To reduce the negative effects of a bank-lending crunch on economic activity, adequate credit provision should be ensured. Further bank recapitalization, restructuring and consolidation of the banking sector, and regulatory reform decisions will reduce uncertainty. A long-lasting configuration of the euro-area’s fiscal architecture can be achieved by tightly coordinated reforms of national fiscal frameworks. Substantial benefits will emanate from deepening further structural reforms. Financial sector reform in the EU is proceeding at a rapid pace, and poses challenges and opportunities for the EU.


To reduce the negative effects of a bank-lending crunch on economic activity, adequate credit provision should be ensured. Further bank recapitalization, restructuring and consolidation of the banking sector, and regulatory reform decisions will reduce uncertainty. A long-lasting configuration of the euro-area’s fiscal architecture can be achieved by tightly coordinated reforms of national fiscal frameworks. Substantial benefits will emanate from deepening further structural reforms. Financial sector reform in the EU is proceeding at a rapid pace, and poses challenges and opportunities for the EU.

II. Gaps in the Euro Area Fiscal Framework: Options for a New Fiscal Contract1

A. Introduction

1. For the second time in less than 10 years, the euro area’s fiscal framework2 is under severe stress. In both instances, the failure to encourage fiscal discipline in good times was key. Unsurprisingly, the increased flexibility during bad times that emerged from the first reform of the Stability and Growth Pact failed to address this flaw. Hence, a new debate has started on ways to improve the framework, and a high-level Task Force chaired by EU Council President Van Rompuy is expected to make concrete proposals by the end of October 2010. The concrete challenge in the design of fiscal policy rules and institutions is to devise credible and collectively sensible EU-wide mechanisms to limit national authorities’ discretion, while preserving their capacity to use such discretion when it is in their best interest to do so.3

2. This paper first identifies the main gaps in the existing framework and suggests key ingredients of desirable reforms (Section II). While first principles demand to think outside the box, possibly reopening the Treaty,4 alternatives approaches could close existing gaps to a considerable extent (Section III).

B. Fiscal Restraints in EMU: Rationale and Remaining Gaps

3. The combination of a centralized monetary policy with decentralized fiscal policies creates a unique configuration of interdependent policymakers (one central bank and multiple fiscal authorities) where coordination problems concern both the credibility of macroeconomic policies and their stabilizing role.5 The setup of EMU attempts to solve these problems with a politically independent central bank mandated to deliver area-wide price stability, and a common set of rules and principles guiding the conduct of national fiscal and structural policies. The case for binding fiscal constraints in a fiscally decentralized monetary union ultimately rests on the fact that all member’s solvency constraints need to be simultaneously satisfied, effectively exposing the credibility of the common currency to fiscal policy mistakes by the weakest performer. A related argument is that the incentives to maintain fiscal discipline may be weaker in monetary union, as individual members expect to be bailed out if they cannot credibly secure solvency through adjustment on their own.

4. Long-standing flaws that now need to be urgently addressed are:

  1. The preventive arm of the SGP has failed to encourage the buildup of sufficient buffers in good (boom) times, slowing down the decline in public debts and limiting countercyclical firepower in bad (bust) times. This is most evident in countries where financial excesses and asset bubbles gave the illusion of structural improvements in budget balances, permitting unsustainable spending increases. Exclusive reliance on soft law in the preventive arm of the SGP is partly to blame.

  2. Weak governance aggravated the structural flaws of the SGP. The regular fiscal surveillance has been narrowly focused on procedural aspects and formal deficit limits, while the enforcement of the EDP was tainted by political considerations inherent to the ultimate responsibility of the Council in implementing the Procedure. The result was insufficient room for sound economic judgment to shape sensible policy recommendations, undermining the effectiveness of preventive legal instruments. As public debt developments took the backseat, the analysis of fiscal risks was insufficient to support a genuine risk-management approach to fiscal policy.

