The Effect Of Fiscal Rules On Public Finance Sustainability In The Euro Area

Abstract

This article presents the impact of fiscal rules on the public finance sustainability in the Euro Area, which resulted from a wrong strategy of the Economic and Monetary Union. The situation has become critical for countries such as Greece, Portugal, Ireland, Spain. Without large-scale structural reforms, the sustainability of the European Union is under question mark. The optimal solutions for ensure the fiscal sustainability in the euro area could be the fundamental changes regarding the restructuration of the Economic and Monetary Union and the solution of the contradictions referring to imposing a single currency and a common monetary policy in countries having different fiscal policies.

Key words: debt crisis, governmental deficit, public debt, fiscal rules

JEL classification: E52, E58, E63, F36.

Introduction

The current economic crisis revealed a series of deficiencies, weaknesses of the Stability and Growth Pact concerning the surveillance and fiscal coordination mechanisms. The inefficiency of the Stability and Growth Pact becomes clear in the case of the high public debt of Greece. Although starting with 2003, 30 states were subject to an excessive deficit procedure, the European Commission didn’t apply any financial sanction against them. The interventions of the European Union towards these states consist in recommendations and warnings regarding the consolidation of public finances. The role of the Stability and Growth Pact was rather limited concerning the public debt chronicity of some states form the Euro Area, such as Ireland, Spain, France (Rebecca M. Nelson, Paul Belkin, Derek E. Mix, 2010).

In 2008, in the context of the economic and financial crisis, a large number of states violated the stipulation of the Stability and Growth Pact. Thus, 20 states out of the 27 member states registered a deficit ratio above 3 % of GDP and the public debt of the states in the Euro Area reached in 2010 84% of GDP, 18% higher than the level of 2007, a lot above the imposed limit, of 60% of GDP (Will James and John Butters, Carolina Braken, 2011). A major deficiency of this Pact consists of the incapacity to prevent or manage the financial crises.

The European Commission worried about the public debt spiral of Greece, considering that it will affect the financial stability in the Euro Area. Besides the austerity measures, Greece benefited from financial assistance from the Euro Area states (€ 8 billion) as well as from the International Monetary Fund (€ 3 billion). At the end of 2010, Ireland faced similar problems and the Euro Area states agreed to grant Ireland a 11,7 € billion financial assistance. Besides this measure a Special Purpose Vehicle was created: the European Financial Stability Facility worth € 440 billion consisting of guarantees of the European Union member states which will finance the future cash in-flow. Thus, there is the possibility of refinancing the public debt of Ireland, Portugal and Spain.

We have to mention the incompatibility between the fiscal policy which belongs to each democratic state as the expression of its sovereignty and the objective of coordinating the budgetary policies at a European level. A monetary union with strong connections between the banking systems can face problems without a fiscal coordination, because the national governments may be tempted to increase inefficiently their public debt, which, in case of contagion, can have serious repercussions on other economies.

The Sustainability of Government Debts in the Euro Area

Many member states of the European Union finance the governmental deficit by public borrowings. When contracting a public borrowing, the states must correlate the current market value of debt and the up-dated value of future budget surpluses. If he value of the public debt increases faster than the economic growth rate, it means that the budgetary policies need to be revised. A public debt is considered to be efficient and sustainable when the evolution of its debt-to-GDP ratio follows the economic growth trajectory. Otherwise, the debt is unsustainable.

The risk of Greece’s sovereign debt shocked the European Union and raised the problem of the public debt sustainability in the Euro Area. The effect of the fiscal policies adopted by a government is extremely important for the decrease of the public debt. Regarding the fiscal policies if the member states, the European Union drew up clear rules of budgetary behaviour, i.e.: The Excessive Deficit Procedure, based on the two criteria – the budget deficit must not exceed 3% of GDP and the public debt must not exceed 60% of GDP.

