Abstract :
• From a macroeconomic theory perspective, European fiscal rules are often considered highly restrictive and poorly calibrated to ensure public debt sustainability and stable growth;
• Despite the fact that European fiscal rules have been poorly respected, empirical research tends to show that fiscal policies have become more sustainable since the ratification of the Maastricht Treaty and even after the creation of the euro;
• However, the procyclical nature of European fiscal policies remains the main pitfall of the European fiscal framework and the main risk to fiscal sustainability.
The unsustainability of public debt in the eurozone is rarely debated, nor is the idea that the current fiscal rules are not sufficiently restrictive and that sanctions are too rarely applied, encouraging member country governments to engage in « fiscal free-riding, » which would explain the eurozone’s vulnerability to sometimes irresponsible fiscal behavior. This was the main motivation behind the latest reforms of the European budgetary framework (Six-Pack, Two-Pack, and TSCG). Although still fairly widespread, this analysis is increasingly being debated and nuanced, including at the highest level of the European institutions (Buti, 2017). Theoretical and empirical research on budgetary rules and public debt sustainability can shed useful light on all of these issues.
The analysis of fiscal sustainability initiated by Henning Bohn (1998) proposes a framework for study in terms of « fiscal rules » that describe the dynamic response of the primary budget balance to the level of public debt. Bohn concludes that a strictly positive reaction of the primary balance to the level of debt is sufficient for the government to verify its long-term intertemporal budget constraint. More recently, this analysis has incorporated the concepts of fiscal limits and fiscal fatigue to derive estimates of the maximum debt threshold based on Bohn-style fiscal rules.
Thus, given the existence of a maximum public debt threshold according to the literature, recent work now considers a more restrictive sustainability criterion, according to which fiscal policy must stabilize its public debt-to-GDP ratio in the medium term at a level that guarantees sufficient fiscal space to cope with macroeconomic shocks of the magnitude of those seen in 2008-2009 (see in particular Daniel and Shiamptanis (2013), Ghosh et al. (2013a,b)). A stabilization fiscal rule therefore implies that the primary balance’s response to debt should not only be positive, but on average greater than the actual interest burden.
What can we learn from this literature about the issue of public debt in the euro area? Are the European fiscal rules defined by the Stability and Growth Pact (SGP) theoretically justified? Are European fiscal policies and public debt unsustainable?
1. Can European fiscal rules be justified in theory?
European budgetary rules include a preventive component, which sets a medium-term balanced budget or surplus target, and a corrective component, the Excessive Deficit Procedure (EDP), which is triggered when the nominal deficit of the general government exceeds 3% of GDP or when debt exceeds 60% of GDP, with no prospect of a satisfactory and credible reduction.
On the one hand, given the requirement for stability in the public debt-to-GDP ratio, the medium-term balanced or surplus budget target would appear excessive and unjustified. It would imply (if strictly adhered to) that public debt would converge towards 0% of GDP in the case of a balanced budget target, or even that the state (in the sense of all general government) would become a creditor to the rest of the economy in the long term in the case of a medium-term budget surplus. In practice, given real GDP growth and inflation, a fiscal policy can run a deficit and still stabilize its debt level as a percentage of GDP in the medium term, which defines the concept of a « stabilizing deficit. »
On the other hand, macroeconomic analysis puts forward theoretical arguments showing that a balanced budget rule can be inherently destabilizing. First, because it amplifies the macroeconomic cycle, from a neo-Keynesian perspective, by preventing automatic stabilizers from functioning. But academic research also suggests that a balanced budget rule can expose the economy to « multiple equilibrium » situations and thus to self-fulfilling prophecies (Schmitt-Grohe and Uribe, 1997). Finally, research on the optimal policy mix in a monetary union shows that such a rule is suboptimal because it limits the ability of national fiscal policies to stabilize the national economy in the face of « asymmetric » macroeconomic shocks to which monetary policy (by definition, common to the entire monetary union) cannot respond (Gali and Monacelli, 2008; Ferrero, 2009).
To a certain extent, the corrective component and the 3% deficit rule find more theoretical support, since it corresponds to a rule for stabilizing the public debt-to-GDP ratio at the 60% threshold (Buiter et al. 1992). However, its application is arbitrary and strict. First, the 3% and 60% thresholds are only mutually consistent under the assumption of 5% nominal growth. Second, the choice of a 60% public debt threshold for triggering the EDP seems questionable given its arbitrary nature, compared with estimates of the maximum sustainable public debt-to-GDP ratio, which are often well above 100% of GDP (see Ghosh et al. 2013a,b). Furthermore, a rule to stabilize the debt-to-GDP ratio does not imply that the actual deficit must strictly follow the stabilizing deficit, but only « on average » and excluding cyclical effects. Finally, because it masks differences in real interest rates, the nominal deficit is a rather poor indicator of the sustainability of public finances, and it is probably better to consider the primary budget balance.
The adjustment rules, defined in terms of changes in the structural deficit (of around ±0.5% of potential GDP, depending on the case), are closer to a Bohn (1998) sustainability rule. However, they are probably still too demanding and potentially more recessionary than the initial SGP (Creel et al. 2013), in addition to relying on complex techniques for estimating potential GDP (Eyraud and Wu, 2015; Eyraud et al., 2017).
In many respects, European fiscal rules are too demanding in terms of sustainability constraints, despite the many reforms they have undergone to increase their flexibility. On the contrary, it is increasingly recognized that their growing complexity has undermined their credibility (Eyraud and Wu, 2015; Claeys et al. 2016; Eyraud et al., 2017).
