Editors' note: This column is a lead commentary in the VoxEU debate on EU economic policy and architecture after Covid.
Following the suspension of the fiscal rules due to the COVID crisis, European policymakers are now considering whether to reinstate from 2023 the existing rules with only the most necessary adjustments, or whether to put in place a framework better suited to guide sustainable fiscal policies in the rapidly changing global environment (e.g. Martin et al. 2021).
The existing (if presently suspended) fiscal rules include the requirement of a simply defined nominal budget deficit below 3% of GDP. Following the previous crisis, this was supplemented with a focus on the structurally balanced budget within the constraint of reducing public debt above 60% of GDP by one-twentieth per year until it reaches 60%. While the focus on the structural budget balance was an analytical improvement, it has proven operationally problematic because of the uncertainties associated with the estimation of potential output and has simply varied too much over short periods of time to be a constructive guide for the annual fiscal policy processes. Meanwhile, the debt reduction requirement was softened because a strict application of the rule would have implied an excessively tight fiscal stance for high-debt countries.
At a minimum, the post-COVID higher public debt levels require a longer path down to below the level of 60% of GDP debt than the presently envisaged one. But what is the optimal fiscal path that will assure sustainable public finances while facilitating growth in the years ahead?
Globalisation and demographics have put downward pressure on wages and inflation, contributing to a lower natural real interest rate, with clear implications for both public and private debt – as well as for investors’ asset allocation. In addition, the urgent need to address climate change, to bring Europe properly into the digital age, to navigate what appears to be the end of post-1989 peace dividend, and so on surely call for different parameters and priorities than those that guided policymakers 30 years ago.
Blanchard et al. (2021) argue that the world will always be too uncertain for predetermined fiscal policy rules to be helpful. They recognise the usefulness of the safety valve in the form of the right to suspend the rules – an escape clause which is the central element in the argument (by mostly Northern Europe) that the existing rules are sufficiently flexible and should be reintroduced from 2023. But what good are rules which can, and will, be suspended when they become inconvenient? Therefore, rather than relying on ‘rules’, Blanchard et al. propose a set of fiscal ‘standards’ to guide fiscal policy, focused on the need to maintain debt sustainability (which may mean different things for different countries at different times).
Blanchard et al. are right when they point out that the uncertainties of the future require flexibility in policymaking. But the European political reality is such that ‘rules’ will have to remain the anchor of European cooperation.
In this column, I suggest a compromise anchored in the two most important economic criteria for public sector debt sustainability: first, ‘standards’ for the distribution between public investment and consumption within an overall objective of a declining debt ratio during ‘good years’ for the highest indebted member states; and second, a higher-frequency ‘rule’ to flag potential trends which might compromise future public debt sustainability early on. The best such rule is a cap on projected interest payments as a share of fiscal revenue.
The ‘standards’ for a healthy budget composition should include an agreed minimum ratio of investment, including for climate change, and maybe for education and defence, relative to GDP. Policymakers should also agree a ‘rule’ that countries with public debt in excess of a certain level of GDP (e.g. the existing, if randomly chosen, 60%, although 90–100% seems more appropriate) will reduce that ratio during ‘good years’. In this context, good years are defined as years when the level of GDP exceeds its estimated potential, i.e. a positive output gap.
In addition to this trend objective for debt levels, a higher-frequency measure of developments in debt sustainability, properly defined, should be added to leave zero room for doubt about European public debt. The proposed measure reflects the fact that default on public debt is always the result of a political decision. The very role of a government is to prioritise competing demands on its resources, and to decide the level of those resources via taxation and the potential disposal of public assets. Ultimately, therefore, public debt sustainability is a function of the share of available resources needed to service the debt, within the government’s willingness to tax society.
With this in mind, the single most important gauge of debt sustainability is the ratio of interest obligations to public revenue. With an average maturity of public debt in Europe of roughly seven years, the interest/revenue ratio is the most relevant concept available without the uncertainties of forecasting. Even a sudden and sizable increase in interest rates would only begin to gradually burden the budget after some years.