If we analyze the evolution of the steady state debt level, we can notice that it increased in the period 1980-1990 and it was characterized by high interest rate and slow growth. When the monetary union was created, the debt-to-GDP ratio became stable in Austria, Belgium, Greece and Spain, decreased in France and Germany and increased in Finland, Ireland, Italy, Holland and Portugal. The financial crisis led to an increase of the level of he debt-to-GDP ratio in nearly all the member states, canceling thus the progress made in the years before the crisis. In 2010, the public debt of the Euro Area increased to nearly 84% of GDP and the public debts of the European Union increased to approximately 79% of GDP, 20% more than in 2007. The evolution of the public debt in time present serious deviation from the balance level in the following states: Italy, Belgium, Germany and France. Moreover, the public debt of Ireland, Sweden, Spain, France and Finland registers oscillatory tendencies.

Some of the causes of the public debt crisis in the Euro Area could be:

the non-observance of fiscal policies, precisely violations of the fiscal rules imposed by the Stability and Growth Pact, such as the disclosure of false financial information (for exemple, in the period 2000-2008 Greece reported a government deficit of almost 3% of GDP, while actually its level was 5% of GDP), the insufficient decrease of the public debt in Italy, Portugal and Spain.

Major macroeconomic lacks of balance, which determined an increase in credit tendencies, the growth of the building sector, strong currency appreciation in states like Ireland and Spain; in 1999-2007, Ireland had fiscal positions indicating budget surplus, as well as a public debt decreasing from 50% of GDP in 1999 to 25% of GDP in 2007;

Weak regulation of banks having low capital reserves, which obliged the governments to transform the private debt into public debt when the crisis began. Ireland and Great Britain are the most relevant examples for this situation.

DG ECOFIN has constructed an index of strength of fiscal rules (FRI) based on the following elements: statutory base of the rule, the body in charge of monitoring the respect of the rule, the body in charge of enforcement of the rule, and the enforcement mechanisms relating to the rule (Wim Marneffe, Bas Van Aarle, Wouter Van Der Wielen, Lode Vereeck, 2010).

Figure 1 The evolution of the fiscal index in the Euro Area in 1996-2008

Source: Wim Marneffe, Bas Van Aarle, Wouter Van Der Wielen, Lode Vereeck,“ The Impact of Fiscal Rules on Public Finances: Theory and Empirical Evidence for the Euro Area”, CESIFO Working Paper no. 3303, p. 18

The effect of the adoption of various fiscal rules on the evolution of the public debt can be analysed from the figure below:

Figure 2 The evolution of the public debt in the Euro Area in 1998-2010

Source: data processed by the authors upon the information published on Eurostat

The effect of the measures adopted by the Euro Area states to support the financial sector upon their public debt was significant in comparison to their effect upon the governmental deficit. Despite the dimension of certain financial institutions, they risk to turn from „too big to fail” into „too big to be saved” (Gros and Micossi, 2008), endangering the entire state (Richard Baldwin, Daniel Gros and Luc Laeven, 2010). This is how the phenomenon of contagion to other economies is created.

From the national governments, the effective measures for banks safeguarding under the supervision of the European Central Bank consisted in: governmental guarantees for the interbank credits; recapitalisation of financial institutions having problems, including national capital inflows; extending the coverage of the Retail Deposit Guarantee Schemes. While countries like Germany, Austria, Greece, Spain, France and the Netherlands chose to guarantee the credits and to apply recapitalisation measures, other states, such as Belgium, Holland, Luxembourg, Ireland chose to make aleatory interventions, even the nationalisation of individual financial institutions threatened with the solvability risk. Other states, like Spain, Holland, Italy adopted measures of buying assets, taking over/canceling debts, temporary swap arrangements or guaranteeing the deposits and debts of internal banks and external branches in the case of Ireland. In April 2009 Ireland announced the creation of the National Asset Management Agency, a non-governmental institution, which started its activity in May 2010. The main attribution of this agency is to buy risky credits from banks, allowing them to consolidate their balance sheet.

Figure 3 The evolution of public debt and private debt in the Euro Area

Source: Richard Baldwin, Daniel Gros and Luc Laeven, “Completing the Eurozone Rescue: What More Needs to Be Done?”, VoxEU.org Publication, Centre for Economic Policy Research, June 2010, p.10

In relative values, the effect of these measures for safeguarding the financial institutions upon the evolution of the public debts in the Euro Area was a strong one, generating it increase to 2,5% of GDP. The public debts of some Euro Area states increased considerably: Belgium (6,4%), Ireland (6,7%), Luxemburg (6,6%), Holland ( 11,3%) (Maria Grazia Attinasi, 2010).

