Euro Area Policies: Selected Issues

This Selected Issues paper assesses the youth unemployment problem in advanced European economies, especially the euro area. Youth unemployment rates increased sharply in the euro area after the crisis. Much of these increases can be explained by output dynamics and the greater sensitivity of youth unemployment to economic activity compared with adult unemployment. Labor market institutions also play an important role, especially the tax wedge, minimum wages, and spending on active labor market policies. The paper highlights that policies to address youth unemployment should be comprehensive and country specific, focusing on reviving growth and implementing structural reforms.

Abstract

This Selected Issues paper assesses the youth unemployment problem in advanced European economies, especially the euro area. Youth unemployment rates increased sharply in the euro area after the crisis. Much of these increases can be explained by output dynamics and the greater sensitivity of youth unemployment to economic activity compared with adult unemployment. Labor market institutions also play an important role, especially the tax wedge, minimum wages, and spending on active labor market policies. The paper highlights that policies to address youth unemployment should be comprehensive and country specific, focusing on reviving growth and implementing structural reforms.

Fiscal Governance in the Euro Area: Progress and Challenges1

1. 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 and 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 area-wide interest rates due to crowding out; contagion effects; and bailout costs.

2. 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 to the impaired financial sector. Fiscal rules were put to a 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.

3. 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 pre-crisis 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 interferences became particularly apparent when the Council decided to hold in abeyance the Stability and Growth and Pact’s procedures in 2003.

4. This paper 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 paper is structured as follows. Section I briefly reviews the underlying drivers of the public debt increase in euro area countries during the crisis. Section II and III examine past reforms and the track record of the framework. Section IV identifies remaining gaps in the areas of rule design and implementation. Section V discusses options for future reforms. Section IV concludes with some considerations on reform priority and sequencing.

A. The Setting: Public Debt on an Upward Trend

5. Public finances have deteriorated significantly since 2008. Average public debt-GDP ratio soared to 95 percent in 2013, almost 30 percentage points above the pre-crisis level. The debt increase during the crisis was due to a combination of cyclical and discretionary factors. This is illustrated by a decomposition (Table 1) using the Debt Sustainability Analysis framework (IMF 2013c).

Table 1.

Decomposition of Debt Change; in the Euro Area 2008–13 1/

article image
Source: IMF staff calculation

The decomposition is applied to the EA18 aggregate data.

Cumulative interest payments over the period,

6. 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 reflected financial sector intervention and rescue packages in the early stages of the crisis, as well as the realization of contingent liabilities (Blanchard and others, 2013).

7. 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 debt surge.

8. The economic contraction 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 very minimal increases in nominal GDP over 2008-2013. As a result, the interest component dominated the changes in the interest rate-growth differential term, with a net contribution of 11.7 percentage points, or 40 percent of the total increases in debt-to-GDP ratio.

9. One-fourth of the debt increase resulted from the accumulation of primary deficits over time, although the discretionary part was limited. Of the 29.2 percentage point increase in the debt-to-GDP ratio since 2008, 7.7 percentage points can be accounted for by the cumulative primary deficits, more than half of which were due to changes in cyclical conditions (19 percent). The remainder reflected the accumulation of cyclically adjusted primary deficits (CAPB). Further analysis reveals that a substantial part of the accumulated CAPB can be attributed to one-off items. The contribution from the accumulated structural balance to debt increases since 2008 was modest—about 1.0 percentage point for the euro area or slightly above 3 percent of the total debt increase.

10. 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 EU fiscal and economic governance framework since its inception.

B. Past Reforms of the Fiscal Framework

11. The European fiscal governance system is established by a number of legal texts. The main principles are defined in the two EU treaties (Treaty on European Union and Treaty on the Functioning of the European Union), which lay the ground for the surveillance and coordination of the member states’ fiscal policy. The SGP refers to the secondary legislations that implement the Treaties’ requirements.

12. Since 1997, the secondary legislations governing the SGP have been reformed several times. The first major revision, which dates back to 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 (“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 taken by 25 Member States through the intergovernmental Treaty on Stability, Coordination and Governance (TSCG), whose fiscal provisions—referred to as “Fiscal Compact” (FC)—transpose elements of the SGP into national legislations.