In the US, Furman and Summers (2020) have suggested the closely related concept of interest obligations over GDP as a key ratio to watch. The idea is that GDP provides the basis for additional taxation, should that be necessary. Yet, history tells us that during economic downturns (when GDP typically drops further than fiscal revenue), the appropriateness – and political willingness – to raise taxes is far from straightforward. Hence, revenue resembles the ‘one bird in the hand’, while GDP resembles the ‘ten birds in the bush’.
Prior to the COVID crisis, public sector interest payments as a share of fiscal revenue in the EU stood at about 3.5%. The share was 1.5–2.0% in several Northern European countries, including Germany, 3.0–3.5% in France and about 8% in, for example, Italy and Portugal. (It was 6% in the UK). During the three years prior to the Greek debt restructuring in 2012, the Greek government paid 15% of its revenue in interest payments; the restructuring helped lower that ratio to roughly 6% last year. (Greece typically paid 20–30% of its revenue in interest on debt during the late 1990s before adopting the euro; unfortunately, the windfall was not put to good use.)
The ratio is a simple function of the interest rate levels during the past roughly seven years (the typical average length of European public debt maturities), the debt stock, and fiscal revenues. The interest rate charged on public borrowing by investors is a function of ECB policies, markets’ (and credit rating agencies’) assessment of fiscal sustainability in the individual countries, as well as the availability of alternative investment opportunities. Fiscal revenue is a function of GDP and taxation levels, of course.
Given the higher debt levels and on the assumption that it will take some time for European GDP to catch up with its pre-pandemic trend, the ratio is likely to increase from the pre-COVID levels by up to 1.0 percentage points in most countries during the next year or two, depending on developments with the pandemic and the abilities of the economies to rebound.
More structurally, with interest rates presently compressed to the zero lower bound by ECB policies, it is reasonable to expect – indeed, to hope for – a future of higher interest rates. This implies that the public sector interest-to-revenue ratio will increase to the extent that interest rates charged by markets rise at a faster clip than nominal fiscal revenues. Whether this will happen or not will depend on the answer to a series of questions mostly around the quality of fiscal policy; hence the need for the ‘standards’ for sustainable fiscal policies, as discussed above.
But one thing is clear: given the relatively long average maturities for public debt, the process of driving the critical interest/revenue ratio in one direction or the other will be a gradual one. It is therefore appropriate to assess it on a rolling two-to-three year basis.
What level of interest obligations to revenue should be considered problematic is a matter of judgement. Given the recent history of fiscal crisis in Europe, a repeated projection over a 12–18 month period of an interest/revenue ratio above 10% could be a reasonable yardstick for a ‘yellow warning light’, which should trigger more comprehensive discussions about the need for policy adjustments, with more concrete demands for corrective policy measures kicking in at a projected ratio of 12–13%. Such a policy would also help incentivise governments to further lengthen the maturity structure of their debt to lock in the presently low interest rates.
These rules could be implemented without any changes to the European treaties (though the so-called Fiscal Compact, an intergovernmental treaty, as well EU secondary law – the regulations and directives that currently make up the Stability and Growth Pact – would need to be amended). The 3% of GDP deficit and 60% of GDP debt reference values could remain, so long as the prescribed adjustment to the 60% is not mechanical, as is the case today, but governed by the proposed new debt criterion. The criteria to reduce excessive debt levels and restrict interest payments as a share of incoming resources, as well as the use of ‘standards’ with regard to the composition of public spending are all consistent with the present treaty because it allows the Commission to “take into account whether the government deficit exceeds government investment expenditure and take into account all other relevant factors” (TFEU Article 126(3)) when deciding whether deficits are excessive or not.
As today, the issue of enforcement is important. While fiscal policy is ultimately the domain of the national parliaments, so too is the commitment to the EU’s fiscal resources. It seems reasonable, therefore, for the EU to begin withholding financial transfers to a member state which breaches fiscal standards and rules, after appropriate warnings.
Blanchard, O, A Leandro and J Zettelmeyer (2021), “Redesigning EU fiscal rules: From rules to standards”, PIIE Working Paper 21-1.
Furman, J and L Summers (2020), “A Reconsideration of Fiscal Policy in the Era of Low Interest Rates”.
Martin, P, J Pisani-Ferry and X Ragot (2021), “A new template for the European fiscal framework”, VoxEU.org, 26 May.