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The Stability and Growth Pact: Problems and a Possible Solution Birkbeck College, University of London, and CEPR In this note, I describe why we need a European …scal framework. I specify what itmeans for a government’s …scal policy to be sustainable. I argue that while the currentEuropean …scal framework is likely to promote sustainable …scal policies, if it is enforced,it is also apt to force countries to follow suboptimal …scal policies. I explain why thereis no …scal rule that will provide a satisfactory …scal framework. Finally, I describe analternative: a …scal Sustainability Council. This idea was developed by Fatás, von Hagen,Hughes-Hallet, Sibert and Strauch [1] Why do we need a European fiscal framework? Why Do Countries Unsustainable …scal policies by member states might threaten the area-wide …nancial sys-tem or destabilise the common currency by putting pressure on the common central bankto provide a bailout. National governments may not take this common cost into consid-eration and may be tempted to run excessively large de…cits. Some reasons for this are asfollows. First, governments may be tempted to spend too much and future generations areunderrepresented in the political decision-making process.1 Thus, governments may betempted to borrow to …nance their excessive spending. Second, di¤erent political partiesmay disagree on the composition of government spending –say, one party prefers militaryspending and the other wants more funding on social programmes. Then the party that isin power may attempt to constrain a successor government’s ability to spend by …nancingits spending on the goods of its choice by borrowing. Third, there is a political businesscycle story. Suppose politicians di¤er in how competent they are at using tax revenue toprovide public goods and their competency is known only to themselves. Then incum-bent politicians may lower taxes prior to an election to signal that they do not need asmuch tax revenue as less competent governments do to be able to provide the same levelof public spending. Fourth, suppose unforseen economic circumstances produce a de…citand reducing this de…cit requires compromise between di¤erent groups. Then de…cit re-duction may be held up as the di¤erent groups use delay to signal that the costs to themof reform are particulary high, and thus they must be compensated. In each of these fourstories, the government prefers to keep the country solvent. However, it is possible thatby increasing current de…cits the government may increase the risk of future insolvency.
Brie…ng paper for the Committee on Economic and Monetary A¤airs (ECON) of the European Parliament for the quarterly dialogue with the President of the European Central Bank.
1 One reason for this is that special-interest groups that want increased spending in a particular area tend to be better organised than the larger groups that oppose them. See Fatás, et al [1] for a detaileddescription of factors leading to excessively high budget de…cits.
The Stability and Growth Pact: Problems and a Possible Solution For a government’s …scal policy to be sustainable, it must satisfy two conditions.
First, each period the government must satisfy its within-period budget constraint by…nancing any …scal shortfall by borrowing. Its current spending on goods and servicesplus the cost of servicing its current debt must equal its current tax revenues plus theissuance of new debt. The primary de…cit is de…ned as spending on goods and servicesminus tax revenues; hence, another way of saying this is that each period the government’sprimary de…cit plus the cost of servicing its current debt must equal its issuance of newdebt. The second condition is that the government cannot run a Ponzi scheme wheredebt grows forever in an explosive fashion while the government satis…es its within-periodbudget constraint by issuing ever-increasing amounts of new debt to pay o¤ the old plusthe interest. It can be shown that these two conditions imply that sustainability requiresthat the present discounted value of the goverment’s path of primary de…cits plus thevalue of its initial stock of debt must equal zero; that is, the discounted present value ofits revenues must equal the discounted present value of its expenses.2 The above condition implies a number of things that are important to take into account when designing a …scal framework. There are many di¤erent paths of primarybudget balances that are consistent with sustainability. Running sizable primary de…citsfor a long period of time may be consistent with sustainability if these de…cits are laterbalanced by su¢ ciently large surpluses. A path of primary de…cits that might be unsus-tainable for one country may be sustainable for another, if their future growth or initialdebt stocks are su¢ ciently di¤erent.
There are a number of practical problems associated with assessing whether a partic- ular country’s current de…cit-to-GDP ratio is consistent with sustainability. It requiresprojecting nominal interest rates and nominal GDP growth. Measuring the true …nancialposition of the government is di¢ cult due to data collection and accounting di¢ culties.
The size of future de…cits depends on the composition of current public spending in a waythat is hard to assess. The stituation is complicated by the existence of business cycles; itis di¢ cult to predict how much of a current economic shock is transitory and how muchis permanent.