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

  • 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 on the center stage under both the preventive and corrective arms. In 2011, the Commission improved the measurement of the structural effort with the introduction of the expenditure benchmark and the concept of “adjusted fiscal effort.”

  • 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 piled up overtime. 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 1/20th debt reduction benchmark becoming a possible trigger of the EDP in 2011.

  • Strengthen enforcement mechanisms. Successive reforms have stepped up enforcement in several ways: (i) foster 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 Commission’s recommendations could be incorporated into national budgets and policies; (ii) introduce earlier and stronger sanctions, as late sanctions were found to be non-credible and counter-productive; and (iii) entrust independent institutions such as fiscal councils in monitoring fiscal rules.

  • 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 in case structural reforms are adopted, provided that these entail short-term budgetary costs and long-term gains.

  • Bring more specificity in 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 ageing costs.

C. Track Record under the SGP

14. While 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. Currently, nearly all euro area economies have breached at least one of the fiscal rules. Figure 1 compares fiscal outturns with SGP targets or ceilings since the adoption of the euro.2

Figure 1.

Non-compliance with European Fiscal Rules

Citation: IMF Staff Country Reports 2014, 199; 10.5089/9781498308007.002.A005

Source: AMECO database.Note: Not all member states had to comply with the rules over the whole period, as some countries joined the EMU after 1999.1/ Number of years with fiscal deficit above 3 percent divided by total number of years.2/ Number of years with debt above 60 percent divided by total number of years.3/ Number of years with structural deficit higher than 0.5 percent divided by total number of years.4/In the subset of years with structural deficit above 0.5 percent, share of number of years with annual fiscal effort below 0.5 percent of potential GDP. Fiscal effort is defined as the change in the structural balance.

15. Compliance has been the highest with the 3 percent deficit ceiling. Almost all countries have complied with this target more than half of the time since 1999 (and even more consistently prior to the crisis). Based on ex post data, Greece and Portugal have failed to keep their deficit below 3 percent of GDP every year since they joined the euro.

16. About half of the countries have missed the 60 percent target more than half of the time. At the individual 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 EA18), public debt has been above 60 percent of GDP every year since 1999.

17. Structural deficits have been persistent, reflecting difficulties to build buffers in good times. Compliance with the “close to balance position” has been extremely rare, except in Finland and Luxemburg. In the euro area-18 as a whole, there has not been a single year with a structural deficit below 1 percent of potential GDP. The preventive arm has failed to encourage the buildup of sufficient buffers in good times. While the output gap was positive or close to zero from 1999 to 2007, 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 2). Over 1999–2013, the euro area as a whole had a tendency to tighten (resp. loosen) the structural stance by about 1 percentage point following a year with a negative (resp. positive) output gap.3 At the individual country level, the correlation between the change in the structural balance and the initial output gap is also negative (except in Finland and Luxemburg), suggesting that the fiscal stance was pro-cyclical over the period.4

Figure 2.
Figure 2.

Public Debt

[Percent of GDP; 1999–2013)

Citation: IMF Staff Country Reports 2014, 199; 10.5089/9781498308007.002.A005

Source: AMECO data: IMF staff calculation.Note: Calculations based on ex-post output gap data.

18. Had the euro zone 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 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 (resp. decreasing) by 0.5 percent of GDP when the previous year’s output gap is positive (resp. negative).5 The simulation is based on eurozone-18 aggregate data. A fiscal multiplier of 1 (declining to 0 in 5 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 (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 3.
Figure 3.

Structural Balance and Output Gap 1/

(Euro area aggregate; ex post output gap data)

Citation: IMF Staff Country Reports 2014, 199; 10.5089/9781498308007.002.A005

Source: AMECO database.1 The figure 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 me results’ interpretation.Note: The 2009 data point relates the 2008 output gap to the change in the structural balance in 2009 relative to 2008.

D. Pending Issues and Areas for Further Progress

The Growing Complexity of the Framework

Successive legislative changes have made the SGP increasingly complex

19. 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 really binding.7 Later on, 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 (e.g., 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 inflation of supranational rules is the relative paucity in 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.

20. Today, 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 4). Countries are required to converge towards 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 towards their MTO by means of a national rule, whose specification and scope may be slightly different from the MTO’s.

Figure 4.
Figure 4.

