Balanced Budget Rule Finalized: Basic Problem Remains

Now that the content of the European-wide balanced budget treaty has been finalized, how does it stack up? In my last blog, I noted out that any permanent balanced budget rule is inappropriate because, in the long-term, it implies zero public debt. This is inconsistent with the proposition that moderate levels of public debt have a legitimate role to play, particularly in the financing of infrastructure