  3. The fiscal framework has been lacking centralized crisis management and resolution capacities, increasing the risk of ad-hoc bailouts. It took a panic on sovereign debt markets to conceive under the pressure of events a conditional credit facility accessible to euro area members facing financing stress.

C. A New Fiscal Contract: Filling the Gaps

5. Two broad classes of reforms can be envisaged: those that create a central fiscal agency, and those seeking to perfect the existing framework within the boundaries of the Treaty or with only minor amendments to it.

Central Agencies

6. Perhaps the most natural solution to a coordination problem is to centralize decisions at a level where meaningful externalities can be internalized and scale economies, exploited for the good of all participants. Two models have recently received a lot of attention.

An independent fiscal agency

7. Two categories of proposals have been advanced to establish an independent fiscal agency (or a network of national agencies) with the explicit mandate to maintain government solvency: fiscal authorities, who akin to central banks, receive specific policy prerogatives to fulfill a well-defined mandate, and fiscal councils, which only play technical, advisory, and/or monitoring roles. All independent fiscal agencies build on (i) a simple and transparent mandate, (ii) instruments that the agency can freely use to constrain or incentivize national governments to act in a way consistent with agency’s mandate, (iii) independence from political constraints, and (iv) accountability (Debrun, Hauner and Kumar, 2009).

8. The main advantage of independent fiscal agencies is to strengthen fiscal discipline by fostering—or in the case of certain fiscal authorities, by imposing—a better use of policy discretion rather than subjecting budget aggregates to numerical limits bound to be undesirable in non-trivial circumstances. Hence, fiscal agencies can help strike a better balance between the credibility brought about by binding rules and the flexibility required by changing circumstances because they are insulated from the pressures nourishing indiscipline. Yet relatively few countries have adopted such institutions, and they often take the form of rather weak fiscal councils (Wyplosz, 2008).

9. In the EU context, the proposed fiscal authorities or councils often aim at strengthening the enforcement of the SGP (or replacing it altogether) and in some cases, at improving fiscal stabilization. Fiscal authorities would typically receive the power to set binding constraints on budgetary aggregates (Calmfors, 2003; von Hagen and Harden, 1995; Wyplosz, 2005), or even change selected policy instruments within pre-set limits (Wren-Lewis, 2002) and mandate across the board spending cuts (von Hagen and Harden, 1995). The tasks of fiscal councils are more varied and often revolve around independent monitoring and public assessments of governments’ commitments under the SGP. Their action could induce fiscal discipline by raising the reputational or political costs of reneging on public and measurable promises, and by promoting a better pricing of risk in financial markets. Some have also suggested that the fiscal council’s assessment could form the basis for a judicial enforcement mechanism through the European Court of Justice.

An EMU bond6

10. Even closer to an embryo of fiscal federalism are recent proposals to create a single European bond (e.g., Delpla and von Weizsäker, 2010). By centralizing public debt issuance, two problems could be solved at once. First, one would limit the risk of contagious sovereign debt crises and high-debt traps in fiscally vulnerable countries. Second, terms of access to the common pool of financing (in terms of price or quantities) could be used as an incentive device to encourage compliance with the existing rules-based fiscal framework. Other benefits of such a mechanism include lower average borrowing costs—lower risk and liquidity premiums—and the creation of a deep sovereign bond markets comparable in size to the US treasury bond market. As existing proposals remain limited to first principles, it is beyond the scope of this paper to discuss the operational complexities that still require careful thinking.