The Current European Fiscal Framework Leads to Suboptimal Fiscal In its current form, the conditions of the current European …scal framework – if strictlyadhered to – are likely to result in sustainable …scal policies. However, there are manypaths of primary de…cits that are consistent with sustainability, and some of these paths donot satisfy the de…cit criteria of the current framework. As the EU …scal framework doesnot regulate the level of government spending, I will assume that a government’s spendingis given. I then ask the following. As long as the government follows a sustainable …scalplan, does it matter which sustainable plan it follows? That is, does the timing of taxesmatter for social welfare? If it matters, do plans that satisfy the de…cit criteria yield lowersocial welfare then plans that do not? If government spending is …xed, does the timing of taxes matter? According to a modern textbook paradigm it does not. In this framework, it are the primary de…cit-to-GDP ratio, the nominal growth rate of GPD, and the nonimal interest rate,respectively, at t and b0 is the initial debt-to-GDP ratio.
The Stability and Growth Pact: Problems and a Possible Solution is supposed that a country is inhabited by in…nite-lived households who face no creditconstraints. The government …nances its spending by imposing lump-sum costless taxesor by borrowing. The government remains solvent and the household expects this. Thegovernment’s sustainability constraint, discussed in Section 3, depends only the presentdiscounted value of its tax obligations and not on their timing The household has its own sustainability constraint: the present discounted value of its consumption must equal the present discounted value of its income plus its initial wealthminus the present discounted value of its tax obligations. Thus, the household also caressolely about the present discounted value of its tax obligations and not on their timing.
To see this more concretely, imagine that the government were to cut taxes in the currentperiod, borrow the short fall, and raise taxes next period to pay o¤ the borrowing plusinterest. The household knows that the tax cut leaves it no better o¤. If it invests theamount of the tax cut, the investment will produce just enough income to pay o¤ thehigher taxes next period.
The above argument depends on three things: the taxes are lump-sum and costless, the household can borrow and lend as much as it wants (subject to being able to satisfyits sustainability constraint), the household lives forever. Suppose that instead it is costlyto administer and comply with the tax code and that these costs are increasing at anincreasing rate in the level of tax revenue. Then the total costs associated with taxes areminimised if the taxes are smoothed over time. If the household is credit constrained,then in some periods consumers may be unable to borrow enough to smooth their con-sumption as much as they would like. High or low taxes in these periods can worsen orimprove matters. If households are …nite-lived, then a current tax cut may bene…t currenthouseholds at the expense of future households.
Balancing the budget in the medium term may rule out optimally smooth- Imagine a scenario where there are no business cycles, nominal in- come growth and the nominal interest rate are both strictly positive and constant overtime, and the government’s desired expenditures (net of interest payments) are a constantshare of GDP. The government can …nance its expenditures by borrowing or by taxation.
I assume that the timing of taxes matters because tax collection is costly, as described inSection 4.1. If society prefers smooth to variable consumption over time, then the gov-ernment should smooth taxes over time. Thus, it is optimal for the government to havea constant primary budget balance, as a share of GDP, over time.3 This condition andthe sustainability condition described in Section 3 can be solved to yield the government’soptimal primary budget balance.4 The Stability and Growth Pact requires budgets to be close to balance or in surplus over the medium term. With no business cycles in this example, I interpret this restric-tion to mean here that the government should not run a (conventional) budget de…cit.
Unfortunately, the above optimal …scal policy, with its constant primary budget balance,is not consistent with this. To see this, note that if the government always balances itsbudget (including interest payments), then it never has to borrow and its stock of debtremains constant. Having a constant debt stock implies that there will be constant posi-tive interest payments and the government must always run a primary surplus to balance 3 I make the reasonable assumption that that the actions of a single EU government have negligible e¤ect on the risk-free world interest rate.
4 The government should set a primary de…cit to GDP ratio of ( income growth, i is the nominal interest rate and b0 is government debt as a share of GDP.
The Stability and Growth Pact: Problems and a Possible Solution its budget. Positive nominal GDP growth implies that the ratio of interest payments toGDP falls over time.
Thus, the primary surplus, as a share of GDP, falls over time to leave the budget balanced. Thus, satisfying both the sustainability constraint and thezero-de…cit rule implies that the government must run a sequence of decreasing primarysurpluses (as a share of GDP) over time.5 A three-percent de…cit limit may rule out optimally o¤setting business Suppose that a country is subject to cyclical shocks. The timing of taxes matters because there are costs associated with tax collection and because house-holds are credit constrained and unable to smooth their consumption to the degree thatthey would if they could borrow as much as they wanted. Then the government facesa tradeo¤ between further smoothing consumption, which it can do by increasing taxesin good periods and decreasing them in bad periods, and minimizing the costs of taxesby smoothing them. It should dampen, although not entirely smooth away the e¤ect ofthe shocks. A three-percent upper bound on its admissible primary de…cit may be toorestrictive to permit this.
