European Affairs

Summer/Fall 2003

 

Economy and Business
Critics of EU Budgetary Limits Are Wrong
By Vito Tanzi

 

Critics of the European Stability and Growth Pact (SGP) argue that, given the current slowdown, or even mild recession, in the European economies, there is a need for a Keynesian boost to demand, and that the pact should thus be discarded or at least made less constrictive.

The SGP reduces the freedom of governments to conduct their own fiscal policies by penalizing countries that run fiscal deficits of more than three percent of Gross Domestic Product (GDP) in periods that are not considered exceptional.

There are a number of reasons, however, why the SGP is still a useful guide for EU member countries in their pursuit of good economic policy, and why the kind of demand boost envisaged by Keynes may no longer be appropriate.

John Maynard Keynes, the 20th century's most famous economist, believed that, left to itself, an economy might operate at less than full potential and generate an unemployment rate above the level consistent with full employment. That is certainly the case in Europe today.

Keynes suggested that this problem could be corrected by government action. More specifically, the fall in private demand caused by the private sector's reluctance to spend could be balanced by the government's willingness to run fiscal deficits. By increasing public spending, or by cutting taxes, the government could raise total spending in a way that would stimulate employment.

Today, critics of the SGP say, European governments should accordingly not have to worry about the pact's budgetary limits, but only about the performance of their economies. In this view, higher fiscal deficits, by stimulating spending, would produce stronger growth and more employment. In short, the SGP has become an impediment to the full and desirable use of fiscal policy.

The technical debate over Keynes's theories is still continuing nearly 70 years after they were first expounded in the midst of the Great Depression, and his approach to fiscal policy remains popular with many policy makers and economists. There are three broad lines of criticism, however, that are particularly relevant to today's growing swell of argument over the SGP, even if they are not universally shared.

The first criticism of Keynesian counter-cyclical fiscal policy is theoretical. Starting in the late 1960s, the simple, or some would say, the simplistic Keynesian view of the world has been subjected to intense scrutiny by leading economists such as Milton Friedman, Robert Lucas, Robert Barro, and others. These economists have concluded that several key assumptions of the Keynesian framework are highly questionable or even basically wrong.

Some of these assumptions refer to whether consumption in a given period is determined by the "current" or the "permanent" income of individuals, whether the expectations of individuals are affected by government policies, and so on. Some of these economists have received Nobel Prizes in economics for this work.

It is fair to state that, at least from a theoretical perspective, by the 1980s the simple Keynesian framework had been substantially damaged if not discredited, at least among theoretical macro-economists. More complex versions of the Keynesian framework developed by followers of Keynes have tried to take some of the criticisms into account. It is an open question how successful they have been in this rescue operation.

The second criticism is empirical. There is now ample evidence from the experience of many countries - including the United States in the 1990s, Sweden, Finland, Ireland, Denmark, Australia and Canada - that, contrary to Keynes's prescriptions, a policy-induced reduction of fiscal deficits can actually have expansionary effects on an economy.

The reason is that by intentionally reducing the fiscal deficit, countries set in motion several positive incentives for private investors: uncertainty is reduced and worries about a future tightening of fiscal policy or an increase in real interest rates diminish. On the other hand, countries that allow fiscal deficits to widen substantially often show little or no gains in economic performance while they may make a mess of their fiscal accounts.

In Japan, for example, fiscal deficits of seven to eight percent of GDP have so far produced no visible economic benefits but have created an enormous public debt problem, which could become a major drag on the economy in future. Japanese public debt is now equivalent to 160 percent of GDP and is still rapidly increasing. But the debt has so far been serviced at exceptionally low interest rates, thus hiding its real cost.

The third criticism is political. It is not really true that the fiscal tools available to policy makers (taxes and public spending) can be changed just as easily in either direction, as the Keynesians assume. It is generally far easier, and politically much more pleasant, for governments to cut taxes and raise public spending than to do the reverse.

Expansionary fiscal policy is thus much easier to pursue than restrictive fiscal policy. This is the reason why countries end up with large structural fiscal deficits and large public debts, and why they often fail to use periods of economic expansion to bring their fiscal accounts under control. If in good years all the European countries had managed to bring their fiscal accounts close to equilibrium, as requested by the European Commission, the current debate on the SGP would not be taking place. The debate is a consequence of the fact that some countries did not do so.