We must take into account the fact that by the adoption of this monetary policy to support the financial sector in the Euro Area, the national governments of the Euro Area took high fiscal risks endangering their fiscal position in a medium and long term, especially regarding the public debt. Reinhart and Rogoff’s statement is confirmed, according to which when there is a credit expansion, the private debts becomes public debts, as we can see in Figure 3.

The Effect of the Adoption of Fiscal Measures on the Economic Growth in the Euro Area

If we analyze the fiscal behaviour of the Euro Area states in time, we can notice an evolution depending on the economic situation at a given time. As to the effect of European Union fiscal rules, the majority criticises them, considering them pro-cyclical and unable to generate economic growth, helpless to prevent the situation in which Greece accumulated and excessive government deficit and a huge public debt. In theory, the Stability and Growth Pact guarantees a stimulation of the European economy during recession periods and the consolidation of public finances in boom periods. In reality, few member states experiences structurally balanced budgets, which denotes that the fiscal policies are pro-cyclical during recession periods. If we analyze the fiscal policies of the Euro Area in evolution we can notice that from the creation of the economic and monetary union, their character was more or less pro-cyclical. Since 1999, the only states who have made efforts to reorient the pro-cyclical fiscal policy towards a countercyclical one are France and Finland. The progress of each state to consolidate the fiscal position, to reach the objective of „in-balance or excessive” fiscal position, on medium-term, was different. (Martin Larch, Paul van den Noord and Lars Jonung, 2010).

The evolution of fiscal balances is strongly dependant on the level of GDP per inhabitant; the decline of the fiscal positions is more obvious in the wealthier economies. Thus, we can discern two categories of states: the first category, including Germany, Italy, France, Greece and Portugal and the second category including Spain, Ireland, Austria, Holland and Belgium. The fiscal behaviour of the two categories of states differed significantly in the period 1998-2003. Germany and France were the first states which outran the deficit level of 3% of GDP and also the first which applied the excessive deficit procedure. The reticence of the ECOFIN Council to sanction the states which violated the stipulations of the Pact came from the desire to avoid political conflicts, considering that indulgence might change the behaviour of those who violated the fiscal norms. Typical for the pre-crisis period, once they reached an improved fiscal position, the states of the first category neglected to reach the budgetary objectives on medium term. The member states of the second category continued the same fiscal behaviour, apparently favourable, but with the beginning of the financial crises, they experienced a deterioration of the construction market and massive increase of current account deficits. Thus, the contrast between the pre-crisis and post-crisis evolutions in the two categories of European Union states was different: while in the first category the contrast of performances was weaker one, in the second category, the differences were significant.

During the first decade after joining the Euro Area, Germany had to correct the effects of the „unifying shock” via wage moderation and some labour market reforms. The effect of the implementation of these measures was a weak growth, averaging 1% over 15 years. As Germany accounted for a large share of Euro Area GDP, this weak growth greatly conditioned the monetary policy of the ECB, producing a monetary stance that was too loose for some members, producing rapid growth in the Euro Area periphery. (Angel Ubide, 2010).

So, the pre-crisis period was marked by asymmetrical evolutions since whereas the strong, founding states which accounted for large shares to the European Union budget (Germany, France, Austria, Holland, Belgium, Luxembourg) experiences a slower economic growth and lower rates of inflation, the periphery states of the Euro Area (Greece, Ireland, Spain) experienced a strong development, a growth of economic performances, accompanied by exaggerated price increases and also high rates of inflation (Greece and Spain 8%, Ireland 10%). The contradictory, asymmetrical development of these states generated strong current account imbalances. So, even though generally speaking the situation in the Euro Area was in balance, it hid major imbalances-deficits for the following states: Greece, Ireland, Portugal, Spain, compensated by the surpluses of the big contributors.

