Jean-Pierre Dumas
Wednesday, March 3, 2021
The European Commissioner for economic affairs is thinking about new fiscal rules for Eurozone (EZ) countries. To start he proposes to wave them for another year because of the covid crisis.
In a period of monetary financing of deficit without consequences on inflation, rich countries are forgetting the budget constraint principle which will come back with a vengeance.
Theoretically, the European Central Bank should not bail out states, with the quantitative easing (QE) policy, this is what it is doing every day. But let’s assume that one day the central bank tapers off QE. Governments will need to reduce their debt ratios, or the bond vigilantes will take care of them.
The Stability and Growth Pact (SGP) cannot continue because too complex, with permanent changes and thus contradictory. It is obvious that in crisis periods it is difficult, impossible to fix fiscal rules.
The first rule is that budget should be the exclusive competence of member states (art 121-1 of the Treaty). Therefore, fiscal policy should be set at the national level. (The idea that the Commission should be in charge of the health budget is not obvious, given the recent EC’s performance regarding vaccine financing, negotiation and procurement). But national fiscal power does not mean fiscal irresponsibility particularly in a monetary union where the fiscal irresponsibility of one country will splash back at other countries.
A fiscal rule should be set under the principle of debt sustainability. Nevertheless, the concept of debt sustainability becomes elusive in a universe where a debt ratio above 100% becomes the new normal.
But these debt ratios are possible only because they are today financed without limits by the central banks of rich countries. When the party is over the law of gravity may resume. A debt path in the long run should be set by an authority.
Therefore, it would be useful to fix, as a rule, a debt ratio target over a period of time. Each country is different as regards to its debt level and history; therefore, the targets differ according to the country. The debt ratio will be the objective, the fiscal deficit will be the indicator. Both are linked. The debt ratio evolution, for a country with a fixed exchange rate, depends upon three factors (the primary balance (endogenous), the interest rates (exogenous), and the growth rate (exogenous).
For the French authorities, the only instrument to reduce the debt ratio is economic growth, they fail to grasp that growth is not determined by decree (unfortunately the only instrument under the prerogative of the government is the fiscal balance). If the debt dynamics for a country is the objective, then its fiscal balance will follow according to assumptions on future growth and interest rates evolution. No need to stick to a three percent fiscal deficit, if the debt ratio is going to increase without policy change then a fiscal deficit below than 3% may be warranted.
For the French officials, the 3% target became an obsession to the point that one year under Mr Jospin as PM, the fiscal deficit was less than 3%, the media, the pubic were screaming to raise the fiscal deficit to reach the 3% considered as a target.
Therefore, one objective is enough (public debt ratio evolution), the fiscal deficit is one indicator consistent with the objective. “The debt is the target and the budget is the instrument’’ (see C. Wyplosz Ifo report/2019). If you fix a debt ratio as a target, no need to fix a secondary ratio as the fiscal deficit which can contradict the public debt objective.
Nevertheless, this simple rule has (as all rules) a strong default. The fiscal deficit is the result of two components, receipts (taxes) and expenditures. If you fix the result (the deficit), you let the possibility for the government to select whether it is going to adjust through tax or expenditure. This is not equivalent (A. Alesina, C. Favero & F. Giavazzi). In a country like France with the highest expenditure ratio in the world, it is important not to reach a fiscal target through an increase of taxes (as was done under F. Hollande) but through a reduction of expenditure. This is not equivalent when you raise taxes in a country overburdened with taxes you increase unemployment and decrease growth below the potential. When you decrease useless expenditures in a country with a huge expenditure ratio, you raise productivity and growth (true, at the cost of huge street disturbances).
A public expenditure reduction rule has been done in the past with tremendous success in Sweden. But it was a national decision based on the fact that a country in a free world cannot have a sustainable expenditure ratio amounting to 70% of GDP. This expenditure ratio reduction was consistent over more than 10 years. We doubt that an international organization can oblige a country to follow such a policy, only a national government with a clear vision and a minimum of national consensus can do it.