2. The euro has increased the sustainability of European public debt
European fiscal rules have been largely ignored (see Figure 1): notable examples include the Excessive Deficit Procedures (EDPs) initiated against Germany and France between 2003 and 2007, and more recently the multiple extensions granted to countries under EDPs, such as Spain and France. It should be noted that the objectives associated with the preventive arm (i.e., the MTO and the annual budgetary effort) are less often respected than the objectives of the corrective arm (deficit/GDP and debt/GDP below 3% and 60%, respectively).
Figure 1: Non-compliance with European budgetary rules between 1999 and 2013
Source: Eyraud and Wu (2013), AMECO, BSI economics
Legend: The figure shows the frequency over the period 1999-2013 (in % and per country) of non-compliance with the four main components of European budgetary rules, for the corrective (3% deficit/GDP and 60% debt/GDP thresholds) and preventive (Medium-Term Objective (MTO) and minimum annual fiscal effort). It should be noted that the MTO is the deficit target (as a percentage of GDP) that EMU member states commit to achieving in the medium term, and that the minimum annual fiscal effort is defined as a 0.5% improvement in the structural budget balance.
Paradoxically, however, the available empirical evidence suggests that the majority of European fiscal policies and public debts have been sustainable. Comparing the pre-Maastricht period with the post-Maastricht period, most empirical studies find that the primary budget balance has increased, on average, following a rise in public debt since the ratification of the Maastricht Treaty, in contrast to the pre-Maastricht period.
Thus, the empirical results of Collignon (2012) suggest that the ratification of the Maastricht Treaty and the creation of the euro led to a regime change in fiscal policy, both in terms of objectives—implicit deficit and debt targets—and the pace of adjustment of the primary balance. Daniel and Shiamptanis (2013) show that the creation of the EMU has effectively increased the response of the primary budget balance to the level of public debt, and that European fiscal policies generally follow a rule of stabilizing the public debt-to-GDP ratio.
On the other hand, the widespread widening of primary balances and the increase in debt following the 2009 crisis do not necessarily provide empirical evidence of a weaker response of the primary balance to debt, but are largely the result of greater countercyclicality of fiscal policies in the euro area. On the contrary, several recent studies suggest that fiscal policy has increased the response of the primary budget balance to public debt since the crisis, indicating an increase in long-term fiscal sustainability (see Berti et al. 2016, Checherita-Westphal and Žďárek, 2017).
While the implementation of the SGP rules prior to the creation of the euro increased the sustainability of European fiscal policies, it is sometimes said that euro area member countries relaxed their efforts after the euro was launched, taking advantage of a very significant decline in real interest rates and debt refinancing costs to stabilize their debt ratios. However, Weichenrieder and Zimmer (2014) show that this statistical result is not robust when Greece is excluded, nor when the crisis years (2009-2011) are excluded. Their findings tend to refute the idea that most eurozone member countries relaxed their fiscal efforts after the introduction of the single currency, or at least that this result can be explained mainly by the specific case of Greece and the impact of the crisis. Furthermore, even when including Greece and the crisis years in their estimates, they confirm that fiscal policy has indeed been more sustainable since the ratification of the Maastricht Treaty.
3. The excessive procyclicality of fiscal policies in Europe
While multiple empirical studies point to a positive reaction of the primary balance to the level of public debt, which is strong enough to stabilize it in the medium term, European fiscal policies remain highly procyclical and destabilizing.
Beetsma and Giulodori (2010) use real-time data to study the response of fiscal policies to unexpected changes in the output gap, distinguishing between the budget preparation and execution phases. They find that EU member states pursue an acyclical fiscal policy in the preparation phase and a procyclical policy in the execution phase, while non-EU countries pursue a countercyclical fiscal policy in the preparation phase and an acyclical policy in the execution phase.
Eyraud and Wu (2015) and Eyraud et al. (2017) also document the procyclical bias of European fiscal policies. In particular, they explain that the « deficit » bias of fiscal policies in the euro area is due more to their procyclical nature than to non-compliance with sustainability constraints, i.e., a positive reaction of the primary balance to public debt, despite multiple reforms aimed at making European rules more flexible and credible.
Because they are too procyclical, fiscal policies are mechanically less effective in stabilizing the debt-to-GDP ratio. During expansionary phases, deficits and debt levels do not decline as much as they should, even though fiscal multipliers are likely to be low and fiscal consolidation policies would likely bear fruit. Conversely, during a recession, fiscal consolidation plans cannot achieve their objectives given the higher fiscal multipliers (see Auerbach and Gorodnichenko, 2012a,b, 2017; Riera-Crichton et al. 2015; Blanchard and Leigh, 2013 ) and public debt increases despite fiscal efforts.
Conclusion
So, will public debt be the downfall of the eurozone? From the perspective of macroeconomic theory as a whole, European fiscal rules are often considered too restrictive to ensure the sustainability of public debt.
While the SGP rules were rarely respected during the first decade of the eurozone, empirical research tends to show that European fiscal policies have been sustainable, despite the crisis and the resulting increase in public debt. The European rules, which are rarely respected, therefore seem to have nevertheless led to greater sustainability in fiscal policies.
However, the procyclical bias of European fiscal policies represents the greatest risk to the sustainability of public debt, as it induces a « deficit » bias and increases the instability of the public debt-to-GDP ratio.
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