The new fiscal rules for the EMU. Threats from heterogeneity and interdependence.

• Author: Tamborini, Roberto
• Position: European Monetary Union - Report

1. Introduction

   In the eye of the sovereign debt storm provoked by the 2008-10 world crisis, the member states of the European Monetary Union (EMU) agreed upon, and the EU Commission adopted in September 2010, a revision of the Stability and Growth Pact (SGP) which resets the fiscal rules of member states. The Commission (IP/10/1199) presented this revision as part of "the most comprehensive package of legislative measures" aimed at the "reinforcement of economic governance in the EU and the euro area since the launch of the Economic and Monetary Union". Subsequently, a more ambitious comprehensive reform on "Stability, coordination and governance in the Economic and Monetary Union" with a treaty status was approved in December 2011 (EU 2011, http://ec.europa.eu/economy finance/economic governance/index en.htm). Such a far-reaching re-regulation has been prompted by strong speculative attacks against the Euro Zone as a whole, but it is also motivated by the worrisome leaks that the crisis has opened up in the EMU institutional construction, and which are largely responsible for unleashing the speculators' bets against the survival of the EMU itself. A key tenet of the reform is that fiscal stabilization will be a long and painful endeavour that will engage all major member states for a number of years to come, during which their creditworthiness in the financial markets will have to be underpinned by a tighter institutional framework and credible consolidation plans. As a result, "the SGP will become more 'rule based' and sanctions will be the normal consequence to expect for countries in breach of their commitments" (EU Commission, IP/10/1199).

   The aim of this paper is not a "normative" discussion of the pros and cons of the reform or of alternative proposals. Rather, the aim is a "positive" analysis of one of its new elements in the so-called corrective part, each year member states should submit a Stability and Convergence Plan (SCP), a key component of which is commitment to debt control and convergence towards a defined target. Member states in excess of the 60% debt/GDP ratio in the previous three years should reduce it at a pace defined in 1/20th of the excess per year.

   Whilst the shift of focus from current budget deficits to medium-long term debt management is welcome and long awaited, the feasibility of the SCPs has to be examined more carefully. SCPs will be designed and applied according to the spirit of the Maastricht Treaty, or what we may by and large define the "Brussels Consensus", treats each single member country as an independent, isolated entity, fully responsible for its own conduct and results. According to several observers two are the major faults in this approach that the crisis has dramatized. One is the original conceptual mistake inherent in the "rules + sanctions" approach in a context of sovereign governments under democratic control. The other is the total lack of consideration of the systemic dimension of national fiscal policies in a monetary union, where 'systemic' means that heterogeneity and interdependence across member countries are key factors (e.g. De Grauwe, 2011). The paper highlights why and how these factors may impinge upon SCPs.

   In the first issue of the new Annual Growth Survey (EU Commission, 2011a), the Commission acknowledges the heterogeneity issue, since "EU Member States experienced highly different fiscal and external conditions, which call for tailor-made policies" (p. 9). In other words, different countries facing different initial conditions and debt dynamic paths will have to adopt different policies. At first sight, this does not seem to be a major problem within the country-by-country framework of the SCPs. However, heterogeneity may have important consequences because EMU members are required, and hence are expected by investors, to manage their sovereign debts in such a way that they smoothly converge towards the common Promised Land of the 60% of GDP (or below). As is well known, the recipe for easier debt control wants a nominal trend growth rate greater than the long-term interest rate on outstanding debt. The paper will show that heterogeneous debt motion laws across countries in this respect entail different speeds of adjustment, different fiscal efforts, and, what is more important, clusters of stable vis-a-vis unstable steady-state debt levels. As a consequence, even if all members were one day able to hit the 60% debt/GDP ratio, thereafter they would react to asymmetric as well as symmetric shocks in different, maybe divergent ways. Hence, 'S'tability in SCP cannot be taken for granted. Some countries would find it easier to keep their debt on target, others ought to engage in active fine tuning of their primary balance.

   Heterogeneity may also be problematic as soon as we realize that it is coupled with interdependence. Broadly speaking, interdependence means that the debt motion law of one country depends on that of the others. Since, according to the Commission, "although the degree of urgency is not the same in all Member States, consolidation remains a key priority for all" (EU Commission, 2011b, p. 11), the key question is whether and how simultaneous debt consolidation plans can be successful in a context of heterogeneous and interdependent countries, or else, whether 'C'onvergenge in SCP is achievable. The paper will point out two dimensions of interdependence in debt dynamics, a financial and a real one. The former operates via risk premia, the latter via cross-correlations of GDPs. It will be seen that under both dimensions interdependence may jeopardize convergence of consolidation plans.

