Effective fiscal instruments for the European Commission

A commentary in the VoxEU Debate Has austerity gone too far?

Posted By Beatriz de Blas, Universidad Autonoma de Madrid on 7 June 2012

Fines and other sanctions are an indirect and counterproductive way of eliminating deficit bias. A more direct and credible way to solve the moral hazard problems in Eurozone fiscal policy would be for each member state to delegate executive power over an effective fiscal instrument to a European budgetary authority.

 
European debt levels now hovering around 100% of GDP represent a painful burden for current and future generations. But at low interest rates, they can gradually be paid down. As Corsetti (2012) emphasizes, the real reason reform of European public finances has become so urgent is different: the danger of speculative attacks. Each additional percentage point in the risk premium on national debt now implies that another one percent of GDP must be added to the primary public budget surplus in order to maintain long-term budget balance. A country could quickly spiral into insolvency as a rising risk premium requires ever more brutal cuts, and ever falling GDP, and consequently ever more justifiable doubts about its ability to repay. This is just one of the ways in which self-fulfilling financial panics could occur now in the Eurozone.
 
Lacking independent monetary policies, Eurozone countries cannot stop such speculative attacks on their own (De Grauwe, 2011). Only the European authorities have the ability to stop such attacks. They could do this in many ways; for example, by promising to buy a member state's debt whenever its risk premium surpasses a given threshold. Europe as a whole can honor this promise since, in principle, the European monetary authorities could emit the euros needed to buy any quantity of national bonds. In an environment of low risk premia, debt sustainability would still depend on future austerity in national fiscal policies, but it would no longer depend on the potentially self-fulfilling fears of the markets.
 
European monetary and financial institutions powerful enough to prevent speculative attacks would benefit all member states, including the ones that are currently fiscally strongest. If any member is driven to insolvency by a self-fulfilling spike in its risk premium, this imposes huge, needless costs on the state in question, on others in risk of contagion, and on their creditors. But no rescue mechanisms big enough to protect the major Eurozone countries have been established. The reason is moral hazard: fiscally strong Eurozone countries justifiably fear that they will end up paying for the profligacy of others, if joint backing of all members' debts reduces the incentives of each individual country to put its own fiscal affairs in order.
 
Since its inception the Eurozone has sought to reduce moral hazard by restraining debt accumulation, through the Maastricht criteria and the Stability and Growth Pact and its successors. The Pact promised to fine countries that failed to meet their deficit targets. But fining a country only deepens its financial troubles, so fines are not only politically difficult, but also fiscally counterproductive. Therefore it is unsurprising that when Germany, France, and other major players failed to achieve their targets under the SGP, in 2003-2004, no fines were applied. It is also unsurprising that member states were undeterred by the empty threats of the SGP.
 
The newly-signed Fiscal Compact (European Council, March 2012) increases fiscal monitoring at all stages of the budget process. It is also designed to strengthen the SGP by bringing in sanctions earlier, and more automatically. It requires countries to define rules guiding their fiscal policy, preferably at the constitutional level. But do these requirements really suffice to guarantee budget sustainability? Fines remain counterproductive for budget balance; making them more automatic only increases the risk that they will actually be imposed. Establishing fiscal limits in the constitution may raise the reputational cost of violating them, but does not, in and of itself, establish any mechanism to ensure that the limits will be respected.
 
Costain and de Blas (2012A) argue that any solution based on threats of counterproductive punishments will eventually fail, but that a much more credible guarantee of long-run budget balance could be achieved by delegating fiscal instruments directly to the European Commission. Their analysis follows a long series of policy proposals based on the idea that deficit bias could be mitigated by removing some fiscal decisions from the political process and placing them under the control of an independent authority, just as delegation of monetary policy to a central bank has successfully reduced inflation bias (see Calmfors, 2003, or Debrun, Hauner, and Kumar 2009).
 
A particularly simple example that shows how fiscal delegation could work is Gruen's (1997) proposal for Australia. He suggested that all tax rates should be multiplied by a parameter X, which would initially be set equal to one. The value of X would be determined by an independent authority with a mandate to maintain long-run budget balance. The legislature would, as usual, choose the types of taxes to be collected, and the baseline rates applicable at different levels of income or to different types of transactions; but these baseline rates would subsequently be multiplied by the factor X. In benign fiscal times, the fiscal authority would decrease X to lower all tax rates across the board; in times of trouble the authority would instead raise X.
 
