Home > EMU governance, Fiscal Policy, Growth, Theory > On Fiscal Rules and the Need for Reforming the Stability Pact

On Fiscal Rules and the Need for Reforming the Stability Pact

February 27, 2012 Leave a comment Go to comments

I recently wrote a paper with Jerome Creel and Paul Hubert, in which we try to assess the impact of the different fiscal rules that are being discussed for reforming the Eurozone governance. For our simulations we took into account the standard Keynesian positive effects of deficit spending: Government expenditure substitutes missing private demand, and hence supports economic activity. But we also embedded a negative effect of deficit and debt, that goes through increased interest rates (the famous spreads). High interest rates make it harder for the private sector to finance spending, and hence depress aggregate demand and growth. We assessed the performance of the rules in terms of average growth over the next 20 years.

We have some results that were expected, and some others that were not. The first is that in a situation of exceptionally high levels of debt and deficit (like the current one), the best performing rule is one that is not currently on the floor, the “golden rule” in the British sense of excluding public investment from deficit limits.  The two “fiscal compact” rules impose an excessive cost to the economy in the short run (as I had already argued, for example here or here).

What is more surprising, on the other hand, is that the fiscal compact is also too  constraining even in a situation of “steady state”, i.e. in normal times. The status quo, the Maastricht limit of total deficit to 3% of GDP, seems more apt to absorb standard output fluctuations.

Our exercise confirms therefore that Europe is walking the wrong road. The fiscal compact would impose a straightjacket that is too restrictive, not only in the current situation of strain for public finances, but also in normal times.  To add to the folly,  these rules would be embedded into our constitutions, making it very  hard to backtrack.

Nothing new, to be honest. But it is nice to have something robust to back my argument against austerity…

About these ads

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: