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Tuesday, November 26, 2002

Calmfors and Corsetti Join the Hunt

Hot on the trail of EU commissioner Pedro Solbes, two more European economists argue the case for a loosening of the stability pact in today's Financial Times. A loosening which would allow not cyclical but structural deficit fluctuation. This is to encourage the 'good boys' and punish the 'bad' ones. Only one problem, most of the beneficiaries are non-Euro countries, and it's hard to see how the non-beneficiaries are going to arrive at a clean bill of health.

Their proposal is to allow countries with a debt-to-GDP ratio below a given percentage, for example 55 per cent, to run larger deficits than 3 per cent of GDP in recessions. The deficit limit could then be raised in steps as the debt ratio was lowered. Such a "ladder" of deficit ceilings could enhance the incentives for fiscal discipline, as governments would be seen to enjoy the benefit of moving up a rung after reducing their debt. They stress that for reasons of credibility it is important that any changes in the maximum deficit do not accommodate the current budgetary problems of Germany, France and Portugal etc. Their proposed 55 per cent limit would not do this, as these three countries will all have debt ratios close to 60 per cent - and rising - next year.

They also stress that it would be a mistake to change the long-term rules to solve a short-term problem, that there is no "quick fix", as the present situation was caused by insufficient fiscal retrenchment in the earlier boom. The problem is that it was probably presicesly these countries - those with debt to GDP ratios over 55% and rising, and who are now facing recession - that Prodi had in mind when he called the stability pact 'stupid'. I fear it is precisely the 'quick fix' that the politicians are looking for.

The European Union's stability pact has been much derided. To restore some credibility, the European Commission will tomorrow present its reform proposals. Yet preserving the spirit of the pact will require more fundamental changes than a new interpretation.

The basic problem is how to combine long-run fiscal discipline with short-run flexibility. The stability pact is mainly geared towards the first aim: to create a counterweight to the risk of fiscal profligacy. There has always been a fear that the incentives for fiscal responsibility would weaken once monetary union was created. Recent developments confirm these fears. At the same time, there is a case for refining the stability pact to facilitate counter-cyclical stabilisation.

Any modification of the EU fiscal policy framework involves a trade-off. On one hand, reforms must not be seen as giving in to claims from member states with current difficulties, since this would ruin the future credibility of any rules. On the other hand, if the current framework is viewed as too rigid it will lose its legitimacy.

What should be avoided is a relaxation of the budget target over the cycle, given the future strain on government budgets of ageing populations. Reductions in government debt, and thus in interest payments, are one way of mitigating this problem. So this is not the time to loosen budgetary requirements by introducing a "golden rule", according to which governments can borrow for investment.
Source: Financial Times

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