Supranational Constraints and Rules on Fiscal Aggregates

Citation: IMF Staff Country Reports 2014, 199; 10.5089/9781498308007.002.A005

The high number of rules and sub-rules creates risks of overlap and inconsistency

21. Compared to 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 sub-central governments (states and sub-state entities), compared to five in the euro area.9 In Canada, the United States, and Switzerland, there is no federal restriction 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 1/20th 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 multi-step approach—probably motivated by the relative weakness of enforcement tools, and the desire to make peer pressure more effective—is non-existent in the federations reviewed by Eyraud and Gomez (2014). Overall, the large number of primary and secondary rules may result in redundancy and inconsistency.

22. 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. While the 3 percent nominal deficit rule was initially set to stabilize and cap public debt at 60 percent of GDP (under the assumption of a 5 percent nominal growth), downward revisions to potential growth, which is currently estimated at about 3 percent in nominal terms in many euro area countries, suggest that debt would actually converge towards 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, as 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 debt ratio reduction.12 Simulations show that this pace of reduction is sufficient to either reduce public debt below 60 percent by the end of the forecast period or, if the debt is above 60 percent, comply with the 1/20th 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 in order to strengthen compliance and ownership. This may create inconsistencies if a target or procedure is defined differently by the national and supranational legislations (although the latter can generally be amended). A similar issue may arise with the path towards the MTO, as 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 to achieve the targets and escape clauses may also not match exactly.

The Difficult Migration from Nominal to Structural Balance Targets

23. Nominal balance rules present serious shortcomings. While the 3 perfect deficit ceiling leaves sufficient room for automatic stabilizers to operate under normal circumstances,14 it does not prevent and may even encourage a pro-cyclical fiscal stance (see Section III). During the last decade, the deficit ceiling allowed for fiscal expansion during the pre-crisis boom (e.g., in Spain) and called for politically difficult tightening when the economy weakened in 2011–13. The drawbacks of the nominal deficit ceiling are particularly flagrant when the economy is booming, as it is compatible with very large structural deficits. For instance, when the 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 above, a 3 percent deficit would bring public debt towards 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 the debt level and growth potential; creates incentives for creative accounting/one-off measures; and does not capture stock flow adjustments, which accounted for about 30 percent of the euro area debt increase during the recent crisis (see Section I).

24. The structural balance, which is central in the EU framework since the 2005 reform, addresses some of these issues. Its computation entails decomposing the fiscal position in two parts: one representing the fiscal response to economic activity and other transitory factors, and another one measuring the policy stance. A first advantage of the structural balance is that this indicator constitutes 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 prior to 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 ageing costs. The formula for the MTO “reference value” is designed to ensure that member states are on course towards a sustainable debt position (EC, 2013b).

25. However, computing structural budget balances is difficult and subject to significant errors. Specifically, the structural balance is prone to ex post revisions due to 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 5).16 This suggests that 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, this would produce a permanent drift of public finances. This problem affects all structural stance indicators of the European framework, including the expenditure benchmark.

Figure 5.
Figure 5.

Real-Time Estimation Error of the Output Gap

(Difference between ex-post and real-time data; 1999–2013)

Citation: IMF Staff Country Reports 2014, 199; 10.5089/9781498308007.002.A005

Source: AMECO database (ex post data), and stability programs (real-time estimates)

26. Another issue is the difficulty to extract the non-discretionary component of revenue. The standard methodology filters out cyclical movements by using constant elasticities of revenue to the output gap. However, this is not always sufficient to remove all cyclical factors. While the business cycle is the most prominent source of macroeconomic fluctuations, these can arise from other disturbances such as boom-and-bust cycles of asset or commodity prices, and changes in the composition of the output. To address this issue, the calculation of 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 benchmark17, consists in measuring discretionary revenues through a bottom-up approach by using budget estimates of tax measures mandated by law. While this second approach is conceptually more appealing, the estimation faces practical difficulties, in particular in the definition of the unchanged policy scenario.

27. Despite these issues, the focus on the structural balance remains appropriate. While 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/troughs of the cycle.

28. Measurement issues point to the need to further improve the methodological underpinnings of the concept. They may also explain the inflation 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—the 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

29. As its name suggests, the purpose of the SGP is also 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 towards sustainability over 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.

