fiscal rules vs. fiscal councils

7/31/2019 Fiscal Rules vs. Fiscal Councils

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Introduction

With an emphasis on its macroeconomic, non-distributive component, this paper will discuss the

development of a coordinated fiscal policy in the European Union. Following an explanation of

the costs and benefits of fiscal rules and councils in realising this coordination, an argument will

be made in favour of the establishment of hard fiscal policy councils with a normative mandate

as the most effective means by which member states can ensure a sustainable debt level and

guard against pro-cyclical government spending and political short sightedness.

The Problem

In a monetary union, fiscal policy becomes particularly important, as member states do not have

the power to alter interest rates to counter-act shocks thus rely solely on an effective fiscal policy

in times of turbulence (Lane 2010). When undertaking a discussion of the management of fiscalpolicy by means of rules or councils, it is imperative that we distinguish betw een the micro and

macroeconomic components of fiscal policy. Microeconomic fiscal policy is concerned with

income redistribution. It sets a tax level capable of providing an adequate level of public goods

and services and equitably disseminating wealth across its population. Thus, it has a hugely

tangible effect on peoples standard of living, and must be the responsibility of democratically

elected officials (Wypolz 2008) .

In contrast, macroeconomic fiscal policy is exclusively concerned with achieving a sustainable

level of debt, and thus has no distributive effect (Wypolz 2008). Furthermore, the debt level is

susceptible to mismanagement if left in the subjective hands of politicians with invested interests

in a competitive democracy. The common pool problem has been observed widely, where

interest groups vie for a disproportionate level of spending which undermines the collective

welfare. Also common are time inconsistencies, whereby politicians will accumulate excess debt

in an attempt to win a populous vote or to hinder their predecessors as they near the end of their

reigns (Wypolz 2008). The optimal strategy is a counter-cyclical one, whereby governments run

surpluses in times of prosperity in order to absorb negative shocks during a downturn, thereby

ensuring the ability to undertake a stable and consistent microeconomic fiscal policy. However,

to expect such long sightedness of politicians who dont know how long they will remain in

power is ambitious, if not naive. Therefore, intervention is justified (Hagemann 2010).


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The European Solution: Fiscal RulesUntil the formation of the European Monetary Union, the EUs involvement in Fiscal Policy was

limited to issues of taxation involved with the establishment of the single market, namely the

elimination of customs duties in the union (Croitoru 2010). More relevant to this paper is the

criteria outlined in 1993s Maastricht Treaty which stated, with some ambivalence, that aside

from exceptional and temporary circumstances, the ratio of the annual government debt to gross

domestic product must not exceed 3% at the end of each fiscal year. Also, the ratio of gross

government debt to GDP must not exceed 60%, unless a country began with very high debt ratio.

In this case, the country must have reduced its debt significantly and be approaching the desired

60% ((European Parliament 2011).

The European Stability and Growth Pact was introduced in 1997 as the manifestation of the

Maastricht criteria in a rules based framework in preparation for the adoption of the single

currency by the EMU. The SGP was ushered in amidst German fears that the ECBs new

mandate to control inflation would be undermined by countries such as Italy and Greece running

large deficits and cutting taxation. However, enforcement of the pact proved impossible.

Germany and France repeatedly slipped above the 3% target without sanction and the pact came

under heavy criticism for its lack of flexibility (What is the SGP? 2003).

A decision was made in 2005 to reform the system, as policy makers sought to incorporate a getout clause that would allow for fiscal policy to be used as a counter-cyclical instrument when

necessary. The 3% target for budget deficit and 60% for debt were maintained, but several

variables were now to be considered before sanctioning, such as the level of debt, the duration of

the economic downturn and the long term effect of the incurred debt ie. will the long term gains

of the investment negate the current expenditure. In its current form, the Stability and Growth

Pact first employs a preventive arm which offers early warning and policy advice for member

states threatening to breach the ceilings. If noncompliance persists, 2011s reform see the

excessive deficit procedure being enacted, whereby recommendations for correction in a

prescribed time frame are issued, followed by monetary sanctioning on failure to comply

(European Commission 2011)


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The adoption of fiscal rules across the EMU could be misconstrued as the simplest means of

coordinating national fiscal policies. In practice, this is not true. Rising debt accumulation must

be restricted and allowed simultaneously. Restricted, to ensure sound public finances and assist

the ECB in meeting inflation targets. Allowed, when it proves justified, such as to avoid pro-

cyclicality and to finance productive public investment. For the rules to be effective, they must

be binding, and carry heavy enough sanctions to ensure compliance. They must also contain

detailed and precise descriptions of any contingencies allowed. Evidently, such rules are rife

with contradiction, and designing them so that these contingencies do not become undermining

loopholes is near impossible. Also, there exists a large scope for creative accounting in

submitting data to a numerical framework such as the SGP (Wypolz 2008).

