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Should the Stability and Growth Pact be strengthened?

By JĂ©rĂ´me Creel, Paul Hubert and Francesco Saraceno
The European fiscal crisis and the ensuing need to reduce the levels of public debt accelerated the adoption of a series of reforms of European fiscal rules in late 2011. Two rules were introduced to strengthen the Stability and Growth Pact (SGP). Given that many Member States in the euro zone have structural deficits and public debts that exceed the thresholds under consideration, it seemed worthwhile to assess the macroeconomic implications of compliance with these fiscal rules by four countries, including France.
The current limit of the public deficit to 3% of GDP was supplemented by a limit on the structural deficit equivalent to 0.5% of GDP, and by a rule on debt reduction requiring heavily indebted countries to reduce their level of public debt every year by 1/20th of the difference with the reference level of 60% of GDP. Moreover, the limit on the structural deficit goes beyond the 3% rule because it is associated with a requirement to incorporate a balanced budget rule and automatic mechanisms for returning to balanced budgets in the constitution of each Member State in the euro zone. Due to an unfortunate misnomer, this is now often called the “golden rule” [1]. To distinguish this from the “golden rule of public finance” applied by the French regions, the German Länder and, from 1997 to 2009, the UK, we will henceforth call this “balanced budget rule” the “new golden rule “.
Because of the international financial crisis raging since 2007, the euro zone States often fall far short of the demands of the new rules. This raises the question of the consequences that flow from imposing these rules on the Members. To this end, we decided to study the paths of convergence with the different rules of four countries that are representative of the euro zone, using a standard theoretical model.
We chose a large country with an average level of public debt (France), a small country with a somewhat larger debt (Belgium), a large country with a large debt (Italy) and a small country with a relatively low level of debt (Netherlands). The size of the country, large or small, is associated with the size of their fiscal multiplier, i.e. the impact of public spending on growth: large countries that are less open than the small countries to international trade have a greater multiplier effect than the small countries. The four countries also differed with respect to the size and sign of their structural primary balance in 2010: France and the Netherlands ran a deficit, while Belgium and Italy had a surplus.
In the model, the evolution of the public deficit is countercyclical and the impact of an increase in the public deficit on GDP is positive, but excessive indebtedness increases the risk premium on the long-term interest rates paid to finance this debt, which ultimately undermines the effectiveness of fiscal policy.
The rules that we simulated are: (a) a balanced (at 0.5% of GDP) budget or the “new golden rule”; (b) the 5% per year rule on debt reduction; (c) the 3% ceiling on the total deficit (status quo). We also evaluated: (d) the impact of adopting an investment rule along the lines of the golden rule of public finance which, in general, requires a balanced budget for current expenditure over the cycle, while allowing the debt to finance public investment.
We simulated over 20 years, i.e. the horizon for implementing the 1/20th rule, the impact of the rules on growth, on the inflation rate and the structural public deficit and on the level of public debt. First, we analyzed the path followed by the four economies after the adoption of each fiscal rule in 2010. In other words, we asked how the rules work in the context of the fiscal austerity that Europe is currently experiencing. Second, we simulated the dynamics of the economy after a demand shock and a supply shock, starting from the base situation of the Maastricht Treaty, with the economy growing at a nominal rate of 5% (growth potential of 3% and inflation rate of 2%), and a debt level of 60%. It is interesting to note that the real growth potential in the euro zone countries has been consistently below 3% since 1992, which has helped to make the rule limiting public finances even more restrictive than originally planned.
Our simulations led to a number of results. First, in every case the adoption of the rules produced a short-term recession, even in small countries with a small fiscal multiplier and a small initial public debt, such as the Netherlands. This complements the analysis that the widespread implementation of austerity in Europe is inevitably undermining growth (see The very great recession, 2011) by showing that there is no fiscal rule that, strictly applied in the short term, makes it possible to avoid a recession. This finding points to an incentive on the part of government to dissociate the use of the fiscal rules de facto and de jure: in other words, if the ultimate goal of economic policy is the preservation and stability of economic growth, then it is wise not to act on the pronouncements.
Second, recessions can lead to deflation. Under the constraint of zero nominal interest rates, deflation is very difficult to reverse with fiscal austerity.
Third, the investment rule leads to a better macroeconomic performance than the other three rules: the recessions are shorter, less pronounced and less inflationary over the time period considered. Ultimately, the levels of public debt decreased admittedly less than with the 1/20th rule but, as a result of the growth generated, France’s public debt shrinks by 10 GDP points from its 2010 level, while the Belgian and Italian debt are reduced by 30 and 50 GDP points, respectively. Only the country that was least indebted initially, the Netherlands, saw its debt stagnate.
Fourth, while ignoring the investment rule, which is not part of European plans, it appears that, in terms of growth, the status quo is more favorable than the “new golden rule” or the rule on debt reduction; it is, however, more inflationary for the large countries. This indicates that, in terms of growth, the strengthening of the Stability and Growth Pact, brutally applied, would be detrimental to the four economies.
Fifth, when the economy in equilibrium is hit by demand and supply shocks, the status quo seems appropriate. This confirms the idea that the current Pact provides room for fiscal maneuvering. The simulations nevertheless suggest that the status quo remains expensive compared with the investment rule.
To conclude, it is difficult not to notice a paradox: the rules designed to prevent governments from intervening in the economy are being discussed precisely after the global financial crisis that required governments to intervene to help cushion the shocks resulting from market failures. This work aims to shift the debate: from the goal of fiscal stabilization to the goal of macroeconomic stabilization. The European authorities – the governments, the ECB and the Commission – seem to consider the public debt and deficit as policy objectives in their own right, rather than as instruments to achieve the ultimate objectives of growth and inflation. This reversal of objectives and instruments is tantamount to denying a priori any role for macroeconomic policy. Many studies [2], including the one we have conducted here, adopt the opposite position: economic policy definitely plays a role in stabilizing economies.

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[1] This misnomer has been criticised in particular by Catherine Mathieu and Henri Sterdyniak in 2011, and by Bernard Schwengler in 2012.
[2] See, for example, the cross-disciplinary study that appeared in English in 2012 in the American Economic Journal, Macroeconomics, and the bibliography that it contains, or in French, the study that appeared in 2011 by Creel, Heyer and Plane on the multiplier effects of temporary fiscal stimulus policies.

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