11. Such an extensive pooling of resources represents a paradigm shift. To the extent that the common debt would be a joint and several liabilities, it would arguably turn the “no-bail-out” clause of the Treaty (Art. 125) on its head. However, as recent turmoil showed, the fragmentation of fiscal power and debt markets among national governments with varying records of fiscal discipline can be a direct threat to the stability, if not the very existence, of the common currency. Besides, the European Financial Stability facility (EFSF) adopted in response to extreme market stress creates an important precedent of resource pooling that could clear the way for a permanent mechanism along the lines of euro bond proposals.7

12. The various proposals floated so far recognize two issues that require a new, independent institution to manage the process. The first is to address the moral hazard inherent to assistance schemes. On-lending of the proceeds of the common EU bond will need to be on conditions that discipline member states Pricing formulae could explicitly reflect the numerical limits on debts and deficits enshrined in the Treaty or deviations from the medium-term objectives for the structural balance. Such a disciplining mechanism would provide a smoother and more predictable pricing of risk than that associated with fragmented debt markets, while virtually eliminating the possibility of a sudden cut-off from market financing. It could also explicitly reward and penalize countries in function of their contribution to the creditworthiness of the scheme, thus providing the most creditworthy countries with an incentive to join. The second issue is that a mechanism needs to be available to deal in a comprehensive and transparent way with individual euro area members facing financing difficulties.

Strengthening the existing framework

13. Even though the magnitude of the crisis and its fiscal fallout provides a unique opportunity for enacting deep reforms, the appetite for a paradigm shift may be low, pointing to less transformative, but nonetheless ambitious options. A starting point would be to ensure that all member states have the strong budget procedures and institutions required for—national and EU-wide—fiscal rules to be effective. In the euro area, binding legal instruments (e.g., a Directive pursuant to Article 136) could be used to foster convergence towards the highest standards of fiscal governance at the national level.

Enforcement and governance

14. A credible enforcement of the pact requires modifying the role of the Council in implementing the EDP, a broader range of sanctions, and formal mechanisms to hold national governments accountable for fiscal commitments. This can be done by: (i) introducing greater automaticity in moving up steps in the EDP during benign times, while giving stronger discretionary powers to the Commission when sanctions ultimately have to be decided; (ii) establishing non-pecuniary sanctions to avoid undermining adjustment efforts; (iii) and adopting measures that maximize reputational and political costs faced by offenders.

15. Greater automaticity in the EDP would rebalance the 2005 reform of the Pact, which allowed for longer delays in adverse circumstances and was widely seen as a weakening the of SGP. The idea is that in benign times, steps in the EDP could be made fully automatic and, in some well-defined circumstances—such as misreporting, and high and rising debt levels—could even be accelerated.

16. The imposition of sanctions should nevertheless remain the outcome of a discretionary decision based on sound economic judgment. Indeed, automaticity increases the risk of facing circumstances where imposing sanctions would be so counterproductive that abandoning the procedure could be perceived as a better course. At that stage, the role of the Commission could be increased by placing the decision to impose sanctions directly in its hands, with only a veto right from the Council decided at qualified majority or unanimity. Alternatively, the Council could have to publicly justify (for instance before the European Parliament) why it deviates from a Commission’s recommendation.

17. A broader set of sanctions should be envisaged. Pecuniary sanctions in bad times lack credibility because they only complicate adjustment. Hence, these sanctions should be imposed only in good times, while non-pecuniary sanctions (e.g., related to voting rights in the eurogroup) could be considered.

18. National governments should face formal accountability requirements. At the central level, ex-ante peer reviews of budgets (as proposed by the Commission and endorsed by the Council) are unlikely to be sufficient to foster a stronger sense of responsibility vis-à-vis commitments to sound public finances. More formal procedures could thus be envisaged For instance, countries could be required to explain in a public hearing with the Council or the ECFIN committee of the European Parliament why they deviated from the previous recommendations. At the national levelt the national level, a better integration of stability programs in national budget processes could also increase accountability.

19. Surveillance should be expanded, opening the possibility to activate an EDP regardless of the deficit trigger if clear risks to public debt dynamics are detected. Fiscal surveillance should be based on a broad set of indicators signaling imbalances whose unwinding could have a severe and durable budgetary impact. Signs of such imbalances could trigger early warnings. A greater role should also be given to the monitoring of expenditures. By mapping deficit targets into medium-term expenditure ceiling (to be adjusted for tax expenditure), one would establish more easily the extent to which revenue windfall are spent.

