The Economics of Fiscal Rules and Debt Sustainability

Because they exert cross-border spillover effects, fiscal policies of individual EU member states are a common concern for the entire EU.

2 As is the case for the output gap and the structural balance, potential output growth is not directly observable either. Measurement error is smaller because by taking growth rates, measurement error in the assessment of the level of potential output largely washes out. Claeys et al. (2016) point to the smaller revision errors in medium-term potential growth estimates when compared to changes in the structural balance. However, Barnes and Casey (2019) demonstrate a positive pass-through from revisions in actual to revisions in potential output, which could lead to pro-cyclicality of a spending rule linked to potential output growth. 3 Long-term debt anchors in combination with an intermediate spend- ing ceiling have been proposed by others as well, for example Bénassy-Quéré et al. (2018) and Darvas et al. (2018). The ceiling would correct for discretionary revenue measures and cyclical spending (on unemployment benefi ts). This way the ceiling gives room to the automatic stabilisers on both the spending and revenue side. A ceiling based on nominal growth would allow additional room for stabilisation if demand shocks dominate: when demand is low, actual infl ation undershoots its forecast and spending is allowed to grow even faster relative to actual output. Because they exert cross-border spillover effects, fi scal policies of individual EU member states are a common concern for the entire EU. An expansionary fi scal stance in one country raises imports from other countries, thereby stimulating their economies (Beetsma et al., 2006;Alcidi et al., 2015). But it also pushes up the country's public debt and magnifi es solvency risk, which may spill over to other member states or force them to come to the fi nancial rescue. These spillovers provide the main rationale for the EU's Stability and Growth Pact (SGP), the most visible elements of which are the 3% of GDP reference value for the defi cit and the 60% reference value for the public debt. 1 The SGP strengthens the EU Treaty's "no-bailout" clause by which countries or EU institutions are forbidden to bail out a country in fi nancial diffi culty. The rationale behind the clause is that a credible no-bailout policy limits moral hazard on the side of governments. Knowing that no other party may come to the rescue, they will behave responsibly; otherwise, fi nancial markets will force them to do so. In effect, the SGP is the answer to the fear that markets cannot adequately fulfi l this role, creating a risk that the no-bailout clause will be tested, which is exactly what has happened.

The advice of the European Fiscal Board
In the year before the eruption of the coronavirus crisis, the European Fiscal Board (EFB, 2019) offered President Juncker of the European Commission advice. It concluded that high debt ratios had not been suffi ciently reduced, especially in periods when this was opportune; that national fi scal policies were too often procyclical; and that the fl exibility in the rules had not prevented governments from cutting back on public investment or, more broadly, growth-friendly

Modifying debt requirements
Sustainability should remain the main objective of the SGP. However, the reality is that the debt ratios of several countries are well above 100% of GDP and, hence, the current 60% ceiling remains unattainable for a long period to come. It seems politically impossible to ask countries to run a structural primary surplus of more than 3%-4% for a decade, as numerical analysis by the European Fiscal Board (2018) for some countries suggests is required for a situation more benign than the current one. 5 Regardless, these countries would remain well above 60% after 15 years. The coronavirus crisis has only worsened the debt reduction burden.
Calls for doing away with the current 60% debt reference value and allowing for much higher debt levels come as no surprise. These calls are motivated by the current low nominal interest rates and the expectation, in the fi nancial markets, that interest rates will remain low long into the future. Allowing for higher debt would reduce the pressure for harmful consolidation and enable governments to make the necessary investments in the energy transition and the digitalisation of their economies.
However, this is one side of the debate. There are sensible counterarguments. First, fi nancial markets tend to be shortsighted and may prove to be wrong in their assessment of future interest rates. Infl ation has gone up sharply recently. While this may not be the baseline scenario, there is a 5 Eichengreen and Panizza (2014) show that such long periods of fi scal restraint are historically unprecedented. Note that the analysis was done under specifi c macroeconomic assumptions, such as a gradual increase in the real interest rate and no feedback effect from the level of debt to the risk premium on the debt. Doing away with these assumptions speeds up the debt reduction considerably. due policy fl uctuations. Third, the EFB recommended introducing a single escape clause replacing all existing fl exibility provisions. This would do away with the current "complete contract" approach. And fi nally, it suggested demarcating policy decisions from economic analysis. The escape clause would be triggered by an independent analysis leading to independent advice that decision-makers at the political level would either follow or deviate from with a motivation.

