Eurozone fiscal rules should be based on national macroeconomic stabilisation, not national debt stabilisation

 

In memory of Andrew Hughes Hallett

Eurozone fiscal rules have been suspended during the COVID crisis, thankfully. But I have argued on this blog since it began in 2012 (e.g. here) that the Eurozone fiscal rules, or any modified version thereof, were not fit for purpose. Now is the time to rethink the whole basis on which those rules were introduced.

Olivier Blanchard, Álvaro Leandro, and Jeromin Zettelmeyer also think the existing rules should be scrapped, but their alternative still has concerns about debt as central. It is the obsession with debt that has helped cause so many problems. We need a much more radical rethink, by going back to basic macroeconomics.

Before the Euro was formed, I argued in academic papers with others (e.g. here) that the Euro could only work well if fiscal policy was allowed to perform a macroeconomic (not debt) stabilisation role. That work continued after it was ignored when the Eurozone was set up (e.g. here). The idea reflects basic macro. During periods where the economy is growing rapidly relative to the EU average individual countries need to contract fiscal policy, and in relative downturns individual countries need fiscal stimulus. This follows once it is recognised that a monetary union takes away effective national monetary policy.

When the Eurozone was set up all this was ignored, and the Eurozone fiscal rules focused on debt stabilisation rather than macroeconomic stabilisation. The result was a disaster. From the beginning of the Eurozone until the global financial crisis (GFC), the smaller European countries experienced a boom because their interest rates were now tied to the Eurozone average, and the resultant fiscal surpluses were used as an excuse for fiscal excess. In contrast a recession in Germany was not met with fiscal expansion there, and produced below average inflation that gradually undercut other Eurozone countries.

These chickens came home to roost during the Eurozone crisis. Germany decided, regardless of the fact that most countries were only just recovering from the GFC, that the Eurozone crisis was because of generalised fiscal excess. A wave of fiscal contraction (with the help of an increase in ECB interest rates) produced a second recession. Because Germany had undercut everyone in the decade before, the only country not to suffer much during this recession was Germany, and the Periphery countries were subject to excessive austerity. For those unfamiliar with some of the horror stories over this period, you only need to read the chapter on the Eurozone in my book.

I can confidently say that if only the Eurozone had followed fiscal rules of the kind we suggested before the Eurozone’s creation, none of this (besides the GFC itself of course) would have happened to the extent it did. (For some analysis that backs this up, see the study I discuss here.) To see why this is, we have to return to macro basics.

Imagine a country that keeps interest rates fixed, but successfully uses fiscal policy to control inflation at target. That is close to how some countries tried to run their economies under the fixed exchange rates of Bretton Woods. What keeps government debt stable in these countries if the macro stabilisation policy is successful? The answer is booms and recessions. With booms and recessions following each other in what we call the business cycle, every period of fiscal stimulus (during a downturn) is followed by a period of fiscal contraction (during a boom). To a first approximation it nets out over time, so government debt is stable and sustainable. .

The Eurozone reproduces that situation with one important difference. When ECB interest rates are not stuck at their lower bound, the ECB controls the average rate of inflation. What national fiscal policy needs to do is to look at domestic inflation relative to the average Eurozone rate. [1] If a country’s inflation is above average, fiscal contraction is required and vice versa.

How would this have worked out before the GFC?

Inflation (HICP) differences to Euro area average: source Eurostat

	2000	2001	2002	2003	2004	2005	2006	2007
Germany	-0.7	-0.4	-1	-1	-0.3	-0.3	-0.4	0.2
Spain	1.4	0.5	1.3	1	1	1.2	1.4	0.7
Ireland	3.2	1.7	2.4	1.9	0.2	0	0.5	0.8
Portugal	0.7	2.1	1.4	1.1	0.4	-0.1	0.8	0.3
Greece	0.8	1.3	1.6	1.3	0.9	1.3	1.1	0.9

If Eurozone countries had followed this ‘basic macro’ fiscal rule, we would have seen fiscal contraction in the periphery countries, and fiscal expansion in Germany. As a result the fiscal position of the periphery countries would have been much healthier, and Germany would not have undercut everyone else. The actual fiscal rule that focused on excess deficits failed, because the periphery countries fiscal position looked healthy because output was growing too fast.

