Chapter 8. Fiscal Governance in the Euro Area: Progress and Challenges

Petya Koeva Brooks, and Mahmood Pradhan
Published Date:
October 2015
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Luc Eyraud and Tao Wu 

The Stability and Growth Pact (SGP) is at the core of the European fiscal governance framework. The SGP’s origin dates back to the 1992 Maastricht Treaty, which launched the Economic and Monetary Union (EMU). Because of the unique structure of euro area integration—with a common monetary policy but decentralized fiscal policies—fiscal rules were introduced to prevent national fiscal policies from producing negative spillovers on other countries and on the conduct of monetary policy (EC 2013a). These fiscal spillovers may take several forms, including unwanted monetary tightening to contain inflation fueled by fiscal expansion in a particular country, higher euro area—wide interest rates caused by crowding out, contagion effects, and bailout costs.

The euro area crisis has revealed gaps in the effectiveness of the fiscal governance framework and in the functioning of the monetary union. In a context of a severe economic downturn and large private sector imbalances, fiscal institutions could not prevent a dramatic surge in public debt, which was, in part, due to national public support provided to the impaired financial sector. Fiscal rules were put to the test, in particular those that did not explicitly foresee how to deal with exceptional economic circumstances (IMF 2013b). The crisis also showed that sovereigns could be priced out of the market or even lose market access altogether. It highlighted how contagion could set in, with deep recessions and fiscal stress in some member states spilling over to the rest of the membership.

Yet, weak fiscal governance is not a recent development. Most countries had built insufficient fiscal buffers in good times before the crisis hit. The windfall from lower interest and debt payments had not been saved in the early years of the EMU, and higher budget revenues generated by unsustainable domestic demand booms were wrongly deemed permanent (Allard and others 2013). In the precrisis years, individual member states did not fully take into account the potential spillovers from their idiosyncratic policies on other countries. Moreover, the European fiscal governance framework was too loosely implemented to ensure the appropriate management of public finances over the cycle. Governance failures and political interference became particularly apparent when the European Council decided to hold in abeyance the SGP’s procedures in 2003.

This chapter aims to contribute to the ongoing discussions on fiscal governance in Europe. It takes stock of recent reforms, identifies areas for further progress, and presents a menu of policy options. The first section briefly reviews the underlying drivers of the public debt increase in euro area countries during the crisis. The second and third sections examine past reforms and the track record of the framework. The fourth section identifies remaining gaps in the areas of rule design and implementation. The fifth section discusses options for future reforms. The final section concludes with some considerations on reform priority and sequencing.

The Setting: Public Debt on an Upward Trend

Public finances have deteriorated significantly since 2008. The average public-debt-to-GDP ratio soared to 95 percent in 2013, almost 30 percentage points higher than the precrisis level. The debt increase during the crisis was due to a combination of cyclical and discretionary factors, as illustrated by a decomposition (Table 8.1) that uses the Debt Sustainability Analysis framework (IMF 2013c).

Table 8.1Decomposition of Debt Changes in the Euro Area, End-2007 to End-2013
Total Changes
Percentage PointsProportion (percent)
Increases in debt-to-GDP ratio28.8100
Stock-flow adjustment9.433
Overall deficit19.467
Interest rate-growth differential11.640
Nominal GDP growth−5.0−17
Interest rate116.658
Primary deficit7.827
Cyclical component5.318
Structural balance1.14
Source: IMF staff calculation.Note: CAPB = cyclically adjusted primary balance. The decomposition is applied to EA18 aggregate data. See the Abbreviations section for composition of EA18.

Cumulative interest payments over the period.

Source: IMF staff calculation.Note: CAPB = cyclically adjusted primary balance. The decomposition is applied to EA18 aggregate data. See the Abbreviations section for composition of EA18.

Cumulative interest payments over the period.

Stock-flow adjustment residuals accounted for about one-third of the total debt increase in the euro area during the crisis. To a large extent, these residuals reflected financial sector intervention and rescue packages in the early stages of the crisis, as well as the realization of contingent liabilities (Blanchard, Dell’Ariccia, and Mauro 2013).

Fiscal deficits in European countries were another important factor behind the rapid debt increase. About two-thirds of the debt surge can be attributed to the accumulation of fiscal deficits. In particular, the interest bill was the largest contributor to the increase in debt.

The economic slowdown during the crisis added to the debt problem. In normal times, a continued economic expansion should offset the effect of interest payments and thus reduce the debt-to-GDP ratio over time (other factors being equal). However, the sharp decline in economic activity and the very sluggish recovery thereafter led to minimal increases in nominal GDP during 2008–13. As a result, the interest component dominated the changes in the interest rate—growth differential term, with a net contribution of 11.6 percentage points, or 40 percent of the total increases in the debt-to-GDP ratio.

One-fourth of the debt increase resulted from the accumulation of primary deficits over time, although the discretionary part was limited. Of the 28.8 percentage point increase in the debt-to-GDP ratio since end-2007, 8.8 percentage points can be accounted for by cumulative primary deficits, more than half of which were due to changes in cyclical conditions (18 percent). The remainder reflected the accumulation of cyclically adjusted primary deficits. Further analysis reveals that a substantial part of the accumulated cyclically adjusted primary deficit can be attributed to one-off (idiosyncratic) items. The contribution of the accumulated structural balance to debt increases since 2008 was modest—about 11 percentage points for the euro area or slightly higher than 4 percent of the total debt increase.

An important lesson of this exercise is that countries should build sufficient fiscal buffers in good times to accommodate cyclical and exogenous shocks in bad times. As shown above, most of the deterioration in public finances during the crisis was not due to discretionary fiscal stimulus. It was the effect of automatic stabilizers (as revenues fell and expenditures rose in the recession) and exogenous factors (like the bailout of the banking sector or the interest bill). In essence, countries did not enter the crisis with strong enough fiscal positions to withstand such large shocks. The 3 percent of GDP nominal deficit ceiling did not prevent countries from spending their revenue windfalls in the mid-2000s. Partly to address this issue, the European authorities have introduced several changes in the European Union (EU) fiscal and economic governance framework since its inception.

Past Reforms of the Fiscal Framework

The European fiscal governance system is established by a number of legal texts. The main principles are defined in the two EU treaties (the Treaty on European Union and the Treaty on the Functioning of the European Union) that lay the groundwork for the surveillance and coordination of the member states’ fiscal policies. The SGP refers to the secondary legislation that implements the treaties’ requirements.

Since 1997, the secondary legislation governing the SGP has been reformed several times. The first major revision, in 2005, introduced more flexibility in the procedures while improving the economic underpinning of fiscal rules. In the context of the sovereign debt crisis, the SGP was further amended in 2011 with five new regulations and one directive (the “Six-Pack”) that brought numerous modifications to the framework, including new rules, new and earlier sanctions, and additional escape clauses. In 2013, fiscal governance was again strengthened. The “Two-Pack” reinforced budgetary surveillance and coordination for euro area countries, reflecting the higher risk of spillovers within the single currency area. Additional commitments were made by 25 member states through the intergovernmental Treaty on Stability, Coordination and Governance, whose fiscal provisions—referred to as the “Fiscal Compact”—transpose elements of the SGP into national legislation.

