Daniele Franco

Assessing Fiscal Sustainability: A Review of Methods with a View to EMU

Balassone and Franco review the literature on fiscal sustainability in order to examine the comparative advantages and disadvantages of different methodologies and indicators and to highlight the areas in which more research effort is still needed. They contrast the intuitive character of the concept of sustainability with the analytical and operational difficulties met with when trying to arrive at a rigorous definition. On the one hand, the literature has not produced a unique definition of sustainability; furthermore, the problem has only been dealt with in a partial equilibrium framework. On the other hand, the statistical definition of the main variables to be used for the assessment of sustainability is not uncontroversial; moreover, as the assessment is based on long-term projections, it is necessarily subject to wide margins of error.Balassone and Franco also point out that, theoretical issues notwithstanding, the Treaty of Maastricht and the Stability and Growth Pact set fiscal rules which, if complied with, ensure sustainability according to any definition adopted. Techniques developed for the analysis of sustainability can therefore be used for the assessment of prospective compliance with such rules, a crucial task for both policy evaluation and timely corrective intervention. In re-examining the pros and cons of available indicators, their paper categorises the studies on the assessment of sustainability into two main strands: those testing for the sustainability of past policies and those assessing prospective fiscal stances. Among the latter a distinction is drawn between works based on standard national accounting concepts and generational accounting exercises. The paper concludes by stressing the need for further efforts to guide budgetary policy more effectively.

Market-Induced Fiscal Discipline: Is There a Fall-Back Solution for Rule Failure?

Fiscal discipline is a public good in federations. As with all public goods, there is a free-riding risk. Hence the need for discipline-inducing mechanisms. EU countries decided to adopt a rule-based framework, which is currently heavily criticised and which may come under further pressure with the enlargement of the EU. The paper reconsider the debate which took place before the approval of the Maastricht Treaty and asks whether market mechanisms can be relied upon as a fall-back solution in case of rule-failure. The issue is tackled in three steps. First, the conditions for an effective market solution are examined and the European institutional framework is assessed against them. Second, the relationship between fiscal performance, credit rating and interest rates is discussed, with reference to both what is expected in theory and what is found in practice. Finally, governments’ sensitivity to market signals is analysed. The findings point to a significant, though small, reaction of interest rates to fiscal imbalances, and to a not so prompt response by governments. The conclusion is thus that market mechanisms cannot be relied upon for replacing fiscal rules. However, greater transparency in fiscal accounts can allow markets to usefully complements rules.

Pension Expenditure Projections, Pension Liabilities and European Union Fiscal Rules

In the current debate on the European Union (EU) fiscal rules there is a widespread consensus on the need to place more focus on government debt and long-term fiscal sustainability in the surveillance of budgetary positions. More specifically, pension developments should be taken into account in assessing fiscal sustainability. The way to make this operational has not yet been defined. The paper examines the pension expenditure projections available in EU countries and their use in the assessment of fiscal sustainability. While acknowledging the progress in the availability and quality of projections, the paper notes that their comparability is still unsatisfactory. Any mechanical use of existing pension expenditure projections should therefore be avoided. The paper also examines the different definitions of pension liabilities and their potential role in the EU fiscal framework. It argues that pension liabilities may bring a clearer understanding of the impact of fiscal policies, may provide a measure of the cost of terminating pay-as-you-go pension schemes and may be useful for the measurement of deficits computed on accrual basis. However, the level of pension liabilities does not provide indications concerning the sustainability of pension schemes and their effects on public budgets. Pension liabilities should not be added to conventional debt. The paper argues that both pension expenditure projections and estimates of pension liabilities can complement the deficit and debt indicators currently used in the EU fiscal rules. The paper concludes by pointing to the need of improving some technical and organisational aspects concerning age-related expenditure projections, such as the independence of forecasters, the transparency of projections and the homogeneity of methods.

EMU Fiscal Rules: A New Answer to an Old Question?

