Home > EMU Crisis, EMU governance, Fiscal Policy, sovereign debt > The “Golden” Rule. Really? Golden?

The “Golden” Rule. Really? Golden?

January 27, 2012 Leave a comment Go to comments

The European Council meeting, next Monday, should finally lift the veil of mystery  that has surrounded the new “fiscal compact”, the set of rules supposed to govern fiscal policy in EU member countries. As of now, the only official document in our hands is the  Statement approved by the Heads of State and Government at the December 9 meeting.
I have argued at length that I am not in the camp of those who believe fiscal profligacy is the source of EMU problems (recently, here and here). Rather the contrary, I always thought (see for example here and here) that even the current rules de facto prevented EMU countries  from effectively using the standard tools of macroeconomic policy.

But here I want to go into the specific solutions that as of now, seem to be on the floor.  The December statement implicitly distinguishes between a phase of consolidation from the current high levels of debt, during which

The specification of the debt criterion in terms of a numerical benchmark for debt reduction (1/20 rule) for Member States with a government debt in excess of 60% needs to be enshrined in the new provisions.

And then, once the 60% reference level is reached, countries should aim at balancing their budget net of cyclical components (i.e. that part of expenditure or revenues that changes with the cycle, like unemployment benefits or tax revenues):

We commit to establishing a new fiscal rule, containing the following elements: General government budgets shall be balanced or in surplus; this principle shall be deemed respected if, as a rule, the annual structural deficit does not exceed 0.5% of nominal GDP. Such a rule will also be introduced in Member States’ national legal systems at constitutional or equivalent level.

This has been sold as a “golden rule of public finances”. And it is not really  new, as the idea of a balanced structural budget was already embedded into the Stability and Growth Pact (SGP), even if not enforced. But did our leaders ask why it was not enforced? The answer is easy and should be a lesson to bear in mind: it is plainly not applicable, and would yield the unpleasant and unjustified result that the debt ratio converges to zero.

In fact, if debt does not increase (or increases of an average of 0.5% per year), while nominal income grows (because of inflation, productivity, the increase of the labor force, etc.), the ratio between the two will decline over time, until it reaches zero. I challenge the proponents of the golden rule to find private firms with little or no debt. (there is a notable and interesting exception). More importantly,  I challenge them to find an entrepreneur arguing that his/her optimal amount of debt is zero.

This constraint, that would be unacceptable to any reasonable entrepreneur, is about to be enshrined in the constitution of EU member countries.  This is the craziness we are talking in Europe these days.

I have a modest (and not original) proposal.  Why not implement norms constraining governments to balance their budget net of public investment? This “old golden rule” has been followed by the UK  under Gordon Brown’s tenure as Chancellor of the Exchequer, and proved rather effective. If it were adopted, current expenditure would have to be financed trough current receipts, and the public capital stock of the country  (infrastructures) would be financed by debt; in other words, the cost of bridges and highways would not be borne by the generation building them, but by all the generations using them. Finally, The debt-to-GDP ratio would converge to the ratio of public capital to GDP. The rule is not uncontroversial, most notably because the definition of public investment is hard (would a school teacher salary qualify?). But none of the technical problems seems insurmountable.

Let’s  summarize: the “old” golden rule  would be sustainable, intergenerationally fair, and above all, commonsensical. The “new” makes little sense, will be recessionary, and is probably not applicable. And yet, the former barely makes it into the academic discussion, while the latter will most probably be adopted on Monday.

That’s Europe baby!


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