remains to again lay emphasis on the fact that good finance cannot be attained without intelligent care on the part of the citizens. The rules of budgetary legislation are serviceable in keeping administration within limits; but prudent expenditure, productive and equitable taxation, and due equilibrium between income and outlay will only be found where responsibility is enforced by public opinion of an active and enlightened community