For more than three decades, fiscal policies of members of the European Union (EU) have been constrained by increasingly complex rules built around common debt and deficit targets, known as the Stability and Growth Pact. Faced with the historic shock resulting from the COVID-19 pandemic, the EU suspended the rules until at least end-2021. There is broad agreement that the rules will need to be reformed before they are reinstated—because of the high levels of debt incurred during the pandemic, but also to address longstanding flaws.
In a PIIE Working Paper, we argue for a different approach. While the design of EU rules can be improved, the main problem is the very concept of country- and time-invariant EU fiscal rules. No rule can come close to fitting the diversity of possible situations, including because many are impossible to predict. The paper thus proposes discarding fiscal rules in favor of fiscal standards—qualitative prescriptions that leave room for judgment—together with a process to enforce the standards.
The limits to incremental reform
The role of EU-level fiscal rules is fundamentally different from that of national fiscal rules. National fiscal rules exist to help countries reach their preferred fiscal policy objectives. In contrast, the only purpose of EU fiscal rules or standards should be to reduce the risk of debt crisis–related spillovers across member states, by making sure that each country’s debt remains sustainable. So long as this is the case, member countries should be free to pursue their preferred fiscal policy.
The problem with any set of fiscal rules built around country-invariant debt and deficit ceilings is that they are an extremely poor proxy for debt sustainability, for four reasons. First, sustainability does not just depend on debt levels—or even debt and deficit levels—but also on future primary fiscal balances, interest rates, and growth. Second, the relationship between future interest and growth rates is uncertain. While the difference between the two is currently expected to be negative far into the future, implying that even high debt is consistent with a primary deficit, this could change. Third, the primary balance that a country can achieve depends on many additional factors. These include the starting level of the balance, the level of taxes, the type of government, and the willingness of the population to support fiscal adjustment. Fourth, investor confidence matters. While the European Central Bank (ECB) may be able to rule out extreme “bad equilibria” in which lack of investor confidence becomes self-fulfilling—as very high interest rates feed into higher debt—it cannot eliminate cross-country differences in the credibility of fiscal policy. These differences make it harder for some countries to adjust even if they want to and consequently lower the debt level that might be considered sustainable.
While it remains possible to come up with a well-founded assessment of whether debt is sustainable or not, such an assessment requires taking into account many factors: expected growth, expected interest rates, the country’s fiscal track record, politics, and institutions. Fiscal rules that treat all countries the same cannot possibly achieve that. But such rules can seriously hamper fiscal policy as a stabilization tool. This matters. The ECB’s “one size fits all” policy can get it right on average, but not for every member of the euro area. Furthermore, while the ECB is constrained by an effective lower bound on interest rates, it may have difficulties in playing its stabilization role even for the euro area as a whole.
Bringing the rules closer to the optimal tradeoff between allowing stabilization policy and limiting the risk of unsustainable debt would require vastly more complex rules—the opposite of what most recent proposals are trying to achieve. And even highly complex rules are unlikely to get it right, because many relevant contingences, the probabilities associated with them, and the right way to map them into a rule are impossible to identify ex ante.
From fiscal rules to fiscal standards
To escape this dilemma, the EU needs to move away from fiscal rules. Rather than attempting to codify the tradeoff between debt risks and output stabilization, this tradeoff should be evaluated case by case.
The legal literature refers to this approach as applying standards as opposed to rules. Standards lay out an objective, but without fully spelling out how it is to be met. “Do not drive faster than 55 miles an hour” constitutes a pure rule; “do not drive at excessive speed” is a pure standard. What speed is considered “excessive” depends on the situation and will be based on judgment, social norms, and legal precedent.
Most legal norms lie between these extreme cases: Rules may include exceptions or state contingencies; standards may list criteria that adjudicators must consider when deciding whether the standard was met.
Standards are commonplace in national and EU law. Article 126(1) of the Treaty on the Functioning of the European Union (TFEU), “Member States shall avoid excessive government deficits,” is an example of a pure standard. And while legal frameworks that seek to constrain fiscal policy tend to be based on rules, there are exceptions, such as New Zealand’s “principles of responsible fiscal management.”
Monitoring and enforcing fiscal standards
The obvious concern about the shift proposed here is that all EU member governments would argue that their conduct meets the standard, knowing that it would be difficult to prove them wrong. Accordingly, fiscal standards must lay out criteria that reduce discretion and guide judgment. In addition, there must be an effective fiscal surveillance and enforcement process:
- Criteria and methods that guide judgment. The existing fiscal standard, “Member States shall avoid excessive government deficits,” would remain as the starting point. EU secondary legislation would then lay out a general standard for when deficits would be considered excessive: namely, when debt is not sustainable with high probability, conditional on current and projected policies. It would also adopt a definition of “debt sustainability with high probability” (including what probability is deemed “high”) and identify methods that can contribute to assessing it. Such methods have been developed by institutions such as the European Commission (EC), the ECB, and the International Monetary Fund. EU secondary legislation could also state criteria that would inform the minimum speed of fiscal adjustment in the event that debt is not considered sustainable with high probability, including the state of the economic cycle, market conditions, and the level of interest rates.
- Surveillance with “teeth.” National independent fiscal institutions (IFIs) and/or the EC would be given the task to regularly monitor debt sustainability risks, much like the EC already does. If debt is not sustainable with high probability, the EC and/or IFI would propose remedial action, guided by the criteria laid out in EU secondary legislation, which the member would be expected to reflect both in its next draft budgetary plan (DBP) and its medium-term fiscal plan. If the EC and/or IFI deems these to be inconsistent with maintaining debt sustainability with high probability, they would be put on hold, pending final adjudication. This is more than the EC is currently allowed to do: While it can request revisions to the DBPs, it cannot delay the implementation of a budget that it considers inadequate.
In the event of a disagreement between a member and a surveillance institution, an EU institution would need to adjudicate (within a few months). Our preferred approach would be to assign this role to a judicial body—such as a new and specialized chamber of the European Court of Justice. This would allow the creation of a fiscal standards jurisprudence that is not encumbered by political considerations. But it would also require a change in the Treaty, which currently assigns the role of enforcer of good fiscal behavior to the Council of the EU. If the latter is maintained, it may be possible to avoid Treaty change. Article 126 allows member states to exceed the 3 percent deficit-to-GDP and 60 percent debt-to-GDP reference values under some conditions. EU secondary legislation could state that these conditions are considered to be met so long as debt remains sustainable with high probability.
Even with the requisite political support, these changes could not be implemented overnight. An interim reform of the fiscal rules could be required as a bridging measure. But reforms should not stop there. In an environment in which the COVID-19 crisis has already led to the suspension of such rules as well as to common and national fiscal action that was previously unthinkable, the opportunity to fundamentally rethink the EU fiscal framework should not be squandered. It is time to question the premises of the framework itself.
Olivier Blanchard is C. Fred Bergsten Senior Fellow at the Peterson Institute for International Economics and Robert M. Solow Professor of Economics emeritus at MIT. Álvaro Leandro is an economist at CaixaBank Research. Jeromin Zettelmeyer is deputy director of the International Monetary Fund’s Strategy, Policy, and Review Department and the Dennis Weatherstone Senior Fellow at the Peterson Institute for International Economics (on leave). Work on this project started while Leandro and Zettelmeyer were at the Peterson Institute for International Economics. The views expressed in this blog are those of the authors and do not necessarily represent the views of either the IMF or CaixaBank.