Posts Tagged ‘Golden Rule’

A Plea for a European Public Investment Agency

May 9, 2023 Leave a comment

The European Commission has introduced a legislative proposal for the reform of European fiscal rules with the aim to have the new rules approved by member states and the European Parliament by the end of the year, and to be in force by 2024. If this timeline is not met, the old Stability and (lack of) Growth Pact (SGP), adopted in 1997 and discredited during the sovereign debt crisis, will be reintroduced.

The Stability Pact, together with the  Fiscal Compact hastily adopted in 2012 in the belief (oh, how erroneous! ) that it was necessary to impose austerity in order to get out of the sovereign debt crisis, impose annual targets in terms of structural (i.e. cyclically-adjusted) deficit to ensure that public debt falls steadily towards the level of 60% set by the Maastricht Treaty (a level that is totally arbitrary, incidentally).  From the outset, many of us criticised the Stability Pact, because the emphasis on annual targets pushes countries to adopt pro-cyclical policies: in the event of a crisis  and a fall in GDP, to stay on the path of debt reduction, fiscal restraint is needed; this has nevertheless a negative impact on growth, triggering a vicious circle. Moreover, the Pact imposes the same objectives on everyone (one size fits all is used). Last but not least, the current rule does not distinguish between current expenditure and investment spending, ending up penalizing the latter which, politically, is less problematic to cut.

To address these issues, the European Commission reform proposal replaces annual targets with multi-year debt reduction programs agreed upon by member countries and the Commission. Although very imperfect, the proposal represents a very clear improvement on the existing rule, on two grounds..

  1. The annual numerical targets are replaced by multi-annual (4-year) debt reduction programs. The adoption of a medium-term perspective, is the only reasonable one when it comes to the sustainability of public finances. It is good that we have finally realised the absurdity of annual targets
  2. Debt-reduction plans are formulated (in terms of expenditure targets) by member countries in agreement with the Commission, on the basis of scenarios for the evolution of public finances. High-debt countries obviously need to make greater efforts, especially if the most likely scenarios are high interest rates and low growth, and therefore more risks to future sustainability. Abandoning the one-size-fits-all and top-down approach is important for democratic legitimacy and credibility of implementation.

Against these very significant improvements, the amended rule would remain seriously problematic for two reasons. The first is that overall the focus is still on debt reduction. Too much Stability and not enough growth, like with the old SGP, at the risk of obtaining neither (ever heard of self-defeating austerity?) This is even trues since, to accommodate strong German pressures the Commission has introduced safeguards to ensure that debt remains strongly anchored to a downward path. This excessive weight on debt reduction might be tempered by the increased politicization of the process, a feature of the Commission proposal that has been criticized but that on the contrary I find quite appealing. I will come back to that in a future post.

The second reason why the Commission proposal (a significant improvement, let me state it again) falls short of my expectations is the lack of specific provisions for protecting public investment. The only concession that is made is that “Member States will benefit from a more gradual fiscal adjustment path if they commit in their plans to a set of reforms and investment that comply with specific and transparent criteria”. This is what I would like to address in this post.

With my colleagues Floriana Cerniglia (Catholic University Milano) and Andy Watt (IMK Berlin), we have been editors for some years of a series of yearly European Public Investment Outlook involving dozens of European researchers. Volume after volume, the message that comes out of this series is that in OECD countries public investment has been sacrificed on the altar of fiscal discipline since the 1980s. In Europe the downward trend is particularly marked and  has further accelerated with the austerity programs of the 2010s. The result is a chronic shortage of public capital, both tangible and intangible (social capital) which today seriously limits the growth potantial of all European countries, even those that are apparently healthier. As an example, the German colleagues who worked on the chapters on Germany estimated the  amount needed over the next decade to fill the German infrastructure gap at around 45 billion per year, not to mention the additional investment needs made necessary by an aging population and by the ecological and digital transition. Italy is no exception: Cerniglia and her co-authors report  an estimate by which between 2008 and 2018 about 200 billion were lost along the way compared to the scenario in which public investment had continued at the (not excellent) previous rates. This figure is sobering: the entire allocation of the Italian NRRP (191 billion), which should project us into the ecological and digital transition, will not even be able to bridge the gap that has opened up in the last ten years.

Looking ahead, the numbers get even more impressive. The Commission has estimated that the  European Union would need €520 billion in additional investment each year to meet the Green Deal’s 55% emissions cut target before the end of the decade.  Although the Commission believes that a significant part of this investment should come from the private sector, the figure gives a measure of the colossal effort that lies before us.