Focusing on relative inflation only works when the ECB is effectively controlling average inflation, as it was during the period above. Once ECB interest rates hit the lower bound, this is no longer the case. As a result, Eurozone fiscal rules need to switch from looking at relative to absolute inflation when interest rates are at or close to this lower bound. How would that have worked out during the period since 2013 when Eurozone inflation has been stuck below target?

Inflation (HICP) rates: source Eurostat

	2013	2014	2015	2016	2017	2018	2019	2020
Germany	0.5	0.4	0.2	0.0	1.1	0.7	0.7	0.3
Spain	1.5	-0.2	-0.6	-0.3	2.0	1.7	0.8	-0.3
Ireland	0.5	0.3	0.0	-0.2	0.3	0.7	0.9	-0.5
Portugal	0.4	-0.2	0.5	0.6	1.6	1.2	0.3	-0.1
Greece	-0.9	-1.4	-1.1	0.0	1.1	0.8	0.5	-1.3

As we can see both German and Periphery inflation was below 2% throughout this period, so fiscal policy should have been more expansionary to get inflation back on track. What stopped this? The existing not fit for purpose Eurozone rules. You can also see excessive fiscal contraction in Greece over this period.

There is plenty of detail around the edges of these ‘basic macro’ fiscal rules for the Eurozone. For example, what is the best inflation index to use? Answer, one that excludes fast moving prices like commodities. Do you need to do anything about countries that fail to follow their rule by persistent excess (or deficient) inflation? Answer, yes. This is where external monitoring needs to come in.

Even in cases where countries persistently fail to get to average Eurozone inflation, the response by the Commission should not be to talk about excess debt but to talk about competitiveness misalignments. Judgement is required because sometimes changes in real exchange rates are required in monetary unions. That apart, any external intervention would be clearly symmetrical, with attempts to undercut other Eurozone countries treated as equally serious to emerging overvaluation. If you focus just on debt, the former is ignored. [1]

In the simulation studies I have been involved with, fiscal rules of this kind tend to reduce by around half the costs of asymmetric shocks to the Eurozone. The current rules seem to amplify the welfare cost of shocks. In reality macro stabilisation among Eurozone countries, trying to eliminate periods of relative boom and recession, may have a critical influence on the fortunes of some of the more extreme right wing national political parties.

Basing European fiscal rules around debt have proved a complete failure. I remember arguing with people from Spain before the GFC saying you need for fiscal contraction, and the incredulous reactions I got. But we are running surpluses, they replied, your suggestion makes no sense. Unfortunately after the GFC it made perfect sense. Having any Eurozone fiscal rules based on deficits and debt has failed, and is bound to fail.

Of course nothing like this will happen. The mindset of policymakers in much of Europe is dominated by the failed ideas that depart from basic macro, and that were hard-copied with the formation of the Euro. But it is important that at least some people outline what fiscal rules derived from basic macroeconomics would actually look like, and why they are much superior to those we have today.

[1] Why do I focus on inflation, rather than output gaps? Simply because output gap measurement is very poor.

[2] There is one possible scenario when the commission needs to worry about debt, and that is when all countries simultaneously fail to enact fiscal contraction in a boom, and the inflationary impact of that is counteracted by higher interest rates. That is the equivalent to why you need deficit based fiscal rules in a single country with a floating exchange rate outwith the zero lower bound. But that can be easily dealt with by the commission requiring an equal fiscal contraction across all Eurozone countries. Problems occur when government debt is used to call for fiscal contraction in some countries and not others. Once again the problem is symmetrical: if countries are simultaneously failing to enact sufficient fiscal stimulus in a recession, leading ECB interest rates close to the zero bound, or worse still not undertaking fiscal stimulus at the lower bound, all countries can be told by the commission to enact more fiscal stimulus.