The EU Should Ditch Its Fiscal Rules and Try This
The EU Should Ditch Its Fiscal Rules and Try This
If you thought the European Union’s bickering about fiscal policy was bad in recent decades, get ready for an epic squabble once this pandemic is over.
Owing to the coronavirus, the EU’s rules on debts and deficits have been suspended and most member states have vastly overshot their normal limits. But at some point next year we’ll have to talk about how fast to apply the rules again. Given the extraordinary macroeconomic situation, it’ll be tempting to tweak them — for the umpteenth time.
There’s a better way: Don’t change the rules, get rid of them. Let’s replace them with something that allows for sound economic judgment. Instead of rules, let’s have standards.
That’s the thesis of a new working paper by the Peterson Institute for International Economics in Washington. Once you grasp its elegant reasoning, you might even join me in recommending that we ditch rules for standards in other areas of life too.
Here’s an example of a rule: “Don’t drive faster than 55 mph.” And here’s a standard: “Don’t drive at excessive speed.” As the authors — Olivier Blanchard, Alvaro Leandro, and Jeromin Zettelmeyer — explain, the difference is that in the first case the legal norm is defined before the event (“ex ante”), in the second after the event (“ex post”).
In this example the rule might seem nice and clear, and thus superior. And yet, I’ve only ever been pulled over for speeding on empty highways and sunny days, when my (slight) transgression wasn’t dangerous to anybody. Meanwhile, plenty of people drive at the official limit even in tricky traffic or weather circumstances, when the legal speed is excessive.
Should we account for these complications in the rule? But then it wouldn’t be simple anymore. Moreover, we can’t factor all contingencies into our assumptions.
The standard, by contrast, keeps our focus on the goal: preventing accidents and saving lives. It demands responsibility and sound judgment, without claiming to foresee every situation. And it can still be the basis for adjudication after a crash.
Now switch to European fiscal policy, which remains almost entirely the remit of national governments. Long ago, the EU adopted a good standard into its treaties: “Member States shall avoid excessive government deficits.” But during the 1990s, in the run-up to currency union, some member states wanted more clarity. Their leader was Germany, which has a reputation of obsessing about rules and frowning at spendthrift budgeting. Thus, in 1997, the Stability and Growth Pact was born.
At its outset the rules were simple enough. Member states may not run budget deficits in excess of 3% of GDP, and their public debt may not top 60%. Exactly where these figures came from, nobody could explain convincingly. But like a speed limit they seemed clear.
As with many rules, however, the pact was flouted almost at once, as it crashed into economic realities. Sometimes it was too stringent, other times not tough enough. Worse, it became clear that errant member states only got in trouble if they were small and politically weak. When France and Germany ignored the rules in 2003, they got away scot-free. This earned Germany a reputation for hypocrisy it’s never lived down. It also undermined the pact’s credibility.
The EU reacted as most rule setters do. It kept making the pact more complicated, in a vain attempt to make it flexible enough for more contingencies. The nomenclature of the tweaks reads like a parody of Brussels technocracy: A “Six Pack” was followed by a “Fiscal Compact” and a “Two Pack.”
As Blanchard, Leandro and Zettelmeyer cheekily point out, the pact gradually resembled the floor plan of the Cathedral of Seville, the largest Gothic edifice in the world, famous for its many additions. If you squint, you might still espy the original idea; but you’d probably get lost finding your way around inside.
Hence the case for returning to a standard. Other countries have done this with great success. New Zealand’s fiscal policy is to “maintain prudent public debt levels” that weigh the impact on “present and future generations.” Its debt-to-GDP ratio is lower than that of Germany, which has a rigid and complicated “debt-brake” law in addition to the EU rules.
Whether the subject is highway speeds or debt, the difficulty is deciding what’s “excessive” or “prudent.” But that’s even more true if you’re making precise rules for some hypothetical future that you can’t foresee.
The Stability and Growth Pact, for example, was written at a time when economists and politicians assumed the rate of interest would self-evidently exceed the rate of economic growth. That leads to projections in which debt quickly becomes “unsustainable.”
In recent years, however, growth rates have tended to be higher than interest rates, and this is likely to recur in coming years. That changes all assumptions about how countries could pay off their debts over time.
The EU should therefore move toward a system where member states make a qualitative case to Brussels that their fiscal policy is sustainable and prudent. The European Commission, with help from a beefed-up European Fiscal Board, can then disagree if it wants, sending national governments back to their parliaments for new budgets. Disputes would be heard by the European Court of Justice.
Nobody’s suggesting we should get rid of all rules. But it’s time to acknowledge that the world is complex and that we can’t regulate everything in advance. Instead we need to cultivate judgment and responsibility, and to simplify what’s gotten knotty. That’s not a rule, of course, more of a standard.