De…cit limits may rule out socially desirable government investment.
Consider a country where current government investment spending is desirable. Thisspending might be thought of as spending on intrastructure in the transition economiesor the United Kingdom, or it might be the …nancing of labor-market reforms in countriessuch as Germany and France. If the government undertook this expenditure and wasforced to balance its budget, there would be an large current tax bill. If there are costsassociated with tax collection, this is not e¢ cient; it would be better to spread the taxbill out over time. It may not be equitable either. As both current and future householdsbene…t from the spending, it is not obvious that current households should bear the entirecost. Thus, both equity and e¢ ciency may imply a sizable current de…cit.
Whether or not a country’s …scal policy is likely to be sustainable depends on the state of the world economy. It is di¢ cult to describe thecurrent state of the economy; it is impossible to describe every possible future state of theeconomy and to specify in advance what is sustainable …scal policy for each state. Oncethe state has occurred, it is di¢ cult to perfectly observe, measure and verify. Thus, thereis no hope that the EU can write and enforce a contract specifying the set of sustainablepolicies for every contingency.
If the EU restricts itself to simple rules that might be possible to implement and enforce, then there will be frequent instances, such as the situations described in Section4, where it is harmful to social welfare to follow the restrictions of the rule. In this casenations have the choice of following suboptimal policies or agreeing that enforcing the ruleis not sensible and that they should renegotiate. The latter option is unlikely to promotethe credibility of EU policy makers and institutions.
As a consequence of the above, Fatás, et al [1] argue that a …scal framework based on rules is inadequate for the EU. Instead, we argue fora Sustainability Council. The Sustainability Council would be an independent body oftechnical experts created by, reporting to, and …nanced by the European Parliament. Its 5 The Pact requires a time-t surplus of ib0=(1 + )t: The Stability and Growth Pact: Problems and a Possible Solution sole mandate would be to safeguard the sustainability of each member state’s …nances.
Having this independent council would solve the credibility problem of the Stability andGrowth Pact: through ECOFIN, national governments judge the quality of their ownpolicies.
The Sustainability Council would comment on policy, but not make it. It would make recommendations on …nes for transgressors to the ECOFIN Council; it would have nopower on its own to set …nes. Its task would be to consider all aspects of country’seconomic environment and …scal policy and then to spell out for both policy makers andthe public its perceived implications of the government’s policies for sustainability.
This Sustainability Council would operate as follows. In the early stage of the bud- getary process, say March or April, governments would submit their …scal plans, for theyear or the medium term, to the Council. If the Council …nds the plan to be seriously‡awed, it would "veto" the plan within two months, returning it to the government withcalls for adjustment and suggestions for improvement. Otherwise, the Council would de-liver a report no later than October. During the course of the year, the Council wouldmonitor the government’s adherence to the plan and would consider changes in economiccircumstances that might call for revisions. By commenting on plans, as well as monitor-ing compliance, the Council would be forward looking, rather than backward looking asis the current …scal framework.
The Council would have no direct legal authority over nations. Instead, its primary tools would be public opinion and political pressure. It would attempt to educate thepublic through its commentary and it would formally admonish governments that were notin compliance. It would allow the ECB, national governments, other interested parties andinterested experts to participate in its information gathering and processing, for example,by holding hearings. Its reports on a member state would be delivered in that nation’scapital.
In addition to political sway, the Council would have the sole right to recommend the imposition of …nes to the ECOFIN Council. Consistent with promoting its independence,the decisions of the Council would be …nal and could not be changed by the EuropeanParliament or any other body. The ECOFIN Council would then either enforce them, orreject them with a majority vote.
The Council would be relatively small, as be…ts a technical decision-making body. As the process is technical, rather than political, the nationality of the members ought notto be a consideration. Members might be senior academics, public servants or membersof international organisations. They must have su¢ cient individual prestige that theirvoices would carry weight with the public and member governments.
[1] Fatás, Antonio, Jürgen von Hagen, Andrew Hughes Hallet, Rolf R. Strauch and Anne Sibert, Stability and Growth in Europe: Towards a Better Pact, Monitoring EuropeanIntegration 13, London, Centre for Economic Policy Research, 2003.

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