New fiscal rules in the Eurozone, but unwarranted lack of national sovereignty persists

 

The EU Commission has put forward proposals for the next version of fiscal rules for the Eurozone, and these have now been agreed with some amendments (see below). (Here is a useful summary of the proposals.) That changes are needed in what existed before the pandemic is undeniable.

The original Stability and Growth Pact rules were a disaster. They were the clearest example of something I wrote recently about deficit targets:

“The cyclical nature of the government’s deficit (rising in bad times, falling in good) encourages politicians to do fiscal consolidation at the wrong time and discourage them from doing fiscal consolidation at the right time.”

These original rules encouraged periphery members of the Eurozone (EZ) to spend too much/tax too little in the early and mid-2000s (leading to inflation above the EZ average), and then encouraged the whole of the EZ to cut spending just when higher spending was needed (the austerity period), producing a second recession after the Global Financial Crisis.

The Commission attempted to rectify these problems by introducing cyclically adjusted deficit targets and other modifications to the SGP rules, but the resulting complexity suited no one, in effect giving considerable discretionary power to the Commission and EZ as a whole over elected national governments.

I wrote a lot about the perverse nature of EZ fiscal decisions during the austerity period, but much less since then. The reason is set out here. I have always thought that the focus of fiscal policy in individual EZ countries should be national stabilisation, not debt stabilisation. If individual countries focus on their own inflation rate relative to the EZ average, for example, then you avoid the dangers of pro-cyclical fiscal policy outlined above. This has always been the message of macroeconomic theory.

The academic rationale for the Eurozone imposing rules for the national deficit was that a common currency would increase the incentives for national deficit bias. What the Eurozone crisis showed was the exact opposite. When deficits rose after the GFC, it was countries with their own central bank that found interest rates on their debt falling. Because the ECB is not a buyer of last resort for national debt, it was EZ countries with excessive deficits that the markets worried about. Market discipline over excessive deficits was greater, not less, with a common currency. There are no good reasons, therefore, for the Commission or other EZ countries to be able to dictate the level of national deficits: instead they should focus on countries with persistently above or below average inflation.

Even if I’m right about this, political pressures will mean the EZ will persist with worrying about national deficits rather than national inflation differentials for some time. So when talking about changes to EZ fiscal rules, I‘m in a similar position to someone who doesn’t believe in dieting having to write about the wisdom of the latest dietary fad. Instead of asking whether the Commission’s new proposals will help reduce national deficits, I will instead ask four questions:

1. Do the proposals make it more or less difficult for national governments to stabilise output and inflation relative to the EZ average using fiscal policy, which is what they should be doing?

2. Do the proposals address the issue of the zero lower bound?

3. Is public investment excluded from the fiscal rules? Will fiscal rules stop contributing to a serious decline in public investment in the EZ?

4. Do the proposals reduce or increase the amount of interference by the Commission or other EZ countries in national fiscal policy
   
   

This last point needs some explanation. Those that wish less national sovereignty for EZ members, and more decision making at the EZ level, may have the opposite criteria. Fiscal rules imposed by the Commission may be a way of getting Fiscal Union by the back door. My own view is that fiscal union by the back door would be a potential political disaster at this point in time, so I want to increase rather than reduce national fiscal sovereignty within the EZ.

Returning to the new rules suggested by the Commission, one aspect might help national governments do countercyclical fiscal policy. The proposals emphasise medium term planning (4 years rather than year to year, and possibly extendable) and the concept of sustainability. However, countries that exceed the 3% deficit limit will not only be expected to reduce their deficit to this limit within the plan period, but will have to reduce the deficit by 0.5% a year at least. The issue of what happens at the zero lower bound, where fiscal policy at the EZ level should take over responsibility from the ECB in enhancing economic recovery, remains unaddressed.

What might seem striking about the proposals is the switch from a focus on cyclically adjusted deficits to adjusted net expenditure. As ‘net’ here means net of cyclically adjusted taxes, and ‘adjusted’ here means excluding cyclical changes in unemployment benefit, this switch is less important than the terminology might suggest. Nevertheless, Charles Wyplosz argues that the new measure is “convoluted and much less intuitive” than the cyclically adjusted balance, and also has a number of technical disadvantages. If the motivation was in part because of very real difficulties in doing the cyclical adjustment, then the new measure also involves doing very similar things. The advantage of true medium term plans and targets (5 years is better than 4) is that most forecasts assume the economy 5 years out is ‘at trend’, so there is no reason to cyclically adjust.

The new ‘adjusted net expenditure’ measure does have one advantage, however. It excludes “above trend” public investment, As a result, an EZ country that decides to increase levels of public investment beyond normal levels will not be penalised for doing so. This is better than nothing, but it doesn’t seem to stop governments from cutting public investment below normal levels to meet suggested net adjusted spending levels proposed by the Commission. This is always a temptation for governments, because cutting investment is less politically painful than cutting current spending or raising taxes. This is why low levels of public investment in the EZ are, in part at least, due to poorly specified fiscal rules.

The proposals nod towards giving “‘independent fiscal institutions’ (IFIs, or fiscal councils) a greater role in the process, but it is not clear to me how substantive that is. Blanchard, Sapir and Zettelmeyer are concerned about the “outsized role” the Commission has in the process. To quote

“The Commission would propose the reference scenario, assess the country’s counteroffer, and recommend a modified plan if it finds the counteroffer lacking. If the country does not accept the modified plan, the Council is expected to adopt the Commission’s reference scenario for surveillance and enforcement purposes.”

One option the Commission had was to transfer its own oversight role to an IFI for any country that appeared not to be ‘at risk’ and if the IFI was truly independent, but this opportunity was not taken. Hopefully the shift to a more medium term perspective will give national governments more freedom, although whether that is achieved in practice we will have to see.

This continuing lack of fiscal sovereignty within the Eurozone is not just (and not mostly) because it gives an unelected Commission power over elected governments. The more serious problem is that it gives other EZ countries, some of whom have a very hawkish and macroeconomically naive view, power over national fiscal policymaking, as this account of the negotiations over these proposals makes clear. (This was most evident, of course, in the case of Greece during the last decade.)

This in turn makes the current EZ stance that any new EU members must also join the EZ very punitive. It is a very good reason why a future UK might stop at joining the EU Single Market and Customs Union, and refrain from full membership, even though that gives it no say in rule making.