On the whole, successive revisions of the framework have pursued five primary objectives:

  • To provide stronger economic underpinnings to the framework—Fiscal rules have increasingly focused on fiscal actions rather than fiscal outcomes, the latter being affected by economic circumstances beyond the control of governments. The 2005 reform put the concepts of structural balance at center stage under both the preventive and corrective arms. In 2011, the European Commission improved the measurement of the structural effort with the introduction of the expenditure benchmark and the concept of “adjusted fiscal effort.”
  • To better align fiscal targets with the final debt objective—The idea, present in the initial version of the SGP, that focusing on the fiscal deficit would be sufficient to contain debt and that the debt criterion could be overlooked, proved incorrect for two reasons. First, in the absence of correction mechanisms, past fiscal slippages on the deficit were not subsequently offset and therefore piled up over time. Second, a large portion of the debt increase resulted from stock-flow adjustments (such as bank recapitalization) that were not captured by the deficit target. These elements led to a renewed focus on public debt, with the one-twentieth debt-reduction benchmark becoming a possible trigger of the Excessive Deficit Procedure (EDP) in 2011.
  • To strengthen enforcement mechanisms—Successive reforms have stepped up enforcement in several ways: (1) by fostering ownership of the supranational framework by transposing some rules at the national level and better integrating supranational surveillance within the national budget calendar to ensure that the European Commission’s recommendations could be incorporated into national budgets and policies; (2) by introducing earlier and stronger sanctions—late sanctions were found to be not credible and counterproductive; and (3) by entrusting independent institutions such as fiscal councils to monitor fiscal rules.
  • To implement fiscal rules with more flexibility—Another lesson from past experience is that rules that are too rigid and do not foresee how to deal with exceptional economic circumstances are often disputed and quickly suspended. To mitigate this risk, some flexibility was brought to the initial framework by extending the scope of escape clauses and allowing deviations from targets when structural reforms are adopted, provided that these reforms entail short-term budgetary costs and long-term gains.
  • To bring more specificity to the definition of the rules—Rules that are vague or ambiguous are difficult to implement. This was a major criticism of the initial debt criterion, which did not include any metric to assess whether debt was “sufficiently diminishing.” Successive reforms improved the measurability and specificity of the rules, including the definition of medium-term objective (MTO), the quantification of annual fiscal effort, and the pace of debt reduction. Another important step was the recognition that some rules needed to be differentiated across member states to reflect diverse debt sustainability concerns. In 2005, the MTO became country specific, with the formula taking into account the debt level and prospective population aging costs of the country.

Track Record Under the SGP

Although successive reforms have brought many positive elements to the framework, they have not been sufficient to prevent a steady deterioration in public accounts. Under the SGP, noncompliance has been the rule rather than the exception. Nearly all euro area economies have breached at least one of the fiscal rules. Figure 8.1 compares fiscal outturns with SGP targets or ceilings since the adoption of the euro.1

Figure 8.1Noncompliance with European Fiscal Rules

Source: European Commission Annual Macroeconomic Database.

Note: Not all member states had to comply with the rules over the whole period, because some countries joined the Economic and Monetary Union after 1999. See Abbreviations section for countries and composition of EA18.

1Number of years with fiscal deficit greater than 3 percent divided by total number of years.

2Number of years with debt greater than 60 percent divided by total number of years.

3Number of years with structural deficit greater than 0.5 percent divided by total number of years.

4In the subset of years with structural deficit greater than 0.5 percent, share of number of years with annual fiscal effort less than 0.5 percent of potential GDP. Fiscal effort is defined as the change in the structural balance.

Compliance has been the highest with the 3 percent deficit ceiling. Most countries have complied with this target during the pre-crisis period (1999–2007). Based on ex post data, Greece and Portugal have failed to keep their deficits to less than 3 percent of GDP every year since they joined the euro.

About half of the countries have missed the 60 percent debt ceiling target more than half of the time. At the member state level, compliance with the 60 percent rule has been uneven, with smaller countries being, on average, more compliant. At the level of the euro area as a whole (EA12 or EA182), public debt has been higher than 60 percent of GDP every year since 1999.

Structural deficits have been persistent, reflecting difficulties in building buffers in good times. Compliance with the “close to balance position” has been extremely rare, except in Finland and Luxembourg. In the EA18 as a whole, there has not been a single year with a structural deficit of less than 1 percent of potential GDP. The preventive arm has failed to encourage the buildup of sufficient buffers in good times. Although the output gap was positive or close to zero from 1999 through 2008, the structural balance recorded, on average, a deficit of 2.5 percent in the euro area. Beyond the absolute level, what is striking is the response of the structural position to the output gap (Figure 8.2). During the period 1999–2013, the euro area as a whole had a tendency to tighten (loosen) the structural stance by about 1 percentage point following a year with a negative (positive) output gap.3 At the member state level, the correlation between the change in the structural balance and the initial output gap is also negative (except in Finland and Luxembourg), suggesting that the fiscal stance was procyclical over the period.4

Figure 8.2Structural Balance and Output Gap

(Euro area aggregate; ex post output gap data)

Source: European Commission Annual Macroeconomic Database.

Note: OG = output gap. The figures uses the previous year output gap to mitigate the feedback effect from the fiscal stance to the output gap. Using the current output gap, which is directly impacted by the fiscal actions taken in the same year, would complicate the results’ interpretation. For instance, the 2009 data point relates the 2008 output gap to the change in the structural balance in 2009 relative to 2008.

Had the euro area pursued a more countercyclical fiscal stance in the first decade of the EMU, it would have entered the crisis in a far stronger position. Figure 8.3 presents the results of a simulation assuming that the euro area follows a simple countercyclical rule from 1999 to 2008—with the structural position improving (decreasing) by 0.5 percent of GDP when the previous year’s output gap is positive (negative).5 The simulation is based on EA18 aggregate data. A fiscal multiplier of 1 (declining to 0 in five years) is used to estimate the GDP effect of the implicit fiscal shock corresponding to the difference between the structural positions in the baseline and in the scenario. The main finding is that the euro area would have entered the crisis with a neutral (that is, balanced) structural position and with a debt ratio of about 60 percent of GDP—about 10 percentage points below the actual 2008 level.6

Figure 8.3Public Debt

(Percent of GDP; 1998–2008)

Sources: European Commission Annual Macroeconomic Database; and IMF staff calculations.

Note: Calculations based on ex post output gap data.

Pending Issues and Areas for Further Progress

The implementation of the SGP has exposed gaps in both the design of the rules and enforcement mechanisms. The first three parts of this section identify and discuss design-related issues; the last part focuses on key dimensions of implementation.

The Growing Complexity of the Framework

By successively layering new constraints and procedures on top of old ones, the European framework has become very complicated with a greater risk of overlaps and inconsistencies between rules.

Successive legislative changes have made the SGP increasingly complex

The growing complexity of the system is rooted in the history of the SGP. The initial pact only included three supranational rules, of which only one was truly binding.7 Later, the fiscal crisis and the unsuccessful experience with a small set of constraints prompted the adoption of additional rules—some of them to address the shortcomings of previous ones (for example, the structural balance supplementing the nominal deficit ceiling). More complex rules were also introduced as a way to ensure enforcement in a wide range of circumstances; for instance, the structural balance rule and expenditure benchmark were seen as effective tools to prevent lax policies in good times. Another explanation for the proliferation of supranational rules is the relative paucity of self-imposed national rules, particularly in the initial years.8 Finally, political factors also played a role, with the mutual lack of confidence leading member states to over-specify rules and procedures.

As of 2014, fiscal aggregates are tied by an intricate set of constraints, which makes the monitoring and communication of the rules more difficult. Both the preventive and corrective arms impose constraints on member states’ fiscal targets (Figure 8.4). Countries are required to converge toward the 60 percent of GDP debt target at a sufficient pace; prohibited from breaching the 3 percent of nominal GDP deficit threshold; and mandated to improve the structural-deficit-to-GDP ratio at an average rate of 0.5 percent per year until they reach their MTO. In addition, government spending (net of new revenue measures) is constrained to grow in line with trend GDP. When countries are under EDP, they are also subject to specific nominal and structural balance targets. Finally, the Fiscal Compact, signed by 25 member states, requires contracting parties to ensure convergence toward their MTOs by means of a national rule, whose specification and scope may be slightly different from the MTO’s.

Figure 8.4Supranational Constraints and Rules on Fiscal Aggregates

Source: Authors.

Note: EDP = excessive deficit procedure; MTO = medium-term objective.

The high number of rules and subrules creates risks of overlap and inconsistency

Compared with most federations, the EU imposes a larger set of constraints on subnational governments. In a sample of 13 federations, Eyraud and Gomez (2014) find that the federal level imposes, on average, two constraints on subcentral governments (states and substate entities), compared with five in the euro area.9 In Canada, the United States, and Switzerland, no federal restrictions are placed on subcentral fiscal targets. In addition, most European rules include restrictions on both the level and the first difference of fiscal targets, the second restriction being conditioned on the breach of the first one. Fiscal rules are, thus, implemented in stages. For instance, when countries do not comply with the 60 percent debt ceiling, a constraint on debt changes—the one-twentieth rule—applies. Similarly, if a member state’s structural deficit is higher than its MTO, it has to improve its fiscal position by 0.5 percent of GDP per year in structural terms. Corrective actions and sanctions are also progressive, becoming more stringent when the target in level is breached and efforts to correct the imbalance are deemed insufficient. This multistep approach—probably motivated by the relative weakness of enforcement tools and the desire to make peer pressure more effective—is nonexistent in the federations reviewed by Eyraud and Gomez (2014). Overall, the large number of primary and secondary rules may result in redundancy and inconsistency.

Specifically, the complexity of the framework creates a number of policy risks:

  • Revisions to medium-term growth have weakened the link between deficit and debt ceilings. The 3 percent nominal deficit rule was initially set to stabilize and cap public debt at 60 percent of GDP (under the assumption of 5 percent nominal growth); however, downward revisions to potential growth, which is currently estimated to be about 3 percent in nominal terms in many euro area countries, suggest that debt would actually converge toward 100 percent of GDP.10
  • A second issue is the overlap and potential redundancy between structural and nominal targets. Provided that it is measured accurately, the MTO, which is a structural balance target, is generally more binding than the other rules (abstracting from the distinction between preventive and corrective arms). It does not come as a surprise that the MTO dominates the 3 percent nominal deficit rule, given that the output gap rarely deteriorates beyond 5 percent11—a situation that would, in any case, lead to a temporary suspension of the fiscal rule framework. Also, the MTO typically brings the fiscal balance above the debt-stabilizing level, resulting in a steady reduction in the debt ratio.12 Simulations show that this pace of reduction is sufficient to either reduce public debt to less than 60 percent by the end of the forecast period or, if the debt is greater than 60 percent, comply with the one-twentieth debt benchmark in its backward-looking version.13
  • Another form of inconsistency may arise between national and supranational rules. The Fiscal Compact requires some supranational requirements—in particular the MTO—to be transposed into national legislation to strengthen compliance and ownership. This may create inconsistencies if a target or procedure is defined differently by the national and supranational legislation (although the latter can generally be amended). A similar issue may arise with the path toward the MTO, because the preventive arm requires a minimum annual effort of 0.5 percent of potential GDP, which may differ from the correction mechanism imposed by national rules. Deadlines for achieving the targets and escape clauses may also not match exactly.

The Difficult Migration from Nominal to Structural Balance Targets

Nominal balance rules have serious shortcomings. Although the 3 percent deficit ceiling leaves sufficient room for automatic stabilizers to operate under normal circumstances,14 it does not prevent and may even encourage a procyclical fiscal stance. During the past decade, the deficit ceiling allowed for fiscal expansion during the precrisis boom (for example, in Spain) and called for politically difficult tightening when the global economy weakened in 2011–13. The drawbacks of the nominal deficit ceiling are particularly apparent when the economy is booming—it is compatible with very large structural deficits. For instance, when current output is 4 percent above potential,15 a 3 percent deficit would translate into a structural deficit of 5 percent, which would be seen as unsustainable in most countries. A second issue is that the deficit ceiling does not prevent a structural medium-term drift of public finances. As discussed previously, a 3 percent deficit would bring public debt toward 100 percent of GDP (under the assumption of 3 percent nominal growth). Other shortcomings of the rule are that the ceiling is identical for all countries—unrelated to their debt levels and growth potential; it creates incentives for creative accounting and idiosyncratic measures; and it does not capture stock-flow adjustments, which accounted for about 33 percent of the euro area debt increase during the recent crisis (see Section “The Setting: Public Debt on an Upward Trend”).

The structural balance, which has been central in the EU framework since the 2005 reform, addresses some of these issues. Its computation entails decomposing the fiscal position into two parts: one representing the fiscal response to economic activity and other transitory factors, and another measuring the policy stance. A first advantage of the structural balance is that this indicator is a tractable fiscal target, which is more directly under the control of governments than the nominal balance. Its changes should, in principle, be mapped directly to discretionary fiscal measures. In addition, the structural balance helps policymakers take a more medium-term perspective rather than attempting to fine-tune fiscal policy; if a country pursues a predetermined structural position, it does not have to offset cyclical factors and can let automatic stabilizers operate. For this reason, the structural balance entails a more binding fiscal stance in good economic times (relative to the overall balance), while allowing some room for maneuver when the economy is weak. This feature is particularly important in Europe, where countries struggled to save revenue windfalls before the crisis (Lemmer and Stegarescu 2009). A third advantage of the structural balance target (as defined in the European framework) is that the MTO is country specific and takes into account debt levels and population aging costs. The formula for the MTO “reference value” is designed to ensure that member states are on course toward sustainable debt positions (EC 2013b).