Broadly speaking, in most European countries, the relationship between changes in economic activity and changes in fiscal accounts is such that a fall in GDP of, say, one percent leads to a rise in the fiscal deficit of about 0.5 percent of GDP. A country that started with its budget in balance would thus have to experience a drop of around six percent in GDP to break through the three percent deficit ceiling imposed by the SGP.

Such a large fall in GDP is very rare and is far from what has taken place in European countries in the past couple of years. So far no European country has experienced more than a small drop in GDP, and by historical standards the current slowdown is mild.

The EU countries have considerable freedom to let their automatic stabilizers operate or even to take some expansionary fiscal measures without exceeding the three percent ceiling. Thus, much of the deterioration in fiscal accounts experienced by the countries that have broken the limit cannot be attributed to the automatic response of taxes and public expenditure to the cycle, as some argue.

The countries that have broken the three percent limit have done so either because they have pursued too expansionary a fiscal policy, or because they had not brought their fiscal accounts close to balance as they were required to do in previous years. If the limits imposed by the SGP were now set aside, as some are demanding, it would amount to accepting the view that past sins somehow justify present and future ones.

There remains a basic question. Once the three percent limit has been broken, as it has by France, Germany and Portugal, how quickly should the offending countries be required to bring their deficits back below the limit? The speed of adjustment demanded by the European Commission is likely to be reasonable even though some countries (France and Germany) will probably ask for more time. The current rule is that a country has to break the three percent limit for three consecutives years before it is penalized.

A country that violates the limit in this way is requested to deposit 0.2 percent of its GDP, plus one tenth of the part of its fiscal deficit that exceeds the three percent limit, in a non-remunerated account. This deposit becomes a non-reimbursable penalty only after a decision is made by the EU Council of Ministers. Whether such penalties would actually be imposed on countries such as France and Germany remains an open question.

One might ask why there is a need for a stability and growth pact in the first place. Why not leave governments free to pursue their fiscal policies in any way they consider appropriate?

The GSP is an example of what economists call a fiscal rule, of which there are now various types around the world. These rules are becoming popular as ways to impose responsible fiscal behavior on policy makers. It could be argued that if policymakers had full control over their policy instruments and if they were always fully responsible, there would be no need for fiscal rules. They would act responsibly in any case. It could also be argued that if policy makers were never responsible, no rule would help.

Most policy makers, however, fall between these two extremes, in part because of political pressures on them that they find difficult to resist. In this case, well-designed fiscal rules may help countries achieve better policy outcomes.

Fiscal rules are also necessary in a monetary union, such as the European Economic and Monetary Union, to prevent what economists call "free rider" behavior by individual countries. When financial capital can move freely throughout a monetary union, an individual member country does not have to use its own savings to finance a fiscal deficit. The deficit can be financed by the savings of the whole union. Fiscal deficits and especially public debts, however, affect the level of interest rates throughout the union because interest rates tend to be the same for all the countries of the union.

This means that a country that runs a large fiscal deficit, and accumulates a large public debt, will impose higher interest costs on all the members of the union. In other words, the cost of the country's higher deficit will be shared with other countries. For this reason it is reasonable to impose limits on the fiscal behavior of all countries to prevent them from accumulating large public debts.

These limits should be more rigid for countries that already have high public debts, but should be flexible enough to allow for some deterioration of fiscal accounts in a slowdown. By and large, the SGP satisfies these requirements, even though some marginal adjustment to the rules may always be possible.

There is now much discussion of ways in which the SGP could be modified. Some have argued, for example, that public debt should be given more weight in the rules than fiscal deficits. The reason is that econometric studies have shown that public debt affects real interest rates more than fiscal deficits do.

Others argue that some spending on union-wide public works could be excluded from individual countries' public spending in calculating their fiscal deficit for SGP purposes. Still others would allow countries to exceed the three percent ceiling temporarily if the reason was the introduction of structural reforms necessary for growth. It is likely that some fine-tuning of the rules will be introduced in the near future. But calls for a major revision of the pact should be resisted.

Vito Tanzi was until recently Undersecretary in the Ministry of Economy and Finance of Italy. Before that, he served as a senior associate at the Carnegie Endowment for International Peace, and as Director of the Fiscal Affairs Department and Chief of the Tax Policy Division at the International Monetary Fund. He was also President of the International Institute of Public Finance. Currently a senior consultant at the Inter-American Development Bank, he has also been a consultant for the Organization of American States, the World Bank, the United Nations, and the Stanford Research Institute.