Marco Buti

Group of Policy AdvisersEuropean Commission

Revisiting the SGP: Grand Design or Internal Adjustment?

6th European WorkshopCrete 24-31 August 2003

FISCAL RULES UNDER DISCUSSION

"The stability pact is a vote of no confidence by the European authorities in the strength of the democratic institutions in the member countries. It is quite

surprising that EU-countries have allowed this to happen, and that they have agreed to be subjected to control by European institutions that even the International Monetary Fund does not impose on banana republics."

Paul de Grauwe, Financial Times, 25 July 2002

"Of course, the stability pact restricts the room for manoeuvre enjoyed by national fiscal policymakers. But this is the price that must be paid for a common currency. Historically, stability between currencies has been possible only when

countries have been prepared to relinquish some national sovereignty."

Horst Siebert, Financial Times, 6 August 2002

CRITICAL VIEWS

Three main arguments:

(1) There is no need for fiscal rules. Rules lead to sub-optimal solutions. Better rely on discretionary ad hoc decisions

(2) Rules are necessary, but we could have more intelligent rules than the SGP

(3) The SGP may be fine in principle, but it is now an obstacle to adequate stabilisation policies

(1) EMU WITHOUT RULES?

Rely on wise governments or effective financial markets

High deficit high interest rates pressure on government consolidation

Changes in regulations may reduce vulnerability of banks & enhance financial market discipline(large exposure directive & solvency ratio directive) but: (i) sufficient information?

(ii) timely reaction of markets?

(iii) timely reaction of governments?A risky solution with 12 ( 25) sovereign countries?

(2) CURRENT CONSTRAINTS

Four EU countries are close or above the 3% deficit limit. Dilemma:

- either avoid discretionary anti-cyclical policies / adopt pro-cyclical policies

- or neglect rules loss of credibility

Solutions depend on views about SGP in steady state: - if rules are unnecessary or SGP

inferior to other solutions, why bother?- if rules necessary and no solution

clearly superior to SGP, better retain it and bear some adjustment costs

(3) SGP VS OTHER RULES

Core issue: What rules would we want if we could start again scratch?

Are there rules clearly more intelligent than the SGP?

Paper addresses issues under three aspects:

compares SGP to criteria for design and compliance to rules

examines criticisms to SGP and alternative rules

proposes an internal reform of the SGP>> DE FACTO ECONOMIC RATIONALE FOR THE COMMISSION PROPOSALS OF

27 NOVEMBER 2002

Policy mix: Euro area vs US

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Fiscal expansionMonetary restriction

Fiscal restrictionMonetary expansion

Fiscal restrictionMonetary restriction

Fiscal expansionMonetary expansion

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Fiscal expansionMonetary restriction

Fiscal restrictionMonetary expansion

Fiscal restrictionMonetary restriction

Fiscal expansionMonetary expansion

Policy mix: Euro area vs Member States

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D F I EU3 EU9 EU12

target in SPs

out-turn

The roots of the current fiscal problems: budgetary non-consolidation in 2000

Ideal fiscal rule EU fiscal rulesWell-defined ++Transparent ++Simple +++Flexible ++Adequate relative to final goal ++Enforceable +Consistent ++Underpinned by structural reforms +

EU RULES vs KOPITS-SYMANSKY CRITERIA

Criteria Strong rule EU rules

Timing for review Ex post Ex post

Override bymajority rule Not allowed Not allowed

EnforcementEnforcer Independent PartisanAccess Open ClosedPenalties Large Large

AmendmentProcess Difficult Difficult

EU RULES vs INMAN CRITERIA

• Certain features are typical of supranational rules

• Trade offs are heightened

• First best at domestic levels are poor second best at EU level

IMPORTANT ISSUES:SUPRANATIONAL VS DOMESTIC FISCAL

RULES

EU-12/15

SimplicityFlexibility

EnlargedEU

Number of

countriesN*

SIMPLICITY VERSUS FLEXIBILITY

Reforming the SGP: main proposals

Critical issue Reform proposals Authors Institutional implications

Numerical rules do nottackle at source thebudgetary misbehaviour;SGP needs a morecredible and non-partisanenforcement.

- Improve rationalbudgetary procedures;Create independentFiscal PolicyCommittee.

- Strengthen financialmarket discipline.

Wyplosz (2002)Wren-Lewis (2000 andforthcoming),Von Hagen (2002)

Reform the Treaty,abolish ExcessiveDeficit Procedure.Amend LargeExposure Directive.

The SGP pays too muchattention to the deficit, notto the quality of publicfinance.

- Introduce expenditurerule; move to goldenrule.

Mills and Quinet(2001),

Brunila (2002), IMF(2001)

Von Hagen (2002),Fitoussi and Creel(2002)

The golden rulerequires changes inthe Treaty and theSGP. It is only in asoft version that it isnot inconsistent withthem.

Sustainability depends onthe stock of debt, not onthe deficit.

-Introduce a DebtSustainability Pact;move to a country-by-country articulation ofthe close-to-balancetarget.

Pisani-Ferry (2002) The DebtSustainability Pactrequires changes inthe Treaty. For somecountries it replacesthe SGP.

The 3% and the close-to-balance target arearbitrary and inconsistentwith an appropriate fiscalstance.

Move to structuralbalance; introduce thenotion of PermanentBalance Rule.

Buiter and Grafe(2002)

Abolishing the close-to balance requireschanges in SGP;abolishing the 3%requires changes inthe Treaty.