However, computing structural budget balances is difficult and subject to significant errors. Specifically, the structural balance is prone to ex post revisions resulting from the measurement bias of potential GDP. Even when it is measured on the production side, potential output calculations typically involve the use of statistical filters that give excessive weight to the most recent observations and result in frequent revisions—an issue described as the “end-point bias.” In the euro area, real-time output gaps are found to be underestimated, on average, by about 1 percent compared to ex post data (Figure 8.5).16 These revisions suggest that the structural balance is initially overestimated by half a percent of potential output—under the assumption of a budget semi-elasticity of 0.5. In other words, a structural balance rule relying on real-time estimates would tend to allow deficits exceeding ex post their targeted values by about 0.5 percentage point per year. Without a correction mechanism, relying on this rule would produce a permanent drift of public finances. This problem affects all structural stance indicators of the European framework, including the expenditure benchmark.

Figure 8.5Real-Time Estimation Error of the Output Gap

(Difference between ex post and real time data; 2003–13)

Sources: European Commission Annual Macroeconomic Database for after-the-fact data; and stability programs for real-time estimates.

Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.

Another issue is the difficulty of extracting the nondiscretionary component of revenue. The standard methodology filters out cyclical movements by using constant elasticities of revenue to the output gap. However, this method is not always sufficient to remove all cyclical factors. The business cycle is the most prominent source of macroeconomic fluctuations, but such fluctuations can arise from other disturbances, such as boom-and-bust cycles of asset or commodity prices and changes in the composition of output. To address this issue, the calculation of the structural balance has evolved in two distinct directions. The first approach adjusts the structural balance formula beyond the output gap. New structural balance indicators have been developed to correct for a broader range of macroeconomic fluctuations, but they add further complexity to the concept (Bornhorst and others 2011). In this vein, the “adjusted fiscal effort” used in the corrective arm explicitly corrects for revenue windfalls or shortfalls unrelated to the economic cycle. The second approach, which is pursued with the expenditure benchmark,17 consists of measuring discretionary revenues through a bottom-up approach that uses budget estimates of tax measures mandated by law. Although this second approach is conceptually more appealing, the estimation faces practical difficulties, in particular in the definition of the unchanged policy scenario.

Despite these issues, the focus on the structural balance remains appropriate. Although this indicator imperfectly filters out asset and commodity price cycles, it is still more “accurate” than the nominal balance, which does not extract these factors at all. In addition, the output measurement error is usually significantly lower than the “noise” created by the cyclical component of the nominal balance. An empirical analysis shows that, if the nominal balance is used to measure the underlying fiscal position, the error is about 25 percent higher than with the real-time structural balance. The gap is particularly large at the peaks and troughs of the cycle. Finally, the output gap measurement error is less of an issue when structural indicators are expressed in first-difference (see section “Should the Current System of Fiscal Rules Be Simplified (and if So, How)?”).

Measurement issues point to the need to further improve the methodological underpinnings of the concept. They may also explain the proliferation of structural indicators in the European framework. Currently, the European Commission maintains four alternative measures of the structural stance (the structural balance and expenditure benchmark in the preventive arm; and the observed and adjusted fiscal efforts in the corrective arm) and has recently proposed a fifth one—discretionary fiscal effort (EC 2013c). All these indicators differ in their specification and purpose, reducing the transparency of the system and creating risks of conflicting messages and assessments.

Reconciling Fiscal Sustainability and Growth Objectives

As its name suggests, one purpose of the SGP is to foster growth. In a difficult balancing exercise, the European framework tries to achieve two potentially conflicting goals: leaving sufficient space for member states to offset asymmetric shocks with fiscal instruments, while ensuring that they do not take advantage of the single currency to free ride on collective discipline and build unsustainable fiscal positions. In light of the lackluster growth performance of the euro area since the 1990s, some have argued that the balance has tilted toward sustainability at the expense of growth. For instance, the focus on fiscal sustainability may have fostered adjustment strategies—such as cuts in public investment or tax hikes—that are detrimental to long-term growth.

A first question is whether the SGP leaves sufficient room for macroeconomic stabilization. Stabilization may take the form of automatic stabilizers or discretionary fiscal policy. Regarding the first type, it seems that the SGP provides adequate margins. With a budget semi-elasticity of 0.5 and a structural deficit of 0.5 percent, a deficit ceiling of 3 percent is compatible with full operation of automatic stabilizers in downturns up to a negative output gap of 5 percent. In other words, the SGP does not compel countries to offset cyclical variations in spending and revenue unless the crisis is exceptionally severe—in which case the escape clause would probably be triggered and fiscal rules held in abeyance. The second issue is more difficult and controversial because not all agree that stabilization should involve discretionary fiscal policy. It is often argued that the SGP impairs the ability to conduct countercyclical policy, in particular in downturns. Admittedly, the lower limit of the MTO (−0.5 percent as a general rule, and −1.0 percent in low-debt countries) leaves little room for fiscal relaxation if the initial position is balanced. However, the preventive arm includes two economic downturn escape clauses, which authorize temporary deviations from the MTO or the path toward it.18 Therefore, a more relevant question is whether the 3 percent deficit ceiling (rather than the MTO) constrains the scope for fiscal stimulus. In a “normal” downturn corresponding to an output gap of −2 percent, a 3 percent deficit would correspond to a structural deficit of 2 percent, leaving some room for discretionary actions if the initial position is close to balance.

Box 8.1.The Trade-Off between Fiscal Consolidation and Structural Reforms

Structural reforms are generally successfully implemented in countries with healthy initial fiscal positions or that implement fiscal stimulus (IMF 2004; Beetsma and Debrun 2004; Høj and others 2006). Conversely, fiscal consolidation tends to coexist with a slower pace of structural reforms.

Several explanations have been advanced to explain why consolidation and reforms rarely coexist in practice:

  • Political capital is limited and governments that are too ambitious in pursuing reforms are not reelected.
  • Some structural reforms have large short-term budgetary costs. These costs can be direct, such as funding a public research and development program. But there are also indirect costs—in particular the cost of compensating the losers. These costs make it more difficult to simultaneously reform and consolidate.
  • Structural reforms tend to yield fewer benefits when the economy is weak. For instance, when demand is depressed, relaxing employment protection may not stimulate job creation. Or increasing the retirement age may just raise the number of unemployed. For this reason, Barkbu, Rahman, and Valdés (2012) recommends that structural reforms be complemented by policies to boost aggregate demand.
  • The combination of structural reforms and fiscal consolidation should be avoided when it is likely to produce hysteresis effects.