EMU fiscal rules aim at ensuring sound fiscal policies in EU Member States while allowing sufficient margins for stabilisation policy. The Treaty of Maastricht and the Stability and Growth Pact introduced a detailed framework of rules, surveillance procedures and sanctions that are tighter than those generally applying in federal countries. In this paper we try to assess to what extent the issue facing the founders of EMU was a new one in the field of public finance and to what extent the solution chosen can be regarded as innovative. To this end, we review the literature on budgetary rules from its very beginning to the years immediately before the Treaty of Maastricht. We consider the arguments brought forward to justify EMU fiscal rules and the novel feature of the problem faced at the EU level, represented by the interaction between its multinational nature and the lack of a political authority of federal rank. The solutions chosen, while drawing heavily on ideas that were central in the debate on fiscal rules, reflect this new aspect of the problem. The highly decentralised setting of fiscal policy in EMU gave prominence to moral hazard issues; it is probably at the roots of the rejection of both the dual budget approach and the distinction between ordinary and extraordinary finance; it motivated the adoption of a detailed multilateral surveillance procedure and the introduction of a predetermined limit for the annual deficit in a framework that envisages the targeting of a balanced budget over the cycle.

Fiscal Federalism and the Stability and Growth Pact: A Difficult Union

Balassone and Franco note that while the budget rules that frame EMU apply to national States, several EMU member nations are already organised on a federal basis and others, pressed by political and economic needs, have started to enact reforms aimed at increasing the degree of decentralisation. They highlight several critical areas in the interaction of fiscal decentralisation and the Stability and Growth Pact. Balassone and Franco point to the reduced flexibility of the European approach compared with solutions adopted in federally structured countries and to the asymmetry between the responsibilities laid on national and local governments by European rules (compliance with the rules depends on the conduct of all levels of government, but de facto it is the central government that is answerable to the EU and that must pay the price for non-compliance). This calls for strict controls over local governments to prevent free-riding. The authors examine alternative solutions to deal with these problems, such as the mechanical extension of the Stability and Growth Pact, the introduction of a golden rule for decentralised governments, also in the form of a market for deficit permits, and the use of reserve funds. Finally, Balassone and Franco analyse how the issue has been addressed in Italy through the introduction of the Domestic Stability Pact and stress the need for further significant refinements of these domestic rules.

The SGP and the ‘Golden Rule’

The slowdown in growth in 1998 and its possible implications for the level of unemployment raised worries and doubts concerning the fiscal rules set in the Treaty of Maastricht and in the Stability and Growth Pact. It has been argued that these rules may represent an excessively binding constraint for appropriate counter-cyclical action and that the attempt to reach rapidly a budget position ‘close to balance or in surplus’ may worsen the slowdown. The risk that the rules may permanently reduce the public sector’s contribution to capital accumulation has also been pointed out.

Italy: Fiscal Consolidation and its Legacy

Balassone, Franco, Momigliano and Monacelli examine the process of fiscal consolidation in Italy during the Nineties. They highlight its success in reversing a trend that could have led to public debt default, and in ensuring the early participation of Italy to monetary union. The authors argue that some features of the process may have amplified its costs and may have left the country with a difficult legacy. The adjustment relied on significant tax increases, capital spending reductions and the rationing of transfers to local governments. Balassone et al. examine the reforms introduced in the pension system in order to contain expenditure growth, reducing distortions in the labour market and increasing the role of funding. They acknowledge that much has been achieved but point to some aspects that still remain problematic. They also analyse the changes introduced in the tax system and highlight the persistent contrast between the need to maximise revenue and that of minimising distortions. According to the authors, there is now a need to shift the focus of fiscal policy from the arithmetic to the microeconomics of fiscal sustainability. Sustaining high taxes and low investment may become difficult as the integration of the Single European Market goes further. Allowing for a lower tax burden, while complying with EMU fiscal rules, calls for expenditure control, a task made more difficult by the upward pressure on outlays exerted by the ageing process. Balassone et al. note that the current trend towards greater autonomy for local governments may require significant institutional engineering to ensure consistency with EMU fiscal rules. More generally, existing budgetary procedures and institutions will have to be reconsidered. Finally, with EMU macroeconomic stabilisation regains importance, while during the Nineties it was not the main focus of fiscal policy. Budgetary targets should allow sufficient room for manoeuvre. Size and quality of automatic stabilisers will have to be reconsidered.