30. 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, as 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 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 towards it.18 A more relevant question is therefore 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 minus 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.

31. By focusing on annual/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 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 and others 2005; Heinemann, 2005; Deroose and Turrini, 2006). Nonetheless, there is evidence 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, exceeds one per cent of GDP in some countries. 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.”

The Trade-Off Between Fiscal Consolidation and Structural Reforms

Structural reforms are generally successfully implemented in countries with healthy initial fiscal positions or countries 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 that consolidation and reforms rarely co-exist in practice:

  • Political capital is limited and governments that are too ambitious in terms of reforms are not reelected.

  • Some structural reforms have large short-term budgetary costs. These costs can be direct, such as funding a public R&D program. But there are also indirect costs—in particular the cost of compensating the losers. All 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, IMF (2012) has recommended that structural reforms be complemented by policies to boost aggregate demand.

32. 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 come to the fore again in recent years, as the financial crisis prompted politically-easier cuts in government investment in many advanced economies, reinforcing a long-term declining trend (Figure 6). With private investment also falling in many countries, medium- and long-term growth prospects could be impacted. 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 6.
Figure 6.

Investment in the Euro Area

(Share of Potential GDP; Total Economy)

Citation: IMF Staff Country Reports 2014, 199; 10.5089/9781498308007.002.A005

33. 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 over the long run. This type of rule has some intuitive appeal but raises concerns, as 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 link to sustainability.

34. A better approach could be to boost the ability of the center to fund public infrastructure projects. Such investments could include cross-border projects in transportation, communications, and energy networks. This could be done in the form of public-private partnerships, while keeping national budgets within the bounds of the fiscal framework. Such European-level projects raise the politically difficult question of how to finance them (Allard and others, 2013). But 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

35. Rule design problems and governance failures may have contributed to poor enforcement of the SGP. Compliance may be at risk when SGP targets are too demanding or rigid, in particular in a low-growth environment. While recent reforms have strengthened the economic underpinnings of the framework, greater complexity is likely to create new loopholes. The second aspect pertains to the surveillance and coordination procedures within the EMU. The textbook model of supranational surveillance rests 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 is incomplete in the European Union, as the Council has the final word on monitoring decisions, while the Commission, guardian of the Pact, only makes recommendations. In other words, the Commission has the right and duty to monitor the SGP implementation without having full power to take actions in case of non-compliance. As such, the system falls between the peer pressure model and full supranational control, reflecting the absence of a full-fledged political and fiscal union.

36. This incomplete separation of powers has long been seen as a weakness of the Pact. Finance ministers make the ultimate judgment on whether or not 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, as they might be 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 has been questioned as a tool to safeguard fiscal discipline. Recent reforms may have, nonetheless, mitigated this problem (see below).

37. 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 crisis (Figure 7). This is because reputation costs decline; the “sinners judge sinners” incentive problem becomes more acute; and the difficulty to impose sanctions increases with the number of delinquent countries.

Figure 7
Figure 7

Euro Area: Share of “Non-Compliers”

(1999–2013, EA18)

Citation: IMF Staff Country Reports 2014, 199; 10.5089/9781498308007.002.A005

Souroes: AMECO; and IMF.Note: Fiscal effort compliance defined as those countries who failed to comply with the structural balance rule but had a change in structural balance larger than 0.5 percent of GDP.1 The “share of non-compliers” refers to the share of euro area countries who did not comply with fiscal rules.

38. Another issue is that the SGP enforcement mechanisms are not as strong as in other federations. While 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 in opportunity costs from financial deposits.19 The conditions to convert 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, while they exist and are applied in other countries. In some federations, individual officials are held liable for the 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 a deposit at the EU, nor liable to a fine in case of 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 in case of 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, while they exist in some federations.

39. Recent reforms of the 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 in case of deviations. In addition, sanctions for euro-area countries have become more automatic, as 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 votes against it. It is now more difficult for the Council to go against the Commission’s advice.20

E. Issues for Discussion and Policy Options

Should the preventive and corrective arms be consolidated?

40. 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 time period. A number of provisions deal with non-compliance when targets are breached. Subnational governments failing to abide by the rules may be subject to sanctions and/or corrective actions.21 Finally, escape clauses allow for temporary suspensions of these provisions in case of predetermined events.