By focusing on annual or short-term constraints, the SGP may reduce incentives to introduce structural reforms and foster long-term growth. The experience of past fiscal adjustments suggests that there may be a trade-off between fiscal adjustment and structural reforms (Box 8.1). The 2005 reform of the SGP explicitly recognized this trade-off, by allowing temporary deviations from the MTO in the preventive arm and flexibility in the EDP for countries introducing some reforms. However, in practice, the current framework only applies to pension reforms, whose short-term budgetary cost and long-term impact on public finances are well understood and estimated. Going beyond pension reforms is a matter of current debate. The literature on the budgetary impact of structural reforms does not provide much guidance. Empirical studies do not find significant effects of broad reforms on the cyclically adjusted deficit (Giorno, Hoeller, and van den Noord 2005; Heinemann 2005; Deroose and Turrini 2006). Nonetheless, some evidence suggests that some specific reforms have large and measurable short-term costs. For example, the budgetary cost of active labor market policies, as estimated by the OECD databases, exceeds 1 percent of GDP in some countries.19 In light of the mixed evidence, further research should be conducted, perhaps focusing on particular structural measures and trying to address measurement issues. Another issue is that many structural reforms remain little more than policy announcements. Any flexibility provided by the framework should therefore be tied to the implementation of reforms, going beyond the promise stage.

A related question is whether the MTO and, to a lesser extent, the 3 percent deficit cap may discourage public investment. This is an old debate, but the question has recently come to the fore again because the financial crisis prompted politically easier cuts in government investment in many advanced economies, reinforcing a long-term declining trend (Figure 8.6). With private investment also falling in many countries, medium- and long-term growth prospects could be affected. The public investment deceleration was particularly pronounced in the countries hit hard by the crisis, such as Greece, Ireland, and Portugal (IMF 2014). Although this problem extends beyond the fiscal governance framework, the SGP should set the right incentives to avoid further depletion of capital.

Figure 8.6Investment in the Euro Area

(Share of potential GDP; total economy)

Source: European Commission Annual Macroeconomic Database.

A fundamental question is whether the fiscal framework should exclude capital outlays from targeted fiscal balances (the “golden rule”) on the grounds that such spending contributes to growth in the long term. This type of rule has some intuitive appeal20 but raises concerns because it weakens the link between fiscal targets and gross debt. In addition, capital expenditure is not necessarily productive, while other items such as expenditures on health and education may raise productivity and potential growth even more. Thus, the exclusion of capital expenditure needs to be weighed against the risks of lower transparency, “creative accounting,” and weaker links to sustainability. Another direction that the SGP could take is to induce member states to better internalize the benefits of domestic investment. For instance, EDP targets and deadlines could be adjusted when fiscal consolidation protects capital expenditure. Nonetheless, this would further complicate the framework and raises practical difficulties, which are, to a large extent, similar to those previously described.

A better approach could be to boost the ability of the center to fund pan-European public infrastructure. Such investments could include cross-border projects with network externalities, in particular in the energy sector. As national budgets have to be kept within the bounds of the fiscal framework, other sources of financing should be considered, such as, for example, the European Investment Bank (EIB) and other forms of common borrowing to promote public-private partnerships. Although difficult, this option should not be lightly discarded, at least in a medium-term perspective, given that low public investment is a serious issue in the euro area, with implications for potential growth and debt sustainability.

Enforcement: The Limits of Peer Pressure

Both rule design problems and governance failures have contributed to the poor enforcement of the SGP. First, compliance may be at risk when SGP targets are too demanding or rigid, particularly in a low-growth environment. Although recent reforms have strengthened the economic underpinnings of the framework, greater complexity is likely to create new loopholes. Second, the unique surveillance and coordination procedures within the EMU create new challenges to enforcement. The textbook model of supranational surveillance relies on a strict separation of powers between the monitoring entity of the rules and the executing entity to minimize the risk of moral hazard. In practice, this separation has been incomplete in the European Union—the European Council has the final word on monitoring decisions, while the Commission, guardian of the SGP, makes recommendations. In other words, the Commission has the right and duty to monitor SGP implementation without having full power to take actions in cases of noncompliance. As such, the system falls between the peer pressure model and complete supranational control, reflecting the absence of a full-fledged political and fiscal union.

This incomplete separation of powers has long been seen as a weakness of the pact. Finance ministers make the ultimate judgment on whether excessive deficits exist and penalties should be imposed. In assessing the fiscal performance of other member states, Council members may have incentives to be lenient and avoid actions that are politically costly for other members because they might find themselves in a position of fiscal distress in the future. This makes collusion more likely than strict application of the sanctions and correction mechanisms. In addition, enforcement could be tainted by political considerations. Otmar Issing, former chief economist of the ECB, described the situation as one in which potential sinners pass judgment on actual sinners. As a result, the credibility of the EDP as a tool for safeguarding fiscal discipline has been questioned. However, recent reforms may have, nonetheless, mitigated this problem (see end of this section).

The crisis has further highlighted the limits of moral suasion. Peer pressure is less effective when the number of fiscal delinquents rises, as observed during the global crisis (Figure 8.7). This ineffectiveness occurs because reputation costs decline, the “sinners judging sinners” incentive problem becomes more acute, and the difficulty of imposing sanctions increases with the number of delinquent countries.

Figure 8.7Euro Area: Share of “Noncompliers,” 1999–2013

(Percent, EA18)

Sources: European Commission Annual Macroeconomic Database; and IMF staff calculations.

Note: Fiscal effort compliance defined as those countries that failed to comply with the structural balance rule but had a change in structural balance larger than 0.5 percent of GDP. The “share of noncompliers” refers to the share of euro area countries that did not comply with fiscal rules. See Abbreviations section for composition of EA18.

Another issue is that the SGP enforcement mechanisms are not as strong as in other federations. Although the unique structure of the EMU and the relative weakness of the supranational level would call for strong enforcement tools, sanctions and corrective actions are, on the contrary, relatively mild in Europe. Sanctions usually consist of opportunity costs from financial deposits.21 The conditions for converting these deposits into outright fines are very strict and have, so far, never been applied. In addition, the EU framework does not provide for administrative sanctions, whereas they exist and are applied in other federations. In some federations, individual officials are held liable for fiscal slippages. In addition, sanctions only apply to euro area member states. For instance, countries under the EDP that are not part of the euro area are neither required to hold deposits at the EU, nor liable for fines for insufficient progress. By contrast, in federations, central constraints usually bear on all subnational governments in a nondiscriminatory way (Eyraud and Gomez 2014). Finally, corrective actions required for noncompliance are also relatively weak, in part because the European authorities do not have the ability to impose direct controls on national budgets. For instance, borrowing restrictions imposed by the federal level do not exist in the European framework, whereas they do exist in some federations.