Rainy Day Funds: Can They Make a Difference in Europe?

Rainy Day Funds (RDFs) have an important role in the USA. They allow States i?½ which usually have rules requiring a balanced budget for current revenue and spending i?½ to limit procyclical fiscal policies. This paper examines the possible role of RDFs in the European fiscal framework. The analysis suggests that RDFs would not fundamentally alter the incentive problems at the root of the difficulties in the implementation of the Stability and Growth Pact. Moreover, RDFs are not an option for countries with high deficits. However, for low-deficit countries, RDFs can lessen the rigidity of the 3 per cent threshold in bad times. RDFs could be introduced on a voluntary basis at the national level and could contribute to make the rules more country-specific. The introduction of RDFs would require a change in the definition of the i?½Maastricht deficiti?½: deposits and withdrawals should be considered respectively as budget expense and revenue. In this way, the balances held in RDFs could be spent in bad times without an increase in the deficit. To ensure that RDFs are not used opportunistically, deposits should only be made out of budget surpluses and circumstances allowing withdrawals should be specified ex ante.

Public Debt: A Survey of Policy Issues

The role, the limits and the effects of public debt have long been at the core of the fiscal policy debate. Public debt affects the allocation and distribution of resources and the stabilisation function of government. It reflects decisions taken by previous generations and it constrains those of future generations. History has seen numerous episodes of debt accumulation driven by different economic and political factors. Debt decumulation via consolidation, inflation or default has frequently proved economically problematic and has produced significant political consequences.The debate on public debt has involved economist, philosophers and policy makers, and has highlighted many, sometimes radically different, views. Ricardo refers to the debt as “… one of the most terrible scourges which was ever invented to afflict a nation”, as “… a system which tends to make us less thrifty, to blind us to our real situation”. He feared that the citizen initially “deludes himself with the belief, that he is as rich as before” and then, faced with the taxes levied to pay for the debt, is tempted “… to remove himself and his capital to another country, where he will be exempted from such burthens”. Smith argued that government borrowing would deprive society of resources which could be invested more productively. He also noted that beyond a certain threshold debt inevitably leads to national bankruptcy.However, classical economists were also well aware of the necessity of allowing borrowing in certain circumstances and of its usefulness in others. Building on such awareness, gradually the idea gained consensus that the public debt need not be repaid as it can be refunded and that “the problem of the debt burden is a problem of an expanding national income. How can a rapidly rising income be achieved?” (Domar, 1944, p. 166).This paper aims at providing a concise overview of the main issues surfacing the debate over public debt. In Section 1 we review the main economic factors explaining the existence of debt from three perspectives: public finance, monetary policy and political economy. Section 2 takes a positive point of view and is dedicated to the definition of debt sustainability and to the analytical tools available to undertake its assessment. Section 3 discusses the implications of high debt levels for the macroeconomic performance of the economy. Section 4 turns normative and considers market and rule-based mechanisms to control debt growth. Section 5 and 6 are devoted to more technical aspects concerning both analysis and policy: the former examines the issues arising when measuring public liabilities, the latter considers how fiscal rules and indicators can affect government debt management.

Fiscal Rules for Subnational Governments: Lessons from the EMU

The fiscal rules adopted in the context of Europe’s Economic and Monetary Union (EMU) have extensive implications for European Union (EU) governments at all levels. This chapter focuses on the impact of EMU fiscal rules on the relationship between national and subnational governments, with particular reference to five member countries.2