Opinion

How to reform EU fiscal rules

The current inefficient European fiscal framework should be replaced with a system based on rules that are more conducive to the two objectives of public debt sustainability and fiscal stabilisation.

By: and Date: April 12, 2016 Topic: European Macroeconomics & Governance

The austerity policies implemented in many European countries since 2010 have contributed to the poor economic recovery, raising questions about why EU budget rules failed to deliver both economic stabilisation and public debt sustainability.

In theory the current rules could do a good job, but in practice they face major hurdles. A key indicator used in the current rules is the structural budget balance. This is the government budget balance corrected for the effects of the business cycle and one-off payments such as bank bailouts.

If the structural deficit is too high, then countries must adjust their budgets. If not, they do not have to adopt austerity measures. In theory, when a recession hits, the actual budget deficit deteriorates because of falling tax revenues and increased unemployment benefit payments, but the structural balance does not change for these reasons and therefore it does not trigger austerity policies.

But in practice the structural budget balance is hard to estimate. The estimate relies on uncertain assessments of the economic cycle and its impact on government revenues and spending. Estimated changes in the structural balance are typically revised by more than half a percent of GDP (see here), which is more than the adjustment that the rules require.

Unsurprisingly, finance ministers of eight euro-area countries recently expressed doubts about EU methods for estimating the cyclical position of the economy and its implications for analysing budgets.

Economic forecasts are also a major source of errors. Current fiscal rules rely on European Commission forecasts on growth and inflation, which often turn out to be wrong.  In recent years the commission repeatedly forecast that the economy would return to growth and inflation would quickly return towards 2%, but this has not turned out to be true.

As a consequence, policy recommendations based on these forecasts actually made the economic situation worse. Forecasting accurately is certainly very difficult, especially in uncertain times. Other forecasters, such as the IMF, the OECD or private institutions, did not do better than the Commission. It would be better to have a fiscal rule which is less dependent on economic forecasts.

Another key problem with the current EU fiscal framework is the opaque web of ‘flexibility’ clauses. This leads to never-ending bargaining between member states and the European Commission about the implementation of the rules, which undermines trust in them.

Several politicians in countries that breach the rules regard the rules as inappropriate and openly disregard the rules. Other politicians in countries that comply with the rules worry that the rules are not enforced on their partners.

Preserving the current fiscal framework would therefore be highly inefficient. A new framework is needed.

The best option would be to scrap the current fiscal framework altogether. One way would be to remove the option for European bailout for governments completely, establish conditions for market discipline to work effectively, allow a large degree of fiscalindependence to member states and design European instruments to dampen economic cycles, such as a European unemployment insurance scheme.

However, such a complete overhaul appears politically unrealistic today. That’s why we suggest a second best option. All rules related to the badly-measured structural balance should be dropped. We propose a new rule limiting the growth rate of public spending, excluding certain items such as unemployment benefit payments and large one-off payments like bank bail-outs.

Under our rule, public expenditure growth would be limited to the country’s potential GDP growth, plus the central bank’s inflation target.  In bad times, this would reduce the incentive of governments to cut expenditures. Even if tax revenues fall and spending on unemployment increases, governments would still be allowed to support growth. In good times, it would dampen excessive booms, such as the ones that happened in Ireland and Spain before the crisis, as governments would not be allowed to spend the extra tax revenues generated by bubbles.

The limit would also take into account the level of public debt. Countries with high public debt should have slower expenditure growth than countries with low public debt, to support long-term debt sustainability.

We also propose to get rid of the opaque web of flexibility clauses in current fiscal rules. Instead, the rule would be monitored by national fiscal councils and a newly-established independent European fiscal council. The latter should be composed of an executive board and the chairs of national fiscal councils. The European fiscal council would assess when countries can deviate from the rules in exceptional times.

This overhauled framework would be simpler, more transparent, and easier to monitor than the current system and would avoid relying on an unpredictable indicator.

Enforcement of the rules at the European level should move away from the threat of sanctions. They are not credible in the current framework anyway, and could have highly negative political consequences if they were applied.

Ultimately, countries should not – and will not – observe the rules because they fear sanctions, but because they all agree that the rule represents the best guidance for their fiscal policies to be both sustainable and supportive in a recession.

See more details in our recent policy contribution “A proposal to revive the European Fiscal Framework”.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint.

Due to copyright agreements we ask that you kindly email request to republish opinions that have appeared in print to communication@bruegel.org.

View comments
Read article More on this topic More by this author

Blog Post

Reforming the EU fiscal framework

Researchers have often highlighted the problematic nature of the currently very complex EU fiscal framework. Here we review economists’ views on how it should be changed.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: September 17, 2018
Read article More on this topic

Blog Post

The economic case for an expenditure rule in Europe

Proposals for reforming the euro area back on the agenda. An overhaul of the European fiscal rules should be on high on this agenda, because the current fiscal framework has not worked well. This column proposes substituting the numerous and complex present rules with a new, simple rule focused on limiting annual growth rate of expenditures.

By: Zsolt Darvas, Philippe Martin and Xavier Ragot Topic: European Macroeconomics & Governance Date: September 13, 2018
Read about event More on this topic

Past Event

Past Event

Reforming Europe's fiscal framework

This event will discuss reforming Europe's fiscal framework in order to make it less complex and more effective.

Speakers: Zsolt Darvas, Lars Feld, Philippe Martin, Lucio Pench and Beatrice Pierluigi Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: September 12, 2018
Read article Download PDF More on this topic More by this author

Policy Contribution

High public debt in euro-area countries: comparing Belgium and Italy

This Policy Contribution looks at the evolution of public debt in Belgium and Italy since 1990 and uses the debt dynamics equation to explain the contrasting evolution in the two countries in the run-up to the introduction of the euro, during the early years of the euro and since the beginning of the crisis, arguing that the euro could have been used also by Italy to undertake sufficiently large fiscal adjustment.

By: André Sapir Topic: European Macroeconomics & Governance Date: September 6, 2018
Read article More on this topic More by this author

Blog Post

The great fiscal lever: An Italian economic obsession

In the Italian macroeconomic context, many are convinced that if only we had a large enough fiscal lever, we could set in motion an economy that has stagnated for almost 20 years. But the author argues that the efficiency of Italian (public) investment is currently low. Specific measures can be taken to improve this situation, though, and only once this is done should the public investment lever be used forcefully.

By: Alessio Terzi Topic: European Macroeconomics & Governance Date: August 21, 2018
Read about event More on this topic

Past Event

Past Event

Assessing the EU’s fiscal architecture: a presentation by the European Fiscal Board

This event will discuss the 2019 Fiscal Stance, which assesses the current macroeconomic situation and offers advice for the future.

Speakers: Niels Thygesen, Guntram B. Wolff and Maria Demertzis Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: July 2, 2018
Read about event More on this topic

Past Event

Past Event

For a stronger and more integrated Europe

This event will feature the presentation of the Economic Survey of the European Union 2018 and Economic Survey of the Euro Area 2018.

Speakers: Angel Gurría, Zsolt Darvas, Pierre Beynet and Aida Caldera-Sanchez Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: June 19, 2018
Read article More on this topic More by this author

Opinion

Make euro-area sovereign bonds safe again

In their recent Policy Insight, the team of French and German authors suggest introducing sovereign bond-backed securities to play the role of safe asset in the euro area. This column, part of the VoxEU debate on euro-area reform, argues that an improved euro-area architecture would, in the long run, make all euro-area sovereign bonds safer, and thus make the provision of safe assets through untested and potentially disruptive sovereign bond-backed securities unnecessary.

By: Grégory Claeys Topic: Finance & Financial Regulation Date: May 25, 2018
Read article More on this topic More by this author

Opinion

Fiscal rules and the role of the Commission

The proposals on fiscal frameworks and rules in the recent CEPR Policy Insight on euro-area reform showcase the multiple dimensions of the fundamental dilemmas we are confronted with in the governance of the euro area. This column, part of the VoxEU debate on Euro Area Reform, looks at the challenges to the central role of the Commission that have arisen as the rules-based fiscal framework has been severely compromised.

By: Thomas Wieser Topic: European Macroeconomics & Governance Date: May 22, 2018
Read article More on this topic More by this author

Opinion

Will U.S. tax reform lure U.S. companies away from China?

What will be the results of the changes to the U.S. tax system in China? Will the new U.S. corporate tax rate cause Chinese firms to shift their operations to the U.S. to enjoy the new tax benefits? Read Alicia García-Herrero's opinion on President Donald Trump’s tax reform.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: March 26, 2018
Read article Download PDF More on this topic

External Publication

Reconciling risk sharing with market discipline: A constructive approach to euro area reform

This publication, written by a group of independent French and German economists, proposes six reforms which, if delivered as a package, would improve the Eurozone’s financial stability, political cohesion, and potential for delivering prosperity to its citizens, all while addressing the priorities and concerns of participating countries.

By: Agnès Bénassy-Quéré, Markus K. Brunnermeier, Henrik Enderlein, Emmanuel Farhi, Marcel Fratzscher, Clemens Fuest, Pierre-Olivier Gourinchas, Philippe Martin, Jean Pisani-Ferry, Hélène Rey, Isabel Schnabel, Nicolas Véron, Beatrice Weder di Mauro and Jeromin Zettelmeyer Topic: European Macroeconomics & Governance Date: January 17, 2018
Read article Download PDF More on this topic More by this author

Policy Brief

Beyond the Juncker and Schäuble visions of euro-area governance

Two diametrically opposed visions of the euro-area architecture have been put forward. Departing from both Juncker’s and Schäuble’s proposals, the author identifies new ideas to develop the euro-area governance

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: December 1, 2017
Load more posts