The sustainability of public finances continues to be a priority area for public economic policy around the world, more so in the European Union. The rules are known to all, namely that gross government debt should not exceed 60 per cent of the gross domestic product and the fiscal deficit for a year should not exceed 3 per cent of the gross domestic product. This so-called Stability Pact was drafted in the early 1990s, and was eventually reinforced by the EU’s new governance regime.
However, six years after the start of the financial crisis, the average debt burden has swelled to just under 90 per cent of economic output, although years of prolonged budget austerity has succeeded in reducing the average deficit exactly to the 3 per cent limit. The main focus has always been the 3 per cent limit and less attention was paid to the 60 per cent ratio of government debt to GDP.
Some analysts argue that these rules were drawn up when countries were anticipating prolonged economic growth at rates of between 3 and 5 per cent, a far cry from the EU’s expectations post the financial crisis. Others argue that the regime is inflexible and forces governments to slash public spending when it is most needed, at the height of a recession. In fact, the latter has been a long-standing issue between Germany and a number of other countries who claim that growth policies should be favoured over fiscal consolidation policies.
Italian Prime Minister Matteo Renzi has indicated he will use his country’s six-month EU presidency, which started in July, to push for the budget rules to be temporarily loosened for governments who invest in growth-fostering reforms such as infrastructure projects or research and innovation.
Italy remains within the 3 per cent deficit limit, but a stagnant economy has pushed its overall debt level to 133 per cent of GDP, second in size only to Greece in the EU.
An IMF official recently claimed “fiscal frameworks actively discourage investment and imply pro-cyclicality and tightening at the most difficult times”.
Pro-cyclical policies are seen as those which accentuate economic or financial conditions, as opposed to counter-cyclical measures which can stimulate economic output through infrastructure spending during a recession.
In simple terms he argued that during recessions, the rule relating to the 3 per cent ratio of deficit to GDP should be suspended because it only makes things worse.
He concluded that reducing the level of gross government debt should be the focus of the EU’s governance regime and that the evolution of the debt-GDP ratio should be the single fiscal target to aim for.
He also called for a simplification of the rules relating to public finances. However, the more one simplifies the rules, the more there may be scope for creative government accounting and the more pro-cyclical they are likely to be.
One can draw the analogy with a private business. If a business is going through a bad patch, generating losses instead of profits and the level of borrowing is becoming unsustainable, what should it do?
Closing it down or selling it off could be two options, but one can neither sell off a country nor shut it down. The other option is a strategy that encompasses a mix of measures that will reduce costs and increase revenue coupled with new investment to achieve further growth.
A country needs to go through the same process. It needs to eliminate waste in public expenditure, have a more efficient tax system such that tax revenues increase without increasing the tax burden, and increase investment to expand the growth potential of the economy.
However, it seems that a successful formula of these three elements has eluded most EU governments. It still leaves us with the questions posed by the IMF official I referred to.
Reducing the level of gross government debt should be the focus of the EU’s governance regime
How can the rules of the EU in relation to fiscal policy be made counter-cyclical rather than pro-cyclical? And should the single measure to be used in terms of assessing fiscal sustainability be the level of gross government debt?
As several EU member states continue to struggle to achieve robust economic growth, these questions will persist.
What is crucial is that we do not end up with a situation where the tail is wagging the dog, that is the EU governments become slaves to the systems and frameworks that they themselves would have created.