In the mid-1980s, only seven countries had fiscal rules. In 2015, when the International Monetary Fund last counted, 96 did. Most had provisions limiting public debt, budget deficits, or both, and some had additional rules on public expenditures.
This circumscription of fiscal discretion was partly a response to traumatic experiences such as Latin America’s “lost decade” following the debt crises of the 1980s; the painful adjustment suffered by countries caught off-guard by rising interest rates in the early 1990s; and the European sovereign-debt crisis of 2010-12. But the adoption of fiscal rules also owed something to growing distrust of fiscal activism.
In 2000, John B Taylor of Stanford University captured the spirit of the time when he wrote that it is “best to let fiscal policy have its main countercyclical impact through the automatic stabilisers” – in other words, to put it on automatic pilot. The consensus then was that monetary policy is a nimbler and more effective policy tool, because the key decisions are made by an independent central bank and implemented with the stroke of a pen.
Nowhere are fiscal rules as detailed and prescriptive as in the European Union, whose budgetary rulebook is nearly 100 pages. There are good reasons for this. Because euro members share a currency, they cannot inflate away their individual debt burdens. As Paul De Grauwe of the London School of Economics has observed, they are in a position similar to countries that borrow in a foreign currency. Yet excessive public debt results in pressure on partner countries to come to the rescue to avoid severe financial fallout from debt restructuring or, worse, an exit from the currency union. This is what happened with Greece in the 2010s. So there is a real motive for preventing fiscal irresponsibility.
But there are also bad reasons for having codified budgetary behaviour so extensively. Germany is traditionally wary of stabilisation policy (though not in response to the 2008 financial crisis or the pandemic), and smaller northern European countries are even more fiscally gun-shy. In addition, member states lack mutual trust. As a result, they have piled up a tangle of rules so complex that people in Brussels joke that only one person in the whole European Commission actually understands it all.
But times have changed. For 12 years now, interest rates have been pinned near zero, making a mockery of claims touting monetary policy’s effectiveness. Instead of protecting the central bank from fiscal vagaries, the priority in such an environment is to ensure that monetary and fiscal policy function in tandem. Breaking a taboo, Isabel Schnabel, a member of the European Central Bank’s Executive Board, has stressed that today’s situation requires unconventional monetary policies and unconventional fiscal policies, which should complement one another to protect the economy from large downturns. As outlined in a recent Geneva Report, the long-forgotten concept of a policy mix is back in fashion.
In parallel, concerns about sovereign solvency have greatly diminished. As former IMF chief economist Olivier Blanchard notes, there is no such thing as an unsustainable debt as long as the interest rate remains below the growth rate. In many countries, this has now been the case for a decade; and even in the United States, where bond rates have recently increased, the margin remains wide.
Recognising the implications of these debt dynamics, US President Joe Biden’s administration has lost no time pursuing its fiscal agenda. Whereas the post-2008 US stimulus was too timid, the recently adopted $1.9 trillion fiscal package, coming on top of trillions of dollars in spending enacted last year under Donald Trump, amounts to massive overkill.
The question now is what Europe will do. In March 2020, it wisely availed itself of an escape clause in its fiscal rulebook, allowing member states “to temporarily depart from the normal budgetary requirements.” This exception will likely remain in place for 2022 but, pandemic permitting, will end in 2023.
In the meantime, the debate will focus on whether the rules should be reformed before they are reinstated, and – more fundamentally – whether fiscal initiatives should be regarded as a problem or as a solution.
The case for comprehensive reform was strong before the pandemic and has now become overwhelming. The current rules were built for a world that no longer exists. They are opaque, excessively constraining, and reliant on numerical targets that do not make sense in a low-interest-rate environment. Moreover, they are no longer credible. With a debt-to-GDP ratio approaching 160% this year, Italy can scarcely be expected to hit the EU’s debt-to-GDP limit of 60%.
Make no mistake: in a monetary union, fiscal responsibility is crucial. The question is not whether member states should be given high standards to meet, but how this should be done. Reformers want to retain the commitment to fiscal discipline but change the yardstick for assessing actual behaviour. Others, worried that this commitment would not survive a renegotiation, prefer to tinker on the margin. But sticking to an obsolete commandment out of fear of being unable to define a better one is a formula for undermining trust in the rules altogether.
If there is any silver lining to the Covid-19 crisis, it is that we have been forced to rethink rules that have survived on inertia. Short of the radical reform advocated by some, it is possible to design a fiscal framework that creates more space for fiscal discretion but preserves the essential commitment to responsibility. The first step is to accept that all countries cannot be expected to achieve the same goal. The second is to acknowledge that fiscal discipline must be based on principles and buttressed by well-designed institutions, rather than by rigid numerical targets.
The EU has not shied away from pursuing taboo-free responses to the current crisis. By embarking on a comprehensive reform of its fiscal framework, it would signal that it is strong enough to rethink economic policy for post-pandemic conditions. It should launch the discussion now, with a view to agreeing on a blueprint within a year. — Project Syndicate
* Jean Pisani-Ferry, a senior fellow at Brussels-based think tank Bruegel and a senior non-resident fellow at the Peterson Institute for International Economics, holds the Tommaso Padoa-Schioppa chair at the European University Institute.
BACK IN BUSINESS: The long-forgotten concept of a policy mix is back in fashion.