The COVID-19 crisis has strengthened the case for reform
The coronavirus crisis has led to a jump in public debt ratios, as a result of the operation of the automatic stabilisers, largescale discretionary measures and a drop in GDP. Countries with the highest debt ratios before the COVID-19 pandemic recorded on average the largest increases -see Figure 1. The SGP's severe economic downturn (SED) clause (the "general escape clause" in popular terms) was activated to allow for additional fl exibility in the application of the pact. No excessive defi cit procedures were opened, even though they could have provided some guidance for fi scal policy.
The crisis has made a revision of the SGP even more urgent. Ideally, the time before the deactivation of the SED clause would be used to design a reform of the pact and get countries to agree on the reform, a position also taken by EU Independent Fiscal Institutions (2021). 4 However, due to the expectation that the SED clause will be lifted at the end of 2022 and the fact that countries will need to prepare their budgets for 2023 in the fall of 2022, this would be close to impossible, realistically speaking. Yet, following the Commission consultation, there might be time to produce a blueprint for a revision, which would orient the Commission on how it could apply the pact during the transition to a revised arrangement. This position is not shared by all stakeholders, however. In a recent position paper (Blümel et al., 2021), eight fi nance ministers indicate that a possible reform of the SGP should not be linked to the de-activation of the SED clause. Nevertheless, they write that they are open to a debate on improving economic and fi scal governance, including the Stability and Growth Pact. While sticking to a rules-based fi scal framework, improvements should be made. In particular, simplifi cations and adaptations that favour consistent, transparent and better application as well as enforcement of the rules are worth discussing, but only if new proposals do not jeopardise the fi scal sustainability of Member States, the Euro Area or the Union as a whole. (Blümel et al., 2021)

Forum
Additional measures and provisions should help to instil more credibility. First, the national independent fi scal institutions (IFIs) could be given a larger role in monitoring national debt developments (see Martin et al., 2021). Second, governments could be encouraged to demonstrate their commitment to a revised set of debt requirements by orienting their budgetary planning more towards the medium run. For example, the Netherlands has been quite successful in this respect by imposing spending ceilings on individual public sectors non-negligible chance that infl ation will remain elevated in the face of continued supply constraints, high demand and a shortage of labour that pushes wages up. Moreover, the current loose monetary policy conditions affect infl ation only with considerable lag, so they may cause more infl ation in the medium run than we foresee now. A worldwide increase in investment in the climate transition and digitalisation may shift the savings-investment balance, leading to a rise in long interest rates as well. Higher debt levels increase the sensitivity of government fi nances to rising interest rates. The speed of the pass-through obviously depends on the debt maturity time profi le. Second, new major crises may occur. 6 The three crises since the turn of the century were largely unforeseen. A new crisis in the coming decade is more than a theoretical possibility. Third, the costs of the energy transition and climate-related disasters may turn out to be far higher than anticipated. All these arguments speak in favour of a conservative approach to public debt.
Despite these arguments, the reality of the extremely high debt levels may force deviations from the previously agreed upon public debt in the SGP. Adherence to the one-twentieth rule may not immediately be problematic, as the pick-up of growth when coming out of the coronavirus crisis will exert a strong negative effect on debt ratios via the so-called "snowball effect". 7 However, the rule will likely be constraining further down the road. Box 1 describes some possible scenarios for allowing milder debt reduction trajectories of (very) high debt countries. However, an alleviation of debt reduction requirements begs the crucial question: If countries did not adhere to the required debt reduction in the past, how could we get them to adhere to a milder path now? On the one hand, it can be argued that imposing softer, but more realistic, requirements makes these more credible. On the other hand, a softening now raises expectations of new revisions in the future.
A relaxation of debt reduction requirements would need a revision of the SGP also in other dimensions to enhance the credibility of the debt reduction strategies. While we cannot expect perfect adherence to new reduction paths, an appropriate revision can encourage governments to improve their behaviour. Under the EFB proposals, the rules will be simplifi ed and less reliant on unobservable variables. Use of the escape clause will be better justifi ed on economic grounds. Hence, it will become harder to justify not undertaking the required surveillance actions when fi scal requirements are violated.

Box 1 Setting debt reduction requirement
Economic Forum the calculation of the defi cit. An alternative way of stimulating public investment (on climate transition) is to have dedicated national envelopes within the EU budget that countries could spend on public investment. In the case of a failure to use all the dedicated funds, the remainder would fl ow back into the common part of the EU budget. Blanchard et al. (2021) bemoan the growing complexity of the SGP and propose abolishing numerical fi scal rules and replacing them with "fi scal standards," which could be enforced by, for example, the European Court of Justice (ECJ). The appeal is to no longer be led by numerology that has little substantive support from economic theory and to focus enforcement on the need to maintain debt sustainability, which would be the relevant fi scal standard. While this approach seems attractive, it has a number of limitations. First, although the precise numbers in the SGP are not justifi ed on good economic grounds, they have nevertheless come to serve as a beacon for budgetary policy, thereby constraining governments in their profl igacy. The 3% defi cit ceiling is particularly useful in this regard (EFB, 2021). It is highly visible, and the position of the actual defi cit relative to this ceiling can be established quite unambiguously. Second, a member state's adherence to the standard will likely be determined ex post, although it is conceivable that a country may be brought before the ECJ based on its plans. However, a ruling takes time and therefore at the start of a new government over the entire cabinet period. Third, legal guarantees at the national level constraining indebtedness can be strengthened. Fourth, the credibility of the no-bailout clause could be improved, for example, by installing infrastructure for an orderly sovereign default and by gradually tightening concentration limits on bank balance sheets or introducing and gradually differentiating risk weights on sovereign debt on bank balance sheets. 8 Fifth, a debt reduction fund can be set up that matches public debt reduction with a contribution from the fund. Such support would only be maintained if a country does not lapse back into fi scal profl igacy. 9 While introducing any such measures will be politically sensitive, the desire to revise debt requirements when the SED is deactivated might create room for a grander bargain that includes one or more of these measures. 10