41. The corrective arm of the SGP broadly fits into this standard model, while the preventive arm is more specific to the EU governance system. Similarly to existing federations, the corrective arm defines numerical targets on certain fiscal variables (deficit and debt) and foresees procedures in case of non-compliance (EDP), 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 reach a sound fiscal position in the medium-term.

42. Successive reforms have blurred the distinction between the two arms of the Pact. While the preventive arm was initially thought as a surveillance and peer pressure mechanism, reforms have added many features of the standard rule model, including a fiscal target (structural deficit below 0.5 percent), a convergence path towards 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, as 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.

43. 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 (as 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 (see Section IV.A). The fact that the most elaborate set of corrective actions and sanctions—the EDP—is triggered by the 3 percent deficit rule which has weaker economic rationale than the structural balance rule of the preventive arm is somewhat problematic. 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 has happened in the past).

44. There is a range of options to consolidate the two arms of the Pact. A minimal approach could be to enhance the consistency of the two arms—in the same spirit as 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 overarching target. Minor slippages would trigger mild corrective actions, while the EDP would be used exclusively in serious cases of noncompliance. Along these lines, IMF (2010) proposed to tie the EDP exit with the fulfillment of the MTO.

Should the current system of fiscal rules be simplified (and how)?

45. 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 on both intermediate and final objectives. As 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.

46. The choice of the operational target is more difficult and controversial. Public debt cannot play this role, as 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 a combination of them. Currently, the European framework includes too many operational targets (see Section IV.A). Reducing their number and focusing on the most economically relevant should be a priority. If consolidating 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.

47. From a policy standpoint, the most natural operational target is the “fiscal effort” variable. Fiscal effort, defined as the change in the structural stance, is directly affected by tax and expenditure measures. As recognized in the SGP preventive arm, this indicator can be measured either as the change in the structural balance or through an expenditure benchmark (net of revenue measures) based on potential growth.22 The second method is conceptually preferable, but raises several practical difficulties in the estimation of revenue measures.

48. A more difficult question is whether a structural balance target in level should also be maintained in the framework. Although the structural balance level is important to assess the underlying fiscal position and constitutes a natural medium-term target to anchor public debt, the concept creates greater measurement 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). There is a wide range of options to address the shortcomings of the structural balance (Box 2). All these options have pros and cons. The methodology should be further improved until the risk of misjudging the fiscal stance and the resulting policy errors are sufficiently contained.

How To Move Forward with the Structural Balance Indicator?

Methodological improvements can contribute to reduce 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; and 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. This could be done by including an ad hoc adjustment factor in the structural balance formula and/or conduct a study into whether there is anything predictable about 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 on the lower-than-initially estimated potential GDP.

Some have proposed to replace 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 entail a procyclical stance.

More radical options suggest to abandon the structural balance altogether. For instance, Debrun and others (2008) propose to replace it with an expenditure rule including a correction mechanism associated with the debt level.

49. 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 fostering a pro-cyclical fiscal stance. Dominated by the structural balance rule, the 1/20th debt reduction benchmark would become redundant if the structural balance was used to determine the existence of an EDP, as suggested in the previous section.23

How to further strengthen enforcement?

50. Two main directions can be followed to improve compliance.24 The first approach reinforces the existing supranational framework by stepping up 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.

51. Existing enforcement mechanisms can be further strengthened. More automaticity could be introduced in moving up steps after a rule is breached and the breach is acknowledged. In some cases, 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.

52. A broad set of sanctions could be envisaged. Financial sanctions in bad times lack credibility, as they exacerbate the financial difficulties of distressed governments. Hence, these sanctions could be imposed only in good times (e.g. reduced access to structural funds and other EU subsidies25), while non-pecuniary sanctions could also be considered in bad times. Administrative sanctions (e.g., personal sanctions or constraints on new staff hire) exist in other federations. Political sanctions (e.g. limitation of voting rights) are another option.