The Alternative: Fiscal Policy CouncilsThe quagmire that arises as the result of the inherent contradictions in using fiscal rules to shape

fiscal policy is not seen in monetary policy. That is because monetary policy is the responsibility

of the institution that is the European Central Bank, and not that of a framework of complex and

contradictory inflexible numerical rules (Lane 2009). The ECB, like all effective institutions,

embodies a set of distinctive characteristics that underpin its efficiency. It has a precise mandate,

to maintain price stability at an inflation rate of 2%. The decisions it makes are not a rule, but

require some amount of judgement by decision makers who are experts in the field. The ECB has

full independence, but remains accountable to European governance. Thus far, the results

achieved by the ECB have been admirable (Wypolz 2008).

In light of this success, a growing body of literature has advocated the establishment of a similar

network of Fiscal Policy Councils to achieve the mandate of debt sustainability. The de-railing of

fiscal policy from its optimal strategy for political gains can be stopped by the advocating of

macroeconomic fiscal policy to an independent fiscal policy council of experts. By reporting all

findings both to government and the public, FPCs increase the transparency of fiscal policies

and become credible and trusted institutions (Hagemann 2010). However, the existence of these

institutions alone is not enough; there must be a strong level of political will alongside this.

Nevertheless, fiscal councils are not without complications, and one of the principle concerns

when conceptualising a FPC is how much autonomy such an institution should possess (Wypolz

2008).


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Although not yet widespread, several versions of fiscal policy councils exist. Throughout the

literature, several classifications of these councils exist. Among the most useful of these is

Wypolz (2008) classification of these institutions along the lines of soft and hard. Soft FCPs

play an advisory role for government. Their effectiveness relies entirely on public debate as they

are just one of many pressure groups, and the strength of their pro-fiscal discipline stance can

rely on the councils credibility which may take some time to accrue. Such institutions, in many

variations, exist in Denmark, Belgium, Chile, Sweden and the Netherlands.

Hard FPCs, on the other hand, follow the central bank model discussed earlier. This institution

sets the budget balance, without commenting on the size of the budget. The councils decision in

this regard is binding the government and parliament. The FPC must deliver the target level of

debt that the government has prescribed, away from which the government cannot deviate. A get

out clause is incorporated into the legislation, to allow for large, unforeseen shocks. No such

institution currently exists (Wypolz 2008).

Despite the sound economic case for the implementation of these councils, and their proven

effectiveness, resistance persists. This resistance however, is largely based on misunderstandings

of the effect on citizens democratic rights and the difficulty of implementation in establishing

these councils. Budgets should be made exclusively by democratically elected officials.

However, FPCs will only deal with the macroeconomic issues of fiscal policy, controlling the

debt level, thus will not directly affect any distributive element of the budget (Wypolz 2008).

Total de-politicisation is never advisable, as accountability is imposed in a democracy by our

ability to vote for our decision makers. This is not being advocated in establishing independent

councils. Far from undermining our democratic rights, it can be argued that FPCs are necessary

to protect future generations, who cannot yet participate in our democracy, from the debt bias

that would unfairly burden them in the future. Another concern is that government will set too

ambitious a target for the FPC, because they dont feel responsible for any potential failings ofthe council. However, the fiscal council must clearly communicate that despite their

independence, they work on behalf of the government, thus its failings are the governments

failings (Hagemann 2010).


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Of biggest concern is the issue of accountability. During its decision making process, the council

must be independent. In retrospect, the council must then become accountable. There is a large

risk that the process of evaluating the performance of the council could become politicised

(Wypolz 2008). Again, we must rely on a strong political commitment to maintaining a

sustainable debt level. Equally controversial is the issue of how to measure debt. Gross public

debt, the measurement used by the EU, ignores the value of public assets and implicit liabilities

and assets such as the commitment to provide pensions for an aging population. Incorporating

these into our measurements would establish the true net debt, but placing values on public assets

and the implicit balance is a hugely difficult task and causes much controversy. Because of this,

the EU chooses to measure gross public debt, insisting that any calculation of net public debt

would be inaccurate. However, it could be argued that an inaccurate measurement of net public

debt would be still more effective than using gross public debt as the measurement around which

fiscal policy is designed (Wypolz 2008).

Conclusion

It is clear that the two reforms to Europes rules based framework, the Stability and Growth pact,

have not been effectual in coordinating the fiscal policies of the EMU countries. The reality is

that practically all EMU countries are currently undergoing excessive debt procedures, which

demonstrates the rules inflexibility in times of crisis such as these (European Commission

2011). This years reform, which implements automatic sanctions, serves only to increase the

rigidity of the framework. The argument for the delegation of the macroeconomic aspect of fiscal

policy to a network of fiscal policy councils has been clearly demonstrated, and widely accepted

amongst academics (Coene 2010; Lebrun 2006). FPCs offer an unparalleled transparency and

eliminate all but a fraction of the scope for political bias. Therefore, it can only be assumed that

the reasons for the non-adoption of fiscal councils and the persistence with sub-optimal fiscal

rules lie with the politicians responsible for implementing the necessary structural change. This

is understandable, if somewhat frustrating, as the adoption of the optimal strategy would bindgovernments in forcing them to adapt a debt target and uphold the necessary policies as outlined

by the FPCs to achieve this (Wypolz 2008). However, a post-crisis era offers a platform for

change, and some governments have moved towards the adoption of a soft version of a FPC.

With the success of these councils, and a continued appetite for fiscal discipline, we may see a

move towards the desired hard version of the FPC by some forward thinking governments.


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