Recent reforms to EU fiscal governance have strengthened enforcement. The Fiscal Compact requires countries to introduce structural balance rules in national legislation (preferably in the constitution); these rules should be monitored by independent institutions and incorporate correction mechanisms for deviations. In addition, sanctions for euro area countries have become more automatic because they are now adopted by the “reverse qualified majority” procedure. This new voting system gives more power to the Commission by ensuring that its recommendation or proposal is approved by the Council unless a qualified majority of member states vote against it. It is now more difficult for the Council to go against the Commission’s advice.

Nonetheless, political interferences are unlikely to disappear entirely. Commissioners continue to be nominated by member states and the EC staff has constant interactions with national authorities (including at the technical level), creating a risk that political constraints be internalized by the Commission. In this case, additional safeguards would be needed. For instance, independent and public reviews of the EC recommendations and technical work may strengthen its legitimacy and provide further guarantees of evenhandedness.

Issues for Discussion and Policy Options

This section presents options for future reforms. Its main argument is that it is possible to simplify the system of rules while keeping some flexibility against shocks and strengthening enforcement mechanisms.

Should the Preventive and Corrective Arms Be Consolidated?

In federations, fiscal targets are generally constrained by rules that follow a standardized design. This design includes three main features. A rule delineates a numerical target for a fiscal variable (often the overall balance) over a long period. A number of provisions deal with noncompliance when targets are not attained. Subcentral governments failing to abide by the rules may be subject to sanctions and corrective actions.22 Finally, escape clauses allow for temporary suspension of these provisions for a predetermined set of events.

The corrective arm of the SGP broadly fits into this standard model, whereas the preventive arm is more specific to the EU governance system. Similar to existing federations, the corrective arm defines numerical targets for certain fiscal variables (deficit and debt) and foresees procedures (such as EDP) in cases of noncompliance, as well as escape clauses. By contrast, the preventive arm has no clear equivalent outside Europe. Its surveillance and coordination procedures are meant to prevent the emergence of fiscal imbalances and ensure that member states achieve sound fiscal positions in the medium term.

Successive reforms have blurred the distinction between the two arms of the pact. Although the preventive arm was initially thought of as a surveillance and peer pressure mechanism, reforms have added many features of the standard rule model, including a fiscal target (structural deficit of less than 0.5 percent), a convergence path toward this target in case of deviation, escape clauses, and, more recently, sanctions. The fact that the Fiscal Compact requires the transposition of the MTO into national law creates another bridge between the preventive and corrective concepts—the MTO has become an annual target for fiscal policy rather than simply a “medium-term objective” used for the multilateral assessment of member states’ fiscal plans.

While maintaining the gradual approach of the SGP, there may be beneficial ways to integrate the two arms of the pact. The strengthening of the preventive arm is a welcome development (early corrections and sanctions are more likely to be effective). However, the conceptual distinction between the two arms has weakened over time, creating potentially redundant and conflicting fiscal targets. The fact that the most elaborate set of corrective actions and sanctions—the EDP—is triggered by the 3 percent deficit rule, which has a weaker economic rationale than the structural balance rule of the preventive arm, creates certain problems. It is very difficult to justify, on economic grounds, that a country at the MTO be placed under EDP if it breaches the 3 percent ceiling (this procedure has happened in the past).

A range of options for consolidating the two arms of the pact are available. A minimal approach could be to enhance the consistency of the two arms—in the same spirit that recent reforms set similar benchmarks for the annual fiscal effort. A more ambitious approach, which raises legal difficulties, would merge the two arms into a two-step procedure based on a common set of rules, possibly with the MTO as the overarching target. Minor slippages would trigger mild corrective actions; the EDP would be used exclusively for serious cases of noncompliance. Along these lines, IMF (2010) proposes tying EDP exit to fulfillment of the MTO.

Should the Current System of Fiscal Rules Be Simplified (and if So, How)?

The ultimate objective of preserving debt sustainability suggests a two-pillar approach to the design of the fiscal framework, with a fiscal anchor and an operational target. By analogy with monetary policy, a fiscal rule framework should set targets for both intermediate and final objectives. Because the final objective of the framework is to preserve fiscal sustainability, a natural anchor for expectations is the debt ratio, which creates an upper limit to repeated (cumulative) fiscal slippages. In addition to the anchor, the framework should also include an operational target, which would be under the direct control of governments, while also having a close link to debt dynamics. To the extent possible, the operational target should be easy to monitor, and serve to communicate the fiscal stance to the public.

The choice of an operational target is difficult and controversial. Public debt cannot play this role given that factors other than policy decisions affect public debt changes, including below-the-line operations and valuation effects. Available options include a revenue rule, an expenditure rule, a nominal balance, a structural balance target—in level or in first difference—or some combination. Currently, the European framework includes too many operational targets. Reducing their number and focusing on the most economically relevant should be a priority. If the consolidation of indicators raises too many legal obstacles in the short term, a first step could be to give more attention and prominence to the preferred target(s) in the fiscal analysis and advice of the Commission.

From a policy standpoint, the most natural operational target is the “fiscal effort” variable. The fiscal effort is defined as the change in the fiscal stance resulting from discretionary fiscal actions taken during the year on the spending and revenue sides. By definition, the fiscal effort should be directly impacted by discretionary budgetary policy actions. Using this variable as a main policy target would define a structural path for future fiscal balances and, implicitly, allow automatic stabilizers to operate fully along this path (in case of cyclical surprises).

The fiscal effort variable can be measured in different ways. Specifically, it can be estimated (1) by identifying and aggregating budget measures in percent of potential GDP (“bottom-up approach”); (2) or by calculating the change in the structural fiscal balance (“top-down approach”); (3) or through other structural indicators such as an annual expenditure growth ceiling linked to potential output growth.23 While these concepts are theoretically equivalent, they often return different amounts of fiscal effort (see Bi, Qu, and Roaf 2013). One of the reasons is that the change in the structural balance calculates the fiscal effort relative to the previous year, while expenditure and tax measures are typically estimated relative to an unchanged-policy scenario at a given point in time. Of the three fiscal effort variables, the expenditure growth ceiling may seem the most appealing. This indicator is tractable (constraining directly the budget), easy to communicate to the public, and conceptually sound provided that it is linked to some measure of long-term output growth.

A difficult question is whether a structural balance target in level should also be maintained in the framework. The ceiling chosen for the public debt anchor determines implicitly a steady-state level for the structural balance, which suggests that setting targets for both variables could be redundant (and potentially inconsistent). That is not to say that the structural balance indicator (in level) is useless and should be eliminated from the framework altogether. It fulfills a function, which is to monitor the progress toward the steady-state—that is the distance between the current structural position and the level consistent with the debt anchor.