A team from the New Economics Foundation (NEF), took the figure given by the Commission as a basis for simulations in which it also considered the needs related to social investment (education, health, etc.) and the digital transition. These simulations lead, in a report also published last week, to conclude that only nine European countries would have the fiscal space to implement such large investment programs, were they to respect the existing rule or even the one amended by the Commission proposal. Italy is obviously not one of them, but neither are France nor Germany. The assumption of the NEF report may be questioned, of course, but the overall picture they draw is quite clear, and highlights a  fundamental incompatibility between the huge investment needs of the coming years and a system of European rules that, even in the reformed version, remain too oriented towards debt reduction as a self standing objective. The intransigent position of the German government has even prompted a usually cautious and moderate economist like Olivier Blanchard, former chief economist of the IMF, to ask rhetorically  whether it is preferable to preserve the earth with a slightly higher debt or to go towards climate catastrophe with  sound public finances

Many, including myself have for years called for a reform of European rules that would allow governments to invest outside the constraints of the budget. Such a “golden rule” would make it possible to finance the ecological transition while preserving the stability of public finances. In the past year it has at times seemed that such a proposal might have a chance of being discussed. Today the mood has changed. We should consider ourselves lucky if the Commission’s proposal is not twisted in an even more restrictive way by the negotiations with the Member States. In the coming years, therefore, it will be necessary to accept a continued state of chronically insufficient national public investment.

What to do then?  If we do not want to fail in the objective of ecological transition, there  is only  one way: to work on the quick creation of a European Investment Agency able not only to finance national governments’ investment (as in the proposal for a Sovereign Fund for Industrial Policy, buried in the Brussels’ mist); but also to design and implement genuinely European investment projects. The governance of such an Agency should be designed very carefully: fiscal policy has an inherently political dimension that requires accountability in front of voters.  In our non federal system this accountability lies with national governments, which should therefore be involved in European public investment choices. Some form of control by the Parliament and the Council in determining (or at least validating) investment projects would certainly make the work of the European Investment Agency more cumbersome. But this seems inevitable to ensure the democratic legitimacy of spending programmes (and their financing) at the European level.


A Plea for Semi-Permanent Government Deficits

December 9, 2016 3 comments

Update (1/7/2016): The whole paper is now available on Repec.

I have recently written a text on EMU governance and the implementation of a Golden Rule of public finances. I will provide the link as soon as it comes out. The last section of that paper can be read stand alone (with some editing). A bit long, I warn you, but here it is:

Because of its depth, and of its length, the crisis has triggered an interesting discussion among economists about whether the advanced economies will eventually return to the growth rates they experienced in the second half of the twentieth century.
One view, put forward by Robert Gordon  focuses on supply-side factors. Gordon argues that each successive technological revolution has lower potential impact, and that in this particular moment, “Slower growth in potential output from the supply side, emanating not just from slow productivity growth but from slower population growth and declining labor-force participation, reduces the need for capital formation, and this in turn subtracts from aggregate demand and reinforces the decline in productivity growth.

In a famous speech at the IMF in 2013, later developed in a number of other contributions, Larry Summers revived a term from the 1930s, “secular stagnation”, to describe a dilemma facing advanced economies. Summers develops some of Gordon’s arguments to argue that lower technical progress, slower population growth, the drifting of firms away from debt-financed investment, all contributed to shifting the investment schedule to the left. At the same time, the debt hangover, accumulation of reserves (public and private) induced by financial instability, increasing income inequality (on that, I came first!), tend to push the savings schedule to the right. The resulting natural interest rate is close to zero if not outright negative, thus leading to a structural excess of savings over investment.

Summers argues that most of the factors exerting a downward pressure on the natural interest rate are not cyclical but structural, so that the current situation of excess savings is bound to persist in the medium-to-long run, and the natural interest rate may remain negative even after the current cyclical downturn. The conclusion is not particularly reassuring, as policy makers in the next several years will have to navigate between the Scylla of accepting permanent excess savings and low growth (insufficient to dent unemployment), and the and Charybdis of trying to fight secular stagnation by fuelling bubbles that eliminate excess savings, at the price of increased instability and risks of violent financial crises like the one we recently experienced.

The former IMF chief economist Olivier Blanchard has elaborated on the meaning of Summers’ conjecture for macroeconomic policy. If interest rates will remain at (or close to) zero even once the crisis will be over, monetary policy will continuously face the Scylla and Charybdis. The recent crisis is a good case study of this dilemma, with the two major central banks of the world under fire from some quarters, for opposiite reasons: the Fed for having kept interest rates too low, contributing to the housing bubble  and the ECB for having done too little and too late during the Eurozone crisis.

