EU economic governance: Do the rules work?

Rules have become an increasingly prominent – even defining – feature of EU economic governance as a result of the various reforms undertaken to resolve the euro crisis. There are now rules on fiscal deficits and debt levels, set out in the Stability and Growth Pact (SGP), and an EU Directive required Member States to enshrine fiscal rules in their national legal order. Euro area countries are also now obliged to submit their draft budgets to ‘Brussels’ for scrutiny, and judged on whether they are likely to be compliant or not with EU rules. Recognising that destabilising imbalances can arise for reasons other than fiscal profligacy, for example in private debt or the housing market, a new excessive imbalances procedure (EIP) with its basis in hard law was also introduced.

In the original architecture of economic and monetary union (EMU), the SGP sought to discipline the fiscal policy of Member States by pushing them to maintain a position ‘close to balance or in surplus’ and had provisions for financial sanctions on countries which allowed their nominal deficits to exceed 3% of GDP. A reform of the SGP in 2005 shifted the focus to the structural deficit, thereby answering one of the stronger criticisms of it, namely that it amplified rather than smoothed the economic cycle. Latterly, national fiscal rules have proliferated, with rules concerning not just the deficit, but also public debt, the aggregate level of expenditure and how to use public revenues.

Does all this work? On the whole, academic research suggests that countries with credible fiscal rules do have more sustainable public finances.  But in the European context the picture is mixed, as I explored in my recent article for the February 2017 NIESR Economic Review.  When Germany and France exceeded the 3% limit in 2002 and 2003, politics ensured they were not subjected to sanctions, and even during the relatively benign first decade of the euro, adherence to the rule was patchy. Then, during the crisis years, compliance with the rules was so poor that the great majority of EU countries were in what are known as excessive deficit procedures. Fast forward to July 2016 when the decisions on Portugal and Spain were almost Kafkaesque: both were found to be in breach of the rules, but effectively let off by being given fines of zero euros

The argument has been made that even if there is not strict adherence to a rule, it may nevertheless restrain government excess and there is some evidence to support this view. But examination of how rules have been working recently in the EU is not encouraging. Debt to GDP ratios remain well outside the limits set in the revised SGP, macroeconomic imbalances persist and the European Commission verdicts on draft budgets shows only a handful of countries being given a clean bill of health, alongside several persistent ‘delinquents’ adjudged to be at risk of non-compliance.

Regarding macroeconomic imbalances, the UK in 2015 was shown to have imbalances in its large current account deficit and its housing market, yet in the verdicts in the spring of 2016 was deemed to have no imbalances, despite no clear improvements. There are no prizes for guessing the political imperative behind the latter decision. Germany’s huge surplus on the current account of its balance of payments is noted, but overall the country is classed as being in imbalance, but not excessive imbalance.  Overall, the strong impression is of a reluctance to use the disciplinary provisions of the various rules and processes, raising the obvious question of whether rules open to politically-motivated discretion can ever fulfil their purpose.

There are several possible explanations for why this has arisen. First, proliferation of rules has led to some confusion about which rule bites at what point, while also allowing governments to obscure what is happening. Second, there are statistical and methodological shortcomings or disputes about, for example, how to calculate the output gap to arrive at the cyclically adjusted deficit. Third, with the establishment of independent fiscal councils in most EU countries, there are now competing channels for monitoring of governments, adding to the scope for mixed messages.

More fundamentally, the economics behind rules are increasingly under challenge.  If rules cause economic damage or inhibit governments from adopting policies designed to improve matters, there is an obvious compliance-appropriateness dilemma. Moreover rules can conflict with voter choice, posing problems of legitimation. It may be time to rule against rules.

For Volume 239 of NIESR’s Economic Review (February 2017) click here.

Prof Iain Begg’s paper was one of three in this Review  from a European Union funded multinational research project, FIRSTRUN. The aims of the project are to investigate the fiscal policy coordination in the EU, to assess the coherence of the recent reforms within the economic governance framework, and to identify reforms that could fill possible gaps. The project commenced in March 2016 and will continue to February 2018. There is much research content available on the project’s dedicated website.