In the current Eurozone context, each member state could be required to delegate executive power over at least one effective fiscal instrument to the European Commission. National legislatures would decide for themselves which fiscal instruments to delegate. One country might choose to delegate control of a multiplicative shift parameter in its income tax code; another might delegate an additive shifter in its value added tax schedule; another might define a shift parameter in the growth rate of pensions and other social benefits. Some countries might choose to give the Commission greater flexibility by delegating more than one parameter. Costain and de Blas (2012B) propose making adjustments to spending quicker and more flexible by budgeting public spending in an alternative unit of account. The fiscal agency would set the value of this alternative numeraire to ensure budget balance, effectively making the prices paid by the government state-contingent. This could help Eurozone countries resist asymmetric demand shocks by restoring some of the lost flexibility of their relative prices and wages.
 
It is crucial that the policy decision to be delegated should be an instrument variable that can be adjusted ex post, rather than a target that is only imposed ex ante. For example, Wyplosz (2005) suggests that an independent authority should choose the deficit level in each fiscal year, and that the government should be required to submit a budget that respects this deficit. But the deficit is the cumulative result of hundreds of tax and spending decisions taken at various levels of government, and is therefore not under the direct control of the executive: it is better understood as a target variable, not as an instrument. A stronger fiscal commitment would be achieved by delegating a fiscal parameter that could be adjusted late in the fiscal year, when unexpected shocks or failures of fiscal discipline could be taken into account.
 
How would such a system work? The European Commission would set up a budget-balancing agency which could logically be called the European Fiscal Authority (EFA). This body would exercise control, when it deemed necessary, over the instruments delegated to it by the member states. Fines and other sanctions would be unnecessary; if the EFA detected an unsustainable fiscal trend, it would simply adjust the delegated fiscal parameter as necessary to steer the national budget back towards balance. Rather than pursuing budget balance indirectly, by monitoring countries and threatening painful sanctions on those found to be irresponsible, the EFA would pursue budget balance directly, and more credibly, by monitoring countries and using the instruments under its control to adjust the deficit towards sustainability whenever countries fail to do so themselves.
 
The very first responsibility of the EFA would be to evaluate the effectiveness of the fiscal instruments proposed for delegation by national governments. An effective instrument is one that produces a large impact on the budget in an administratively simple way; whether the instrument is appropriate in terms of its economic, political, and distributional effects is a question for the national governments themselves to decide. Effectiveness also requires that the instrument has actually been implemented in national legislation: the EFA would verify whether legislation creating the instrument has been passed, whether any relevant constitutional issues have been resolved, and whether the administrative structure needed to operate the instrument is in place.
 
The fiscal rules required by the new Fiscal Compact make the hypothetical EFA's job easier. Any rule to ensure long-run budget balance must have the property that shocks to the debt level are gradually eliminated over time. On the other hand, temporary deficits should be allowed, when recessions occur or when there are exceptional public spending needs. In other words, consistent with Articles 3 and 4 of the Compact, fiscal austerity is essential over the long run, but need not always hold in the short run. Just as the EFA would be responsible for evaluating the effectiveness of the delegated national fiscal instruments, it would also have to evaluate the quantitative realism of the national fiscal rules. If it judges that a member state's proposed rule is based on unrealistic economic assumptions, or would imply excessive fluctuations in deficits and debt, it would require the national legislature to make a more adequate proposal.
 
Once the EFA judges that a member state has delegated an effective fiscal instrument, under an adequate fiscal rule, that member state would be free to manage its own fiscal affairs. Thus it would normally be unnecessary for the EFA to adjust the instruments it controls. Most of the time, its main job would be macroeconomic forecasting: it would forecast output and other macroeconomic variables, and public spending and transfers and revenues, while keeping track of national policy changes. The improved reporting and surveillance of national budgets required by the Fiscal Compact is helpful in this regard. The EFA would monitor the member state's adherence to its own fiscal rule, and the behavior of the deficit and debt over time, warning the member state of predicted imbalances, and evaluating the budgetary impact of new policy proposals. It would normally give the member state adequate time to choose its own path of adjustment when a deviation from the fiscal rule is detected. But when this fails it would always be able to impose a fiscal adjustment directly by resetting its instruments.
 