From a measurement point of view, the structural balance (in level) creates greater issues than its first-difference version. This is mainly because ex post revisions of the output gap generally affect the series level rather than its slope (Balassone and Kumar 2007). A wide range of options are available for addressing the shortcomings of the structural balance (Box 8.2). Each of these options has advantages and disadvantages. The methodology should be further improved until the risk of misjudging the fiscal stance and the resulting policy errors are sufficiently contained.

Box 8.2.How to Move Forward with the Structural Balance Indicator

Methodological improvements can contribute to reducing measurement errors of the output gap. Recent research shows that multivariate filters, which extract information about the cycle from additional observable variables (such as capacity utilization) are less exposed to the end-point problem (see Benes and others 2010; IMF 2013a). In 2010, the European Commission introduced a new method for computing the output gap (d’Auria and others 2010), which uses capacity utilization data to help identify supply.

Another possibility could be to explicitly account for the bias ex ante. Bias could be accounted for in advance by including an ad hoc adjustment factor in the structural balance formula or by conducting a study about the predictability of revisions to the output gap. However, if the bias is not rooted in exogenous technical flaws but in strategic behavior of a political economy nature, introducing an adjustment may result in a larger bias to compensate for the adjustment. Moreover, the bias is unlikely to affect all countries equally. Thus, the adjustment would have to be tailored to each member country and possibly readjusted over time.

The structural rule could include a notional account recording ex post deviations between real-time and mature estimates (in the vein of the Swiss debt brake). When cumulative deviations exceed a threshold, correction measures would have to be taken, for instance, by cutting spending to realign it with the lower than initially estimated potential GDP.

Some have proposed replacing the structural balance with an indicator mimicking its properties without relying on output gap estimates. For instance, the “augmented growth-based balance rule” extracts cyclical effects from the nominal balance by using the difference between economic growth and trend (IMF 2009). However, this indicator does not have strong theoretical underpinnings and may incorporate a procyclical stance.

More radical options suggest abandoning the structural balance altogether. For instance, Debrun, Epstein, and Symansky (2008) propose replacing it with an expenditure rule that includes a correction mechanism associated with the debt level.

Some of the existing rules do not fit well in this simple framework. The 3 percent deficit rule has weak economic rationale and entails large costs when it fosters a procyclical fiscal stance. Dominated by the structural balance rule, the one-twentieth debt-reduction benchmark would become redundant if the structural balance were used to determine the necessity of an EDP, as suggested in the previous section.24

How Can Enforcement Be Further Strengthened?

Two main directions can be followed to improve compliance.25 The first approach reinforces the existing supranational framework by strengthening procedures, correction mechanisms, and sanctions, while making them more automatic. The second approach relies on alternative mechanisms to promote fiscal discipline, such as stronger market oversight or transfer of fiscal powers to the center.

Existing enforcement mechanisms can be made stronger. More automaticity could be introduced in moving up steps after a rule is breached and the breach is acknowledged. In some cases, procedural steps could be accelerated in well-defined circumstances, such as misreporting. The imposition of sanctions should nevertheless remain the result of a discretionary decision based on sound economic judgment.

A broad set of sanctions could be envisaged. Financial sanctions in bad times lack credibility because they exacerbate the financial difficulties of distressed governments. Hence, these sanctions (for example, reduced access to structural funds and other EU subsidies26) could be imposed only in good times, while nonpecuniary sanctions could also be considered in bad times. Administrative sanctions (such as personal sanctions or constraints on new staff hire) exist in other federations. Political sanctions (for example, limitation of voting rights) are another option.

A key question is whether past deviations from supranational fiscal targets should be offset subsequently.27 Currently, countries breaching the 3 percent rule or the MTO are required to bring the deficit back below the ceiling. But the effect of past deviations on debt does not need to be corrected subsequently, creating a risk that debt ratchets up over time until it reaches 60 percent of GDP.28 The debt-brake model addresses this issue by requiring compensation for past slippages. For instance, the Swiss debt-brake rule specifies a one-year-ahead ceiling on central government expenditure equal to predicted cyclically adjusted revenue, which effectively corresponds to maintaining a structural budget balance every year. Differences between budget targets and outcomes are recorded in a notional account. If the negative balance in the account exceeds a threshold, the authorities are required to take measures sufficient to reduce the balance to less than this level within three years. Debt brakes have been criticized for imposing unrealistic adjustments following large slippages given that the fiscal position should not only get back to the targeted level in the following year but also overshoot it because of the correction. However, never offsetting past deviations is misguided because debt eventually increases to a point that the debt ceiling becomes binding. A more balanced approach would be to target a gradual correction for countries with debt of less than 60 percent of GDP. This approach could be achieved by proper calibration of the fiscal rule formulas (IMF 2009).

Better compliance with fiscal rules may also come from stronger market oversight and discipline. Enforcement is stronger when financial markets penalize countries that breach fiscal rules. The provision enshrined in the Maastricht Treaty to ensure that member states do not assume other member states’ fiscal commitments (Article 125 of the Treaty on the Functioning of the European Union)—often referred to as the “no-bailout” clause—was meant to give financial markets an incentive to discriminate among countries and price each member state’s default risk. However, market discipline has not worked properly in the EMU because the no-bailout provision has lacked credibility; the scale of the crisis has warranted some risk sharing through the European Stability Mechanism and other instruments, and the sovereign-bank link has distorted the pricing of risk by markets (Allard and others 2013). Restoring market discipline and mitigating moral hazard are long-term endeavors. Some conditions should be fulfilled, including clear rules for the involvement of private creditors in bailouts of sovereigns and banks. The transition to such a regime would have to be carefully managed and implemented in a gradual and coordinated fashion, so as to not trigger sharp readjustments in investors’ portfolios and abrupt moves in bond prices.

Another possibility would be to rely more extensively on central controls. Restoring market discipline is an important element for fostering compliance and fiscal discipline, but doing so will take some time. Therefore, in the interim—and possibly as a long-term solution, too—enforcement will have to be imposed more directly by the center. This enforcement may have to come at the expense of a permanent loss of fiscal sovereignty for euro area members (for instance, if veto power of the center on national budgets were to be introduced). A thorough analysis of options to deepen fiscal integration in the euro area goes beyond the scope of this chapter (see Allard and others 2013 for an assessment of the costs and benefits of a fiscal union).


Despite recent improvements, the European fiscal governance system faces a number of challenges. The remaining gaps are most apparent in the complex design of fiscal rules and poor enforcement mechanisms. Public debt is approaching unsafe territory in several member states, meaning that the fiscal framework has a key role to play to put public finances back on sound footing. Fiscal governance needs to be particularly strong ahead of time—preventing the emergence of fiscal imbalances is more effective and sometimes easier than correcting them ex post. In this regard, the preventive arm of the SGP has to become more effective in enforcing structural balance targets and limiting the ability of member states to spend revenue windfalls in good times—a challenge given the uneven track record of countries in sustaining healthy structural positions for long periods.

