Reforming the Fiscal Rules: A radical shift or short shrift?

The EU Commission has relaunched its review of the eurozone’s fiscal rules. Announced with something of a whisper, expect a lot of raised voices in the coming months. Sinn Féin Spokesperson for Public Expenditure and Reform, Mairéad Farrell TD, writes.

Thankfully, the fiscal rules of the European Monetary Union were suspended at Covid’s onset and will not return until 2023.

For the uninitiated, the rules place limitations on members’ debt/deficit levels. As such they have a significant impact on economic performance. Two of the principal requirements are firstly, budget deficits below 3 per cent of GDP and secondly, debt to GDP ratios below 60 per cent.

Their suspension allowed states to undertake the necessary countercyclical spending needed to address the pandemic.

Nearly 30 years old, as long as the rules have been with us, so too have been calls for reform. It is speculated the Commission will propose their simplification, greater incentives for productive investment, and changes to debt-to-GDP ratios.

Submissions from members states are being sought and it is essential we have our say. As the IMF pointed out, we are facing a future of considerable uncertainty. Uncertainty for our low corporate tax model, corporate tax revenues, and environmental performance.

Going forward, when it comes to economic growth, if we are to achieve growth that is sustainable, inclusive, and leads to shared prosperity, we will increasingly have to ‘grow our own’.

This requires an entrepreneurial state with visionary/strategic public investments distributed across the innovation chain, which create synergy between the state and private sector, and positive spill overs raising the animal spirits of entrepreneurs.

However, the rules as currently constituted will act as a barrier to that, straitjacketing not only our national efforts to achieve a Just Transition/Green New Deal, but wider European efforts.

Below, I make case for reform, outline what kind of reformation is required and why our government needs to become actively involved in the reform process.

The fiscal rules

First, let us understand the concept of fiscal rules. They are self-imposed constraints governments place on fiscal policy, by establishing numerical limits/references for public finance aggregates (think budget balance, expenditures, public debt). The purpose being to marry short-term stabilisation of economic policy with the longer-term sustainability of public finances.

First gaining popularity in the 1980s, countries shifted macroeconomic policy from the post-war Keynesianism toward the monetarism of Milton Friedman, which found disciples in Thatcher/Reagan. According to economist Bill Mitchell, “the rationale of controlling government debt and budget deficits were consistent with the rising neo-liberal orthodoxy”.

Under this framework independent monetary policy was responsible for delivering price stability, with fiscal policy to be more limited. New Zealand was a first mover passing its Public Finance Act (1989), the same year that Jacques Delors published the Report on Economic and Monetary Union in the European Community.

Interestingly New Zealand was again a first mover, recently reforming its rules on the basis that “arbitrary debt and spending targets are not appropriate and have limited the Government’s scope for change”.

Between 1990 and 2015, countries with national/supranational rules jumped from five to 96. It is worth pointing out that two of the main eurozone requirements; budget deficits below 3 per cent and a debt ratio below 60 per cent, were selected arbitrarily, were not grounded by any serious empirical research, and lacked any solid theoretical foundation.

“If we are to achieve growth that is sustainable, inclusive and leads to shared prosperity, we will increasingly have to ‘grow our own’.”

What I mean here is there was nothing to demonstrate that 3 per cent deficits were more sustainable than 4 per cent. It depends on the circumstances which they arise and how the spending is deployed. The 3 per cent rule implies deficits above this size are problematic, but sometimes deficits in excess of 3 per cent are part of the solution, like when the economy is in the midst of a pandemic.

They were also justified on the basis that they would help to prevent debt externalities, a situation where one nation’s debt troubles (default risk) could have spillover effects for its neighbours. But they came into existence at a time of historically high interest rates, which have been in secular decline ever since. This new world of low and negative rates lowers default risk.

However, it presents a new problem. With monetary policy having lost its stimulatory ability, we are left with a new externality – a demand externality. This can only be addressed fiscally.

Rules made to be broken

Rules built around debt/deficit ceilings will not necessarily be a good proxy for debt sustainability. Sustainability does not just depend on present debt/deficits, but on future things like interest rates, primary balances, and growth. The future is radically uncertain, and whilst we expect interest rates to remain low, debt serviceable and favourable towards investment, the fact is we don’t know what the future holds.

Regarding the primary balance a country can achieve, multiple factors are at play: its tax base, the composition of its government, the business cycle, demographics. This does not mean we should try to add more provisions, because the sheer amount of different possible contingencies renders this too difficult.

The Commission has made various attempts to tweak the rules since their establishment, but it is merely served to add increasing layers of complexity and opacity. One former IMF chief economist compared their evolution to the Cathedral of Seville, a byzantine like structure integrating successively complicated layers.

Moreover, compliance has been poor. One study found that “the share of countries with a debt ratio greater than 60 percent increased from 35 percent in 1999 to 75 per cent in 2015”. Given the large level of additional pandemic spending, they will need to be modified otherwise there will be an automatic return to austerity.

Thankfully, the Commission gets this and comments by certain top Eurocrats indicate an upward revision of debt levels is on the cards. For example, Klaus Regling the head of the European Stability Mechanism, said that countries can “comfortably live with” higher debt. But is this enough?

Towards a reformation

Since introduced there have been calls for them to be rejigged or outright rejected. Precluding abolitionist calls, reformist proposals included exempting public investment, cyclically adjusting the 3 per cent ceiling, shifting from a deficit ceiling to a public debt ceiling, etc.

For now, let us recognise their procyclicality. In other words, they do the opposite of what is intended. Prior to 2008, this meant member states did not push to reduce debt, but after the onset of the financial crisis, they rushed to cut debt/spending when they should have done the opposite.

Fiscal rules should be countercyclical, and yet despite the various amendments made over the years, the outcomes have been mainly procyclical. That is why the Commission acted so swiftly to have them suspended.

Any reforms must account for the environmental crisis. We should aim to introduce some form of ‘golden rule’ which revised the current investment clause. This revision could create the kind of flexibility that would exempt ‘green’ public investment from debt/deficit considerations.

Currently there’s an investment clause which provides scope for exempting investment that has “positive, direct and verifiable long-term effects on growth and on the sustainability of public finances”, but restrictive conditionality means only two EU countries (Italy and Finland) ever qualified.

Naturally, some would argue this would be abused, but checks and balances could be used. The maximum amount of green investment states could exempt could be limited to the size of their ‘green investment gap’. This could be funded through ‘green bonds’ the size of which is determined by this gap and reviewed annually.

Conclusion

Once negotiations begin, dividing lines between northern (surplus) and southern (deficit) countries will emerge. The former favouring a stricter fiscal stance, the latter a more growth orientated approach. Irish governments often sought to associate themselves with the former.

However, the coming international tax changes will see our GDP fall in the future, meaning our interests will lie with southern countries. Our overinflated GDP previously made this debt/GDP ratio manageable. But if GDP falls our debt rises as a proportion of it, hampering our ability to spend at a time when we need it to expand.

More importantly, minor reforms will not help us combat an existential climate crisis. We have a narrow window of opportunity to implement a paradigm shift, but in order to influence the debate the Irish Government needs to get on the pitch.

Unfortunately, they are not even at the grounds yet, they have not togged out and they are seemingly unaware that the match just kicked off. Come on lads, it’s all to play for.