Is it reasonable to expect that member states would be willing to delegate fiscal powers to Brussels in this way? Yes, if the quid pro quo is the establishment of a European monetary and financial regime capable of stopping speculative attacks. Reinforcing the Fiscal Compact by delegating fiscal instruments to the European Commission would greatly mitigate the moral hazard problem, opening the door to any of the obvious solutions to the debt crisis. The EU or the Eurozone could then issue bonds with joint and several backing, and trade these for national debt, knowing that mechanisms are in place to ensure that all member states pay their obligations. The ECB could risklessly purchase national debt on secondary markets, and could commit to limit interest rate differentials across national bonds, knowing that all national debts have equally strong backing. Indeed, ECB acceptance of national bonds as collateral could be contingent on a member state's continued willingness to delegate an instrument that the EFA judges to be effective.
 
Delegating a fiscal instrument to an independent authority might seem to be a loss of democracy. But this is false, because the government faces an intertemporal budget constraint. If the government chooses between n forms of spending and m types of taxation, only n+m-1 of these can be chosen independently: the last budget item is determined by the intertemporal budget contraint (except, of course, if the government defaults). Thus, if the government delegates control of one of its fiscal instruments to an outside authority, but retains control over all others, it has exactly the same degrees of freedom that it has whenever it respects its budget constraint. Indeed, since the political process generates deficit bias, and since intertemporal budget balance is a complex calculation better suited for financial experts than politicians, and since delegation may clarify the government's ability and willingess to pay, the government would gain greater credibility by delegating an effective fiscal instrument to the EFA.
 
In other words, a government that wishes to avoid default gives up no freedom by delegating one quantitative dimension of its fiscal policy to a panel of experts. Insofar as delegation achieves a lower risk premium by enhancing credibility, it increases the set of financially feasible spending and tax policies from which the government can choose. And by avoiding pointless sanctions, fiscal delegation would preserve more national sovereignty than the current version of the Fiscal Compact does. If necessary, budget balance would be maintained by adjustment of the EFA's delegated instruments. While this might be construed as a punishment (and would indeed provide strong incentives for fiscal responsibility ex ante), the point is not to punish, but simply to attain the budgetary objective. The margins of adjustment would be designed ex ante by the member state in question, reflecting its own preferences about how to balance its budget if for some reason its own political process fails to do so.
 
Beatriz de Blas, Universidad Autónoma de Madrid, May 2012.
 
 
References
 
Lars Calmfors (2003), "Fiscal policy to stabilise the domestic economy in the EMU: what can we learn from monetary policy?" CESifo Economic Studies 49 (3), pp. 319-353.
Giancarlo Corsetti (2012), "Has austerity gone too far?" VoxEU, 2 April.
James Costain and Beatriz de Blas (2012A), "The role of fiscal delegation in a monetary union: a survey of the political economy issues." Economic Analysis Working Paper Series 11/2012, Universidad Autónoma de Madrid.
James Costain and Beatriz de Blas (2012B), "Smoothing shocks and balancing budgets in a currency union." Banco de España Working Paper #1207. Forthcoming, Moneda y Crédito 234.
Xavier Debrun, David Hauner, and Manmohan Kumar (2009), "Independent fiscal agencies." Journal of Economic Surveys 23 (1), pp. 44-81.
European Council (2012), Treaty on Stability, Coordination, and Governance in the Economic and Monetary Union. Signed 2 March.
Paul de Grauwe (2011), "The governance of a fragile Eurozone." CEPS Working Document #346.
Nicholas Gruen (1997), "Making fiscal policy flexibly independent of government." Agenda 4 (3), pp. 297-307.
Charles Wyplosz (2005), "Fiscal policy: institutions versus rules." National Institute Economic Review 191, pp. 70-84.

Lead Postings

Latest Commentaries