Front Matter Page

European Department in collaboration with the Fiscal Affairs and Research Departments

Contents

• EXECUTIVE SUMMARY

• CONTEXT

• THE SGP: PAST REFORMS AND CURRENT ISSUES

• REFORM PROPOSALS

• A. Simplifying the Framework

• B. Consolidating the Preventive and Corrective Arms

• C. Shifting to a Single Fiscal Anchor with a Single Operational Rule

• D. Improving Compliance

• CONCLUSIONS

• BOX

• 1. Candidates for Operational Rules

• ANNEX

• Simulations Design and Model Structure

• REFERENCES

• FIGURES

• 1. Average Public Debt Ratios of EU Members

• 2. Fiscal Consolidation and the Output Gap in the Euro Area

• 3. The EU Fiscal Framework

• 4. Noncompliance with European Fiscal Rules

• 5. Comparative Performance of Alternative Fiscal Rules

• 6. Measurement Errors and Public Debt with Real-Time Data

• TABLES

• 1. Variability Around the Steady State

• A1. Fiscal Rule Parameterization

• A2. GIMF Calibration Essentials

• A3. Variance Around Steady-State, Detailed View

Executive Summary

The global financial crisis and its aftermath have tested the European Union’s (EU) fiscal governance framework. The framework in place before the crisis had been useful to improve fiscal policymaking and coordination, but it ultimately did not prevent the buildup of fiscal imbalances. Public debt soared following the crisis in 2008 to an average of 95 percent in 2014—almost 30 percentage points above average precrisis levels. The experiences during the first decade of the European Economic and Monetary Union (EMU) and the euro area crisis led to major changes to the framework, including the 2005 reforms, the 2011 Six Pack, the 2012 Fiscal Compact, and the 2013 Two Pack. The successive reforms have helped to strengthen fiscal policy guidance, but they have also made the framework significantly more complex and difficult to operate, and concerns about compliance remain.

The purpose of this paper is to present options for simplifying the EU fiscal governance framework while enhancing its overall effectiveness. The current framework involves an intricate set of fiscal constraints. For example, both the preventive and corrective arms of the Stability and Growth Pact (SGP) constrain fiscal policies of EU member states through various targets, upper limits, and benchmarks. Fiscal policies are further constrained by the Fiscal Compact, which required countries to put in place national rules to ensure convergence toward medium-term objectives (MTOs). Overall, the framework has helped to strengthen policymaking and coordination, but compliance has remained weak, and the SGP’s complexities have hampered effective monitoring and public communication.

The options presented in this paper would address these issues. In particular, they would:

• Simplify the overall fiscal governance framework design. An ambitious approach would involve merging the preventive and corrective arms of the SGP, and replacing it with a simple two-step procedure based on a common set of rules; this may potentially require substantial legal changes, including treaty changes. A less ambitious approach would seek to enhance the consistency between the two arms across different targets, upper limits, and benchmarks.

• Introduce a single fiscal anchor with a single operational rule. The paper argues for moving to a two-pillar approach with a single fiscal anchor (the public debt-to-GDP ratio) and a single operational target (an expenditure growth rule, possibly with an explicit, that is, formal and deterministic, debt-correction mechanism) linked to the anchor. This approach would help to safeguard fiscal sustainability and macroeconomic stability, while also facilitating monitoring and public communication.

• Further bolster enforcement. Several additional steps would improve implementation of the simpler fiscal framework and support compliance. These include: (1) greater automaticity in enforcement with a gradual step-up of monitoring and constraints; (2) a more credible set of sanctions that better reflect prevailing economic circumstances; and (3) a better coordination of fiscal policy monitoring between national fiscal councils and the Commission.