Protecting public investment
Public investment or, more broadly, growth-friendly public spending suffered following the global fi nancial crisis, especially in very high debt countries (see Figure 2). There is a danger that the same thing will happen under fi nancial pressure in the aftermath of the coronavirus crisis and related political pressure to protect current spending. Hence, there is substantial support for a "golden rule" that would keep public investment out of the defi cit calculation relevant for the 3% ceiling. The fact is, though, that the current SGP already admits a fl exible treatment of public investment that has been used very little so far, potentially because the conditions are quite onerous. An important issue associated with this type of fl exibility is, of course, that governments have an incentive to classify other types of spending as investment spending. Therefore, the EFB has in the past suggested the use of a "modifi ed golden rule" by which, under the condition that debt sustainability is not endangered, investment spending on projects cofi nanced and hence vetted by the EU is taken out of the defi cit calculation. Potential top-ups by governments of these projects would also be removed. Currently, there is substantial sympathy for a "green golden rule", by which climate investment would be exempt, but it runs the risk of "greenwashing".
Besides classifi cation risks, the need for an integral tradeoff on all spending items argues against taking items out of 8 See also European Economy Expert Group (2021). These measures would constrain moral hazard, thereby inducing governments to constrain profl igacy. 9 See also European Economy Expert Group (2021). 10 There are various other measures that could be implemented, such as naming and shaming of non-compliant member states, mandatory spending reviews/review frameworks, revenue reviews for countries with a narrow tax base, etc. No single measure will contain the "silver bullet". They may all provide marginal improvements. See also Beetsma and Larch (2018) on the risk-reduction versus risk-sharing debate. The scope for a reform of the EU fi scal architecture is largest if both "camps", i.e. those in favour of risk reduction and those in favour of risk sharing, receive something in return for what they demand. policies. As argued, once the SED clause is lifted, it is important to have a blueprint for a revised SGP, because returning to the original surveillance practice when the original rules cannot be adhered to will further undermine the SGP's credibility. Also, the momentum for reform may abate. It is crucial that changes in or differentiation of debt reduction requirements post COVID-19 be accompanied by an enhanced commitment to the revised requirements. Such a commitment will be strengthened by the revision of the SGP in other dimensions, which would make it simpler and more transparent, and by whether national IFIs can assume a larger role in monitoring debt developments.
it will not always be clear whether a proposed policy is in line with the standard. Third, the ECJ will need to build up capacity and case law to establish whether a followed policy is in line with the standard. A large number of cases before the court simultaneously will absorb a great deal of the court's capacity. All in all, there are strong arguments to keep numerical rules.

A numerical ceiling on interest payments
Even though public debt has risen, debt interest payments have fallen, prompting some experts to argue that it would be preferable to replace the current numerical SGP ceilings with a ceiling on interest expenditures on public debt. 11 This would be risky, however. In an era of very low interest rates, this may encourage countries to run up extremely high debt levels before the ceiling on interest spending is reached, which would pose risks for fi nancial stability if interest rates start rising again.

The role of the national IFIs
The national IFIs are a very heterogeneous group of institutions with different effective independence, resources, assignments and operational contexts (see e.g. Beetsma et al., 2019). They pay limited attention at best to potential spillovers from national fi scal policy. Hence, EU level fi scal surveillance under a common set of budgetary rules will remain necessary for a well-functioning EU. Still, with their more detailed knowledge of their own country's situation, national IFIs could assume a larger role in monitoring national debt developments, especially when the SGP is revised and debt reduction requirements become more tailor made to the specifi c situation of individual countries. The IFIs could analyse whether potential violations of the requirements are justifi ed on the basis of developments outside the control of the government and provide the Commission with input for its surveillance actions. In their proposal, Martin et al. (2021) assign a key role to the IFIs. Governments propose a fi veyear debt target and primary expenditure consistent with the target. The national IFI assesses the sustainability of the public fi nances, based on a common methodology set by the EFB, and validates the debt target. This serves as input for the Commission which provides a recommendation on the target and spending path, after which the Ecofi n accepts or rejects the proposals. Clearly, some IFIs would need to strengthen their analytical capacity under this proposal.

Concluding remarks
Even though they can never be perfect, numerical fi scal rules are needed to restrain governments in their budgetary