The SGP does not addressthe issue of theappropriate fiscal stancefor the Euro area

Agree on the aggregatebudget balance.

Market solution viadeficit permits

Casella (2001) Within the 3%ceiling, it is notincompatible with thecurrent rules.

CRITICISMS OF THE SGP- 1

SGP reduces budgetary flexibility

it may require pro-cyclical policies or may prevent discretionary action

(i) true in transition

(ii) unlikely in steady state: safety margins sufficient to cope with most recessions + exceptionality clause (in the past high deficit constrained policies) SGP disregards aggregate fiscal stanceaggregation of national fiscal policies may not result in optimal area fiscal stance possible, but

- if stabilisers work, no problem in most cases

- coordination of national policies problematic

CRITICISMS OF THE SGP - 2

SGP discourages public investmentno longer be possible to spread the cost of an investment project over all the generations of taxpayers who benefit from it

true, but

- Golden Rule problematic: distortions, monitoring

- net investment not big in several countries SGP focuses on short term results and disregards debt and structural reforms

true, but

- long term indicators operationally problematic

- close to balance debt ageing

SGP works asymmetrically

does not curb incentives to cut revenue or Increase expenditure in good times

true: need peer pressure, long-term views SGP does not tackle roots of fiscal misbehaviour and does not

sanction politically- motivated policies

unlike 1997 convergence, sticking to rules do not pay politically

true: need peer pressure, long-term views SGP too demanding for countries in sound positions

SGP treats equally countries with different long-term prospects and debt levels true

CRITICISMS OF THE SGP - 3

PRELIMINARY CONCLUSIONS - 1

Each proposal tackles some problems in the design and implementation of SGP, but no one solves all problems. No miracle solution

Some solutions require estimates problematic in multinational context, some require a period of testing, some require a leap forward in integration

Solutions must consider degree of political integration. Rules-based co-ordination necessarily inflexible (implicit mistrust of other members’ behaviour).

Greater fiscal integration would allow more flexibility, but unlikely in medium-term

PRELIMINARY CONCLUSIONS - 2

SGP has some problems, but it combines fiscal soundness and stabilisation, it prepares for the impact of ageing, it is consistent with past debate on rules, it fares reasonably well vis-à-vis fiscal rules’ criteria

Reforming rules from scratch would open Pandora’s box. Risk: current rules suspended but no alternative introduced

Should focus efforts on strengthening SGP: asymmetry of incentives, better monitoring and accounting, complementary sustainability indicators

Should include some aspects of alternative solutions

GOAL PROPOSAL OPERATIONALSTEPS

Overcomeexcessiveuniformity of therules

- Diversify close-to-balance (EC: yes)

- Common estimatesof contingentliabilities- Common estimatesof net investment

Improvetransparency

- Structural balancetargets (EC: yes)- Monitor cashfigures

- Define one-offmeasures- Countries toexplain divergencebetween cash andnational accounts

Correct pro-cyclical bias

- Early warning ingood times (EC:yes)- Rainy-day funds(EC: no)

- Define maximumallowed worsening ofcyclically adjustedbalance- Interpretation ESA95

Move to non-partisanenforcement

- Commissionimplements therules, Councildecides on policymeasures (EC: yes,in Convention)

- Define relativetasks betweenCommission andCouncil

EC: yes or no: included or not included in the CommissionCommunication of 27 Novembers 2002

Some of these suggestions were taken up in the Sapir reportof July 2003

REVISITING THE SGP

DIFFERENT MEDIUM TERM TARGETS

Fix medium term targets also on the basis of debt level and future budgetary trends

If debt and contingent liabilities are low: allow deficit up to “minimal benchmarks”

This would allow funding of net investment without distortions and monitoring problems

Need transparent fiscal accounting and accurate long-term projectionsEC 27/11/02: define debt criterion, 0.5% adjustment for countries in transition

IMPROVE TRANSPARENCY

Transparency can increase credibility of rules and allow greater flexibility in implementation

Current framework problematic: (i) one-off measures, (ii) delays in data provision, (iii) limited data on off-budget liabilities

(i) Publicise one-offs, lower danger threshold for early warnings, net one-off in computing structural balances

(ii) Make greater use of cash data and debt. More independent statistical authorities

(iii) Have regular and transparent estimates of off-budget liabilities, net asset positions and long term budgetary trends

MISBEHAVIOUR IN GOOD TIMES

Try to have some sanctions for slippages in good times and facilitate countries to behave prudently

Use early warning procedures in goods times when deficit diverge from structural target

Allow the use of rainy-day funds: surplus in good times can increase room for manoeuvre in bad times

Rainy-day funds require a change in ESA accounting: transfer should affect deficit (now they would be considered financial transactions)

IMPLEMENTATION OF RULES

Now enforcement is partisan: national authorities apply the rules to themselves. This may also reduce the incentive to behave well in good times

Solution: give more responsibilities to the Commission

- Commission responsible for technical assessment of compliance to the rules (excessive deficit)

- Council decides what measures to require to countries in excessive deficit

- Council decides sanctions on the basis of Commission proposal

CONCLUSIONS

Even starting from scratch we might end up with a solution not radically different from the SGP+Maastricht (deficit fluctuating around medium term target with upward limit, rules on public debt)

Solutions would have to consider multinational context, mistrust of other countries’ fiscal intentions

Reforming rules from scratch would open Pandora’s box. Risk: current rules suspended but no alternative introduced

Better focus efforts on strengthening SGP combining rigor and flexibility.This is what the Commission has done on 27 November 2002