   It may be argued that "technicians" in the official institutions are well aware that these factors may impinge upon consolidation plans (see e.g. Kanda, 2011; IMF, 2012). Indeed, the common practice is to draw SCPs projecting the trend values of nominal growth and interest rates as if each country were in isolation, and treating deviations from projections as ex-post shocks to which the path of primary balances should be adjusted. However, the idea of controlling for these "complications" at the implementation level may be quite demanding, and possibly unsuccessful. I shall give examples of this. Ex-post disappointments of consolidation plans, which are in fact exante misspecification errors of the plan, may be quite costly and undermine the "political ownership" of the fiscal rules. Hence our main concern here is with the institutional level, where the key flaw is that heterogeneity and interdependence are ignored in the original conception of the EMU fiscal rules and subsequent reforms.

   The paper is organized in two parts. In the first part (section 2), I introduce the basic, single-country model of public debt dynamics. Though simple, this model contains all the essential ingredients that are necessary to understand the SCP problem: in particular, (i) the convergence to the debt target, (ii) the related fiscal effort, and (iii) the stability of the debt target. In the second part (sections 3 and 4), the model is used to point out where and how considerations of heterogeneity and interdependence in growth and interest rates may change results and the ensuing policy implications.

2. Stability and convergence plans. The basic tool kit.

   This section provides the basic tool kit for the design and implementation of SCPs. This consists of the well-known system of two equations that tracks the evolution of public debt of a single country in isolation (see e.g. EU Commission, 2011b, p. 89)

   [D.sub.t] = [D.sub.t-1] - [B.sub.t] (1)

   [B.sub.t] = [B'.sub.t] - [i.sub.t][D.sub.t-1] (2)

   where [D.sub.t-1] is the outstanding public debt, [B.sub.t] is the current budget balance, [B'.sub.t] is the current primary balance, and it is the current interest rate paid on the outstanding debt. All variables are expressed in nominal terms.

   These expressions are easily converted into GDP ratios, obtaining

   [d.sub.t] = 1 + [i.sub.t]/1 + [n.sub.t] [d.sub.t-1] - [b'.sub.t] (3)

   where small-case letters for fiscal variables denote GDP ratios, and [n.sub.t] is the current nominal growth rate of GDP (1).

   Equation 3 states that [d.sub.t] grows over time owing to two factors:

   * an interest rate greater than the nominal growth rate, [i.sub.t] > [n.sub.t], and/or

   * primary deficits, [b'.sub.t]

   It can be used to devise the budget policy necessary to achieve some fiscal aggregate target, such as debt stabilization or the speed of debt reduction. In this respect, the standard assumption is that [i.sub.t] and [n.sub.t] are exogenous variables; hence the government has one single control variable, [b'.sub.t].

   As regards the use of the primary balance as control variable, equation 3 can be rewritten in terms of debt/GDP variations, [DELTA][d.sub.t] = [d.sub.t] - [d.sub.t-1], so that

   [DELTA][d.sub.t] = [i.sub.t] - [n.sub.t]/1 + [n.sub.t] [d.sub.t-1] - [b'.sub.t] (4)

   If [n.sub.t] is a small fractional number (say less than 0.1), as is usually the case, equation 4 can be safely approximated by

   [DELTA][d.sub.t] = [i.sub.t] - [n.sub.t][d.sub.t-1] - [b'.sub.t] (5)

   2.1. Implementing the SCP

   With the help of equation 3 we can examine the main elements in a stylized SCP targeted to the debt ratio [d.sup.*] = 60%.

   Let ([d.sub.0], [b'.sub.0]) denote the initial levels of the debt and the associated primary balance ratios, and [d.sub.0] > [d.sub.*]. The typical SCP consists of a target [DELTA][d.sup.*.sub.t]

   b'([DELTA][d.sup.*.sub.t]) = ([i.sub.t] - [n.sub.t])[d.sub.t-1] - [DELTA][d.sup.*.sub.t] (6)

   The SCP yields a sequence of targets on primary balances according to equation 6. Given [d.sub.t-1] > 0 and [DELTA][d.sup.*.sub.t]

   It may be added that the SCP, being a medium-term plan, will necessarily be based on forecasts of [i.sub.t] and [n.sub.t] To this effects, let i, n be the expected trend values of the interest rate and the nominal growth rate, while [i.sub.t] and [n.sub.t] can...