Fiscal reforms have to be properly sequenced, while taking into account the trade-offs between priority and practicability. The most important reforms—those tackling the complexity of the framework and its enforcement—are probably the most difficult to implement (in part because of the legal constraints) and constitute medium-term objectives. Simplifying the framework may require rethinking its overall structure, including by consolidating the preventive and corrective arms and eliminating some redundant or ill-designed rules. Enhancing enforcement mechanisms is also complicated because compliance failures are partly rooted in the unique governance structure of the EU.

Going beyond the fiscal framework, better economic governance can play an important role in reducing future imbalances. The global crisis showed that there is no clear-cut separation between private and public sector balance sheets (Moghadam 2014). In particular, the original framework neglected the risks associated with excessive private leverage and divergence in competitiveness. Another lesson from the crisis is that there is no clear-cut separation between private and public sector balance sheets. Private imbalances can eventually end up as public sector liabilities—either through a direct bailout of the banking system (as in Ireland) or the lost revenue and increased spending required by deep and prolonged declines in output (as in Spain). Conversely, public imbalances can aggravate private imbalances. For instance, a weak sovereign may increase private sector stress if banks have large exposures to domestic public debt or if the government’s ability to honor financial safety net obligations is impaired (Goyal and others 2013). Therefore, improvements in fiscal and economic governance should be pursued together to minimize the occurrence of internal imbalances (both private and public), as well as their scope for disruption to the economy. Some recent reforms are positive steps in this direction. The Macroeconomic Imbalance Procedure goes beyond fiscal metrics to consider private debt, external current accounts, and net international investment positions. The banking union, especially the bail-in regime, better aligns incentives in the financial sector and should reduce taxpayer exposure to banking sector losses.


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This chapter is based on “Playing by the Rules: Reforming Fiscal Governance in Europe,” IMF Working Paper 15-067, 2015.


This simplified exercise should not be considered a formal test of compliance because (1) it is based on ex post data, (2) targets are assumed to be similar across countries and constant over time, and (3) the comparison is carried out for all 18 euro area countries, including those that adopted the euro after 1999.


See Abbreviations section for composition of euro area 12 (EA12) and EA18.


Years with a small output gap (between−1 and +1) are excluded from the average.


The negative correlation is also observed with real-time output gap data (extracted from stability programs).


The simulation assumes that the structural stance is unchanged when the output gap is small (between −1 and +1 percent).


Using real-time output gap data would not fundamentally change this result. The downward bias of the output gap concerns its level rather than its first difference (Balassone and Kumar 2007). There is little reason to think that the annual structural effort would be reduced if countries based their fiscal decisions on real-time (rather than ex post) output gap data.


The initial rules were the 60 percent debt cap, the 3 percent deficit ceiling, and the requirement that medium-term budget positions should be “close to balance or in surplus.”


In the mid-1990s, there was, on average, only one national rule per country in the European Community.


Given the complexity of the European framework, the counting of rules is a matter of judgment. In this chapter’s authors’ view, the framework has four main supranational rules—the 3 percent deficit rule, the 60 percent debt rule, an expenditure benchmark, and MTOs defined in structural terms. It also requires countries to enshrine a structural balance rule in national legislation.


The debt-stabilizing overall balance is computed as d × g/(1+ g), in which d denotes the debt-to-GDP ratio and g the potential growth in nominal terms (Escolano 2010).


With a budget semi-elasticity of 0.5 and a structural deficit of up to 0.5 percent of potential GDP, a 3 percent nominal deficit appears if the output gap deteriorates to 5 percent: −0.5 ≈−3 − 0.5 × (−5).


With an initial debt of 95 percent of GDP (average of the euro area in 2013) and nominal growth of 3 percent, the debt-stabilizing nominal deficit is about 3 percent of GDP. Because a structural deficit of less than 0.5 percent would generally translate into a nominal deficit of less than 3 percent, the debt ratio would decline.


Simulations are not reported in the chapter but are available from the authors upon request.


Provided that the country’s structural position is close to balance and the negative output gap is not excessively large.


Current output 4 percent above potential corresponds to the average of the peak output gaps in euro area countries since 1995 (excluding Estonia and Latvia, which are outliers).


This result is consistent with Kempkes (2012), who finds that in the EU15 sample, the output gap was underestimated by 1 percent, compared with final estimates for 1996–2011. (See Abbreviations section for composition of EU15.)


The expenditure benchmark, which is net of revenue measures, is conceptually equivalent to the structural balance (EC 2013b).


“In the case of an unusual event outside the control of the Member State concerned which has a major impact on the financial position of the general government or in periods of severe economic downturn for the euro area or the Union as a whole, Member States may be allowed temporarily to depart from the adjustment path towards the medium-term budgetary objective referred to in the third subparagraph, provided that this does not endanger fiscal sustainability in the medium term” (EC, 2013b).


The OECD database on Public Expenditure and Participant Stocks on LMP is available at


The main argument in favor of the golden rule is that, as in the case of a private company, a government should not attribute the full cost of a project that is expected to yield gains over several periods to a single year’s account.


If the Council adopts a decision on noneffective action under the preventive arm, the euro area member state in question can be asked to lodge an interest-bearing deposit, which can then be turned into a non-interest-bearing deposit if an EDP is opened (EC 2013b).


Corrective actions can be defined as a set of measures intended to put finances back on a sound footing, and that entail some temporary loss of autonomy for subnational entities. Sanctions are financial and administrative penalties imposed on the subcentral government or its officials; contrary to corrective actions, they only have a disciplinary function and do not contribute to restoring fiscal soundness (financial sanctions may, in fact, aggravate fiscal stress).


Conceptually, certain expenditure growth rules are equivalent to first-difference structural balance rules. Indeed, the structural fiscal balance declines (improves) when expenditure grows above (below) potential GDP—other things being equal. In addition, expenditure rules can incorporate the effect of revenue measures (see the design of the European expenditure benchmark).


Nonetheless, measurement errors and uncertainties affecting the estimates of potential output and the structural budget balance could argue in favor of maintaining the one-twentieth debt rule—as an objective and simple benchmark for consolidation progress.


National fiscal frameworks have a key role to play in strengthening the overall fiscal architecture. Reliance on national fiscal rules and fiscal councils is a central part of the efforts to foster compliance with supranational requirements. In essence, enforcement is likely to be more credible if it takes place at the level at which fiscal sovereignty is exerted. This important issue, which goes beyond the scope of the chapter, is not discussed here.


As of January 2014, structural funds can be suspended if a country does not comply with the EDP recommendations under the corrective arm.


Strictly speaking, correction mechanisms exist at the national level (they are mandated by the Fiscal Compact), but not at the supranational level.


For countries with public debt greater than 60 percent of GDP, the one-twentieth debt-reduction criterion functions de facto as a debt-brake correction mechanism.

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