53. A key question is whether past deviations from supranational fiscal targets should be offset subsequently.26 Currently, countries breaching the 3 percent rule or the MTO are required to bring back the deficit 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 overtime until it reaches 60 percent of GDP.27 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 ex-ante 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 below this level within three years. Debt brakes have been criticized for imposing unrealistic adjustments following large slippages, as the fiscal position should not only get back to the targeted level in the following year but also overshoot it because of the correction. On the other hand, never offsetting past deviations is misguided, as debt eventually increases to a point when the debt ceiling becomes binding. A more balanced approach would be to target a gradual correction for countries with a debt below 60 percent of GDP. This could be achieved by proper calibration of the fiscal rule formulas (IMF, 2009).

54. 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 state’s fiscal commitments (Article 125 of the TFEU)—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. This is 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 is a long-term endeavor. 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.

55. Another possibility would be to rely more extensively on central controls. While restoring market discipline is an important element to foster compliance and fiscal discipline, this 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 may have to come at the expense of a permanent loss of fiscal sovereignty for euro area members (for instance, if a veto power of the center on national budgets was introduced).

F. Conclusions

56. 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. While public debt is approaching unsafe territory in several member states, the fiscal framework has a key role to play to put public finances back on a sound footing. Fiscal governance needs to be particularly strong ex ante, as 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 Pact has to become more effective in enforcing structural balance targets and limiting the ability of member states to spend revenue windfalls in good time—a challenge given the uneven track record of countries in sustaining healthy structural positions over long periods of time.

57. 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, as compliance failures are partly rooted in the unique governance structure of the European Union.

58. Going beyond the fiscal framework, better economic governance can play an important role in reducing future imbalances. The crisis showed that there is no clear-cut separation between private and public sector balance sheets (Moghadam, 2014). Private imbalances can eventually end up as public sector liabilities—either through a direct bailout of the banking system (e.g., Ireland) or the lost revenue and increased spending necessitated by deep and prolonged declines in output (e.g., 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 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 constitute positive steps in this direction. The Macroeconomic Imbalance Procedure goes beyond fiscal metrics to look at 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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1

Prepared by Luc Eyraud and Tao Wu. The authors would like to thank for their comments Celine Allard, Bergljot Barkbu, Craig Beaumont, Nicolas Carnot, Xavier Debrun, Rishi Goyal, Alvar Kangur, Christophe Kemps, Petya Koeva Brooks, Lucio Pench, Stephanie Riso, Gerd Schwarz, Ranjit Teja, and the participants of the seminars organized at the ECB and the EC in May 2014.

2

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

3

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

4

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

5

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

6

Using real-time output gap data would not fundamentally change this result. As discussed in Section V, 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.

7

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.”

8

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

9

Given the complexity of the European framework, the numbering of rules is a matter of judgment. In our view, the framework has four main supranational rules—he 3 percent deficit rule, the 60 percent debt rule, an expenditure benchmark, and medium-term budgetary objectives (MTO) defined in structural terms. It also requires countries to enshrine a structural balance rule in national legislation.

10

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

11

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)

12

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 around 3 percent of GDP. As a structural deficit below 0.5 percent would generally translate into a nominal deficit below 3 percent, the debt ratio would decline.

13

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

14

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

15

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

16

This result is consistent with Kempkes (2012), who finds that in the EU 15 sample, output gap was underestimated by 1 percent, compared to final estimates over 1996–2011.

17

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

18

“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.”

19

If the Council adopts a decision on non-effective 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-interesting deposit if an EDP is opened (EC, 2013b).

20

Nonetheless, interferences are unlikely to disappear entirely, as commissioners are nominated by member states. Some political constraints may now be internalized by the Commission.

21

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

22

The equivalence of the two concepts relies on the idea that an improvement (resp. decline) in the structural balance is mathematically equivalent to keeping the growth rate of expenditure net of revenue measures below (resp. above) potential output growth (EC, 2013b).

23

Nonetheless, measurement errors and uncertainties affecting the estimates of potential output and the structural budget balance could argue in favor of maintaining the 1/20th debt rule—as an objective and simple benchmark for consolidation progress.

24

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 where fiscal sovereignty is exerted. This important issue, which goes beyond the scope of the paper, is not discussed here.

25

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

26

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

27

For countries with public debt above 60 percent of GDP, the 1/20th debt reduction criterion functions de facto as a debt-brake correction mechanism.

Euro Area Policies: Selected Issues
Author: International Monetary Fund. European Dept.