More attention to debt sustainability and a Pact that binds in good times

20. The SGP should allow for the debt level to be used as an explicit trigger in the EDP. Various options can be envisaged:

  • EDPs concerning countries where public debt is above 60 percent of GDP could only be abrogated when they reach a structurally balanced position (or their medium-term objective). This would contribute to strengthen budget balances on average, and incidentally give teeth to the preventive arm of the Pact for countries exiting from excessive deficits.

  • As the Commission proposed in its May 12, 2010 Communication, the EDP could even be activated regardless of the deficit trigger, if the decline in public debt towards the 60 percent reference value is deemed insufficient. One potential problem with that approach is that changes in public debt can reflect many other factors than policy decisions, including a host of “below-the-line” financial operations without lasting impact on the debt position. It would therefore be important to focus on the medium-term trend in public debt implied by unchanged policies.

21. Safeguards for fiscal stabilization in bad times should be matched by symmetric incentives to tighten in good times.

  • The letter and the spirit of the EDP could be reconciled by giving a greater to role cyclical considerations and other developments influencing revenue buoyancy in the assessment of budgetary positions. The reference value specified in Treaty Protocol No 12 could thus be re-defined as the upper-bound of a nominal deficit range consistent with structural balance.8 The range would allow for inevitable uncertainty in the real-time estimation of cyclical positions.

  • Taking the Treaty as given, member states could be incentivized to create “rainy day funds” (Sapir and others, 2003) or to run higher balances in good times by giving them credit during bad times for overperforming on fiscal commitments laid out in their stability programs. Alternatively, a fictitious “compensation account,” as in Switzerland, could allow adjustments to the deficit ceiling to the extent that they do not exceed accumulated overperformance on the account. Conversely, an overdraft position on the compensation account beyond a certain threshold would tighten the deficit ceiling triggering the EDP. The latter system could be centrally run (it involves no real money), avoiding manipulations or improper uses of rainy day funds at the national level. “Rainy day funds” could be mandated through a Directive pursuant to Article 136.

  • Some hard-law elements could be introduced in the preventive arm of the SGP. This is the option preferred by Commission in its recent Communication, when it proposes mandatory interest-bearing deposits in case of insufficient progress towards the Medium-Term Objectives.

  • Building on the successful experience of some countries, certain tax and expenditure items could be automatically adjusted to cyclical developments, complementing the work of automatic stabilizers (Blanchard and others, 2010). Again, Art. 136 could be used to leverage domestic reforms along these lines. One alternative would be to make part of the EU transfers to member states contingent on country-specific cyclical conditions.

A third way: A Pact that binds through national frameworks

22. One possibility to secure an effective enforcement of the common rules would be to increase ownership at the national level by encouraging euro-area member states to transpose in their national fiscal frameworks the common objective of fiscal responsibility. So far, the harmonization of national rules around the common objectives has been left mostly to members’ discretion. National fiscal rules have been on the rise since the inception of the SGP (see Debrun and others, 2008), and in current circumstances, leadership by large EMU members could deliver greater harmonization. If needed, more explicit coordination could be envisaged in the euro area on the basis of Article 136 of the Treaty.

23. Regardless of the process, the harmonization of national frameworks should be guided by two principles: (i) rules compatible with the spirit of the SGP, that is at least structural balance close to balance or in surplus, and (ii) a credible national enforcement procedure which would be adapted to the particular context of each member states in terms of decentralization, form of government, and legal tradition. As credible enforcement requires a strong legal basis and an important dose of expert judgment, non-partisan national fiscal councils could be created with the mandate to monitor fiscal performance continuously, to analyze the contribution of policies to underlying fiscal developments, to advise on early preventive action in case slippages are detected, and ideally, to trigger a judicial procedure activating sanctions.