The result of some research (Agustín S. Bénétrix, Philip R. Lane, 2010) on the effect of the monetary policy upon the economic performances of a state proved that the heterogeneity of the fiscal policies adopted by the member states in the period 2007-2009 is strongly influenced by the direction of the unemployment rates changes in different states and by the significant expansion of the credits provided to the private sector. The interdependency of the fiscal results and the evolutions of the credits in the private sector pre-crisis and during the crisis was different (Agustín S. Bénétrix, Philip R. Lane, 2010).

The downturn in economic activity in the current economic and financial crisis led to a decrease of the public revenues and to the maintenance of the expenditures within the planned level, which contributed to the deterioration of the public finances of the Euro Area. The deterioration of fiscal perspectives was felt by a budget deficit of 6,9% of the GDP in 2010, compared to 2007, when the budget of the Euro Area was almost balanced. This is the result of changes in the consumer trends and the decline of the revenues. In order to attenuate the effect of the economic and financial crisis, the member states adopted automatic stabilizers and implemented a discretionary monetary policy within the European Economic Recovery Plan adopted by the European Commission in December 2008.

According to European Commission estimations, the value of the fiscal stimulus package adopted by the Euro Area reaches 2% of GDP (1,1 % in 2009, 0, 8% in 2010). For 2009, the most consistent “fiscal package” was adopted by Spain (2,3% of GDP), Austria, Finland, Malta (over 1,5% of GDP). Greece and Italy did not adopt the discretionary policy in order to avoid the increase of the governmental deficits.

Figure 4 The evolution of fiscal revenues in the period 1998-2009

Source: data processed by the authors upon the information published on Eurostat

As we can notice from the figure above, the fiscal revenues of the Euro Area economies increased in the period 2005-2007. The causes of fiscal revenues increase are: the increase of tax elasticity, the enlargement of the tax basis, the profit increase and especially the decrease of the tax rate. If in Great Britain the fiscal revenues increase was a consequence of the profit increase n the financial services sector, in Ireland, the fiscal revenues increase in 2000-2007 was caused by an increase in the number of properties transactions. The tax revenues from the capital gains also showed an ascending tendency because of the increase in the price of properties.

After having analyzed the fiscal policies of the Euro Area states, we can notice that there are no major differences between the fiscal policies of the Euro Area states and those of other states, respectively, between the fiscal behaviour of the Euro Area states before and after joining the Eurozone.

4. Proposals for new fiscal rules in the Euro Area

Possible measures to avoid public debt unsustainability could be the increase of fiscal revenues by modifying the tax basis (economic growth) and the decrease of the financing cost (rate of interest). The condition of correlating the level of public debt with the revenues collected in the future is necessary, but not sufficient, because the liquidity risk may occur if the government in question does not have access to the financial markets at the initial maturity date of the debt. In order to reestablish the public debt trajectory, there is the serious need of fiscal adjustments of at least 1% of GDP and also the need to encourage the production in order to increase the fiscal revenues and to decrease the expenditures used to support the unemployed.

Some specialists consider that the future of the Euro Area depends on the capacity to create a political union within the Euro Area, which would remove the major imbalances by a coordination of the competitive positions. This would suppose the transfer of national sovereignty concerning the fundament of economic policies, other than the monetary ones, regardless of the budgetary position, and also the implementation of some measures of minimal solidarity among the member states, including those states which have financial problems. (Paul De Grauwe, 2010).

Effective proposals for new fiscal rules in the Euro Area have in view:

the consolidation of the fiscal norms of the EU;

More efficient mechanisms for macroeconomic surveillance:

The connection of fiscal policies processes at the European Union level and at the national level;

The consolidation of national fiscal frameworks.

If we analyze the member states practices regarding the observance of the EU fiscal norms, we can notice a massive tendency to violate them, as well as to deviate from the medium-term fiscal objectives. The proposals of the European Commission to reform the fiscal rules have in view preventive measures, more exactly the manifestation of a stronger interest for reaching the medium-term fiscal objectives in terms of public debt, as well as corrective measures, more exactly an enhanced focus on the public debt, the sanction of those states which overrun the established limit of 60% of the GDP, by initiating the excessive deficit procedure.

The measure regarding the efficientisation of economic surveillance mechanisms refers to the creation of a preventing mechanism based on a table with several indices such as: current account deficit, real exchange rate, private debt and asset prices, as well as the creation of a mechanism meant to correct massive imbalances. This surveillance and assistance mechanisms should react much quicker to economic and financial crisis. The recent experiences of Ireland and Spain prove effectively that an unsustained boom can lead to serious asymmetrical shocks, to damages, to macroeconomical deteriorations, which contradicts the idea that a monetary union removes the risk of asymmetric shocks. The new surveillance and assistance mechanism should also define clearly the financial assistance costs in monetary terms as well as in terms of losing the fiscal sovereignty.

If we analyze the relationship between national fiscal policies and the community ones, we can notice that they tend to be not associated. Regarding this issue, the European Commission’s proposal is to create an annual special program, in cooperation with the member states: in the first stage of the program the European Commission and the Council of the European Union provide strategic direction; in the second stage those involved will reflect upon the assimilation and consideration of these directions by means of Stability Programs and the National Reform Programs; in the third stage, the Council of the European Union provides specific direction to each state according to the programs presented; in the last stage, the member states finalize the national budgets.

But as long as the elaboration and fundament of fiscal polices remains the privilege of the national governments, the revising of the Stability and Growth Pact should materialize in the adoption of some decentralized measures at the level of each national authority with a view to guaranteeing the fiscal discipline in the Euro Area. (Charles Wyplosz, 2010). In order to render the national fiscal policies more efficient and respecting the transparency principle, some measures must be taken: to define clearly multiannual fiscal objectives; to specify to which extent the fiscal policy has the role of economic cycle stabilizer; to guarantee a transparent financial reporting in order to prevent a hidden government deficit by creative accounting; the creation of councils which would survey the independent fiscal policies at member state level. The creation of independent fiscal councils ate member state level would ease the cooperation between the member states regarding the fundament of optimal fiscal policies as well as the understanding the difficulties faced by the Euro Area states.

At the European Union level there are proposals to create a council for the maintenance of fiscal discipline, independent from the European Commission, having as main attribution the surveillance of national fiscal frameworks, the degree of compliance with the minimum standards and a rigorous surveillance of the private debts evolution.

For the fiscal consolidation in the Euro Area, the governments of the Euro Area peripheral states – Greece, Portugal, Spain want to reach an agreement regarding the elaboration of optimal fiscal measures. The states experiencing excessive governmental deficits should adopt more cautious fiscal policies, anti-cyclical by the efficientisation of public expenditures. If the take into account the failure of the budgetary discipline in the Euro Area, we must mention the example of Germany, which proved a good model concerning the monetary policy (imposed also to the Euro Area). The success of the fiscal policy could be ensured by the optimal coordination between the direction of institutional reform at national level land the market forces for a better surveillance of the government deficit and the public debt in the Euro Area (Jean Pisani-Ferry, 2010). Besides the fiscal coordination measures, the member states of the Euro Area must adopt measures of structural reform, of restructuring the pension system, the labour market, drastic measures upon a nation..

An important problem of the European Union Treaties architecture is the no bail-out clause and the setting up of the European Financial Stability Facility is a violation of this clause. According to these stipulations, each member state of the Euro Area is responsible for its budgetary position. Likewise, it is forbidden for any institution, organisation or any member state to grant financial assistance to another member state. Not even the European Central Bank is allowed to finance the excessive public debt of a state. The conviction on which this clause is based is that a state of the Euro Area which is threatened with bankruptcy is isolated. Until the beginning of the financial crisis this conviction was well-grounded, but in the conditions of stress contagion and the problem of sovereign public debts, this is no longer valid.

Conclusions

As long as the public debt crisis is possible in the Euro Area, it is essential to initiate a financial crisis response mechanism, with a view to restructure the public debt and to ensure the sustainability of public finances. The fines collected from those who violate the stipulations of the Stability and Growth Pact could have the role of financing the crises response mechanisms. For the efficientisation of the activity of the crisis response mechanisms, the task of collecting and managing the fines could be externalized to the European Fiscal Councils, independent bodies.

In our opinion, the optimal solutions could be the fundamental changes regarding the restructuration of the Economic and Monetary Union and the solution of the contradictions referring to imposing a single currency and a common monetary policy in countries having different fiscal policies.

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