Drifting away from the Consensus that he contributed to consolidate, Blanchard concludes that exclusive reliance on monetary policy for macroeconomic stabilization should be reassessed. With low interest rates that make debt sustainability a non-issue; with financial markets deregulation that risks yielding more variance in GDP and economic activity; and with monetary policy (almost) constantly at the Zero Lower Bound, fiscal policy should regain a prominent role among the instruments for macroeconomic regulation, beyond the cycle. This is a very important methodological advance.

Nevertheless, in his plea for fiscal policy, Blanchard falls short of a conclusion that naturally stems from his own reading of secular stagnation: If the economy is bound to remain stuck in a semi-permanent situation of excessive savings, and if monetary policy is incapable of reabsorbing the imbalance, then a new role for fiscal policy may appear, that goes beyond the short-term stabilization that Blanchard (and Summers) envision. In fact, there are two ways to avoid that the ex ante excess savings results in a depressed economy: either one runs semi-permanent negative external savings (i.e. a current account surplus), or one runs semi-permanent government negative savings. The first option, the export-led growth model that Germany is succeeding to generalize at the EMU level, is not viable, except for an individual country implementing non cooperative strategies, because aggregate current account balances need to be zero. The second option, a semi-permanent government deficit, needs to be further investigated, especially in its implication for EMU macroeconomic governance

There are a number of ways, not necessarily politically feasible, to allow EMU countries to run semi-permanent government deficits. A first one could be to restore complete national budget sovereignty, (scrapping the Stability Pact). This would mean relying on market discipline alone for maintaining fiscal responsibility. As an alternative, at the opposite side of the spectrum, countries could create a federal expenditure capacity (which would imply the creation of an EMU finance minister with capacity to spend, the issuance of Eurobonds, etc.). Such an option is as unrealistic as the previous one. In an ideal world, the crisis and deflation would be dealt with by means of a vast European investment program, financed by the European budget and through Eurobonds. Infrastructures, green growth, the digital economy, are just some of the areas for which the optimal scale of investment is European, and for which a long-term coordinated plan would necessary. The increasing mistrust among European countries exhausted by the crisis, and the fierce opposition of Germany and other northern countries to any hypothesis of debt mutualisation, make this strategy virtually impossible. The solution must therefore be found at national level, without giving up European-wide coordination, which would guarantee effective and fiscally sustainable investment programs.

In general, the multiplier associated with public investment is larger than the overall expenditure multiplier. This is particularly true in times of crisis, when the economy is, like today, at the zero lower bound. With Kemal Dervis I proposed that the EMU adopts a fiscal rule similar to the one implemented in the UK by Chancellor of the Exchequer Gordon Brown in the 1990s, and applied until 2009. The new rule would require countries to balance their current budget, while financing public capital accumulation with debt. Investment expenditure, in other words, would be excluded from deficit calculation, a principle that timidly emerges also in the Juncker plan. Such a rule would stabilize the ratio of debt to GDP, it would focus efforts of public consolidation on less productive items of public spending, and would ensure intergenerational equity (future generations would be called to partially finance the stock of public capital bequeathed to them). Last, but not least, especially in the current situation, putting in place such a rule would not require treaty changes, and it is already discussed, albeit timidly, in EU policy circles.

To avoid the bias towards capital expenditure that the golden rule could trigger, we proposed that at regular intervals, for example in connection with the European budget negotiation, the Commission, the Council and the Parliament could find an agreement on the future priorities of the Union, and make a list of areas or expenditure items exempted from deficit calculation for the subsequent years.

Europe Needs a Real Industrial Policy

January 19, 2015 7 comments

The Juncker Commission is now up and running, and it is beginning to give an idea of where it wants to go. Unfortunately not far enough. The two defining moments of the first few months are the Juncker plan, and the new guidelines on flexibility in applying the Stability and Growth Pact. Both focus on public investment.

Public investment deficiency is now chronic across the OECD, and particularly in the EU. Less visible and politically sensible than current expenditure, for twenty years it has been the adjustment variable for European governments seeking to meet the Maastricht criteria, and to control their deficit. Since the crisis hit, private investment also collapsed, and it is still kept well below its long term trend by depressed demand and negative expectations.

Let’s start from the most recent Commission measure. The guidelines issued last weeks, that some countries trumpeted as a great victory against austerity, are in fact just a marginal change. The Commission only conceded that the structural effort towards the 60% debt-to-GDP ratio be relaxed for countries growing below potential, while reaffirming that in no circumstance, the 3% deficit limit should be breached, and that any extra investment needs to be compensated by expenditure reduction in the medium term1.

The Juncker plan foresees the creation of an Investment Fund endowed with €21bn from the European budget and from the European Investment Bank. This is meant to lever conspicuous private funds (in a ratio of 15 to 1) to attain €315bn, mobilized in three years. EU countries may chip into the Fund, but this is not compulsory, and the incentives to contribute are unclear: while the contribution to the fund would not be accounted as deficit (the guidelines confirm it), the allocation of investment will not be proportional to countries’ contributions.

Two aspects of the plan raise issues. First, it is hard to see how it will be possible for the newly established fund to raise the announced amount. The expected leverage ratio is very ambitious (some have described the plan as a huge subprime scheme). Second, even assuming that the plan could create a positive dynamics and mobilize private resources to the announced 315 billions, this amounts to just over 2% of GDP for the next three years (approximately 0.7% annually). In comparison, Barack Obama’s American Recovery and Reinvestment Act of 2009 amounted to more than 800 US$ billions. The US mobilized more than twice as much as the Juncker plan, in fresh money, and right at the beginning of the crisis.

To sum up, the plan and the guidelines are welcome in that they put investment back to the centre of the stage. But, as is the norm with Europe, they are too little, far too little, to put the continent back on track, and to reverse the investment trend of the last three decades.

In an ideal world, the crisis and deflation would be dealt with by means of a vast European investment program, financed by the European budget and through Eurobonds. Infrastructures, green growth, the digital economy, are just some of the areas for which the optimal scale of investment is European, and for which a long-term coordinated plan is necessary. That will not happen, however, for the fierce opposition of Germany and other northern countries to any hypothesis of debt mutualisation.

The solution must therefore be found at national level, without losing the need for European-wide coordination, that would guarantee effective and fiscally sustainable investment programs. With Kemal Dervis I recently proposed that the EU adopt a golden rule, similar in spirit to the one implemented in the United Kingdom between 1998 and 2009. The rule requires government current expenditure to be financed from current revenues, while public debt may be used to finance capital accumulation. Investment expenditure, in other words, could be excluded from deficit calculation, without any limit. Such a rule would stabilize the ratio of debt to GDP, and would ensure intergenerational equity (future generations would be called to partially finance the stock of public capital bequeathed to them). Last, but especially in the current situation not least, putting in place such a rule would not require treaty changes, but just an unanimous Council deliberation.

But there’s more in our proposal. The golden rule is not a new idea, and in the past it has been criticized on the ground that it introduces a bias in favor of physical capital; expenditure that – while classified as current – is crucial for future growth (in many countries spending for education would be more growth enhancing than building new highways) would be penalized by the golden rule. This criticism, however, can be turned around and transformed into a strength. At regular intervals, for example every seven years, in connection with the European budget negotiation, the Commission, the Council and the Parliament could find an agreement on the future priorities of the Union, and make a list of areas or expenditure items exempted from deficit calculation for the subsequent years. Joint programs between neighboring countries could be encouraged by providing European Investment Bank co-financing. What Dervis and I propose is in fact returning to industrial policy, through a political and democratic determination of the EU long-term objectives. The entrepreneurial State, through public investment, would once again become the centerpiece of a large-scale European industrial policy, capable of implementing physical as well as intangible investment in selected strategic areas. Waiting for a real federal budget, the bulk of investment would remain responsibility of national governments, in deference to the principle of subsidiarity. But the modified golden rule would coordinate and guide it towards the development and the well-being of the Union as a whole.

Ps an earlier and shorter version of this piece was published in Italian on December 31st in the daily Il Sole 24 Ore.

1. Specifically, the provisions are the following:

Member States in the preventive arm of the Pact can deviate temporarily from their medium-term budget objective or from the agreed fiscal adjustment path towards it, in order to accommodate investment, under the following conditions:

  1. Their GDP growth is negative or GDP remains well below its potential (resulting in an output gap greater than minus 1.5% of GDP);
  2. The deviation does not lead to non-respect of the 3% deficit reference value and an appropriate safety margin is preserved;
  3. Investment levels are effectively increased as a result;
  4. Eligible investments are national expenditures on projects co-funded by the EU under the Structural and Cohesion policy (including projects co-funded under the Youth Employment Initiative), Trans-European Networks and the Connecting Europe Facility, as well as co-financing of projects also co-financed by the EFSI.
  5. The deviation is compensated within the timeframe of the Member State’s Stability or Convergence Programme (Member States’ medium-term fiscal plans).


On Fiscal Rules and the Need for Reforming the Stability Pact

February 27, 2012 1 comment

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.

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The “Golden” Rule. Really? Golden?

January 27, 2012 3 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.

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Open Letter to European Leaders

January 23, 2012 6 comments

The Financial Times just published a short letter I wrote with some colleagues.  I reproduce it here.

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