24. One interesting dimension of the “third way” is that the creation of these national fiscal responsibility councils with harmonized mandates and scope could effectively lead to the establishment of a European System of Fiscal Responsibility Council (ESFRC). It could work closely with the Commission, with a view to improving fiscal surveillance, enhancing the analysis of budgetary developments underlying EDPs, and strengthening horizontal coordination. It could also serve as a specialized vehicle for the ex-ante peer review of national budgets proposed by the European Commission.

Crisis management

25. Even the best-conceived systems can and do fail. Because debt crises are triggered by liquidity problems, a conditional financing mechanism should be created to avert market disruptions (credit rationing and excessive risk premiums). To minimize moral hazard and maximize credibility, the facility should be paired with enhanced high-frequency monitoring capabilities at the center, along with an immediate escalation of the Excessive Deficit Procedure to Article 126–9, whereby the Council has full authority to request specific measures within a pre-defined time frame against the threat of sanctions.9 In the face of extreme stress, one option would be a transfer system which could take the form of highly-concessional loans with extensive grace periods. Again, the moral-hazard and weaker ex-ante market discipline arising from an explicit assistance scheme further strengthen the case for improved surveillance stricter enforcement mechanisms developed above.

D. Concluding Remarks

26. Extreme sovereign market stress was a wake-up call to euro-area leaders that fiscal discipline was a collective responsibility requiring more solid institutional underpinning. An intense debate is now burgeoning on desirable ways to enhance the euro’s fiscal foundations.

27. As guardian of the Treaty, the Commission took the lead in issuing a set of recommendations to address key issues in the operation of the SGP, including a greater focus on debt sustainability in the EDP, more binding preventive instruments, a broader analysis of risks, and ex-ante peer review of budget proposals. However, more fundamental steps are needed. In particular, the flawed enforcement procedure of the SGP needs repair, which almost inevitably implies amending the Treaty. Indeed, European leaders’ proclaimed willingness to strengthen the common fiscal framework by expanding the arsenal of sanctions will remain cheap talk as long it is not accompanied by a serious commitment to make these sanctions inevitable when violations of the rules are patent.

28. While a long-lasting configuration of the euro-area’s fiscal architecture arguably involves a central fiscal authority entrusted with the power to impose legally binding and enforceable deficit limits to member states, much of the benefits of such a paradigm shift could be achieved by tightly coordinated reforms of national fiscal frameworks. It was argued that Article 136 of the Treaty, which gives to the Council potentially great room for maneuver to enhance budgetary cooperation in the euro area, forms a useful basis to set up a European System of Fiscal Councils. In such a setup, non-partisan fiscal councils would help enforce at the national level rules that reflect the spirit of the SGP (structural budget balance or surplus), coordinated by the Commission with a view to improve fiscal surveillance and strengthen the national ownership of the common rules.


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Prepared by Xavier Debrun. Without implication, thanks are due to Atilla Arda (LEG) and Wim Fonteyne (EUR) for advice, input and ideas.


The fiscal framework is mainly based on the Treaty’s Excessive Deficit Procedure (EDP) and two regulations forming the Stability and Growth Pact (SGP). Treaty provisions on multilateral surveillance, the EDP Protocol and Council Regulation on the EDP Protocol are part of the fiscal framework as well.


Policy discretion means that policymakers are free to choose the value of instruments under their control at any point in time, which implies the absence of any ex-ante commitment or binding constraint on specific actions such as those prescribed by a policy rule or another institution.


In this chapter, “the Treaty” refers to the Treaty on the Functioning of the European Union, unless specified otherwise.


Beetsma and Debrun (2004), and Beetsma and Giuliodori (2010) propose comprehensive surveys of the monetary-fiscal coordination issue in EMU.


This section draws on Fonteyne (2009).


With the EFSF, the Council effectively achieved what an area-wide fiscal authority would have done: to preserve the financial stability of the monetary union by providing centralized fiscal backstopping in exchange of an intrusive surveillance of commitments by vulnerable entities to adjust their policies.


The EDP Protocol can be changed by a unanimous decision of member states that does not require a potentially lengthy ratification process.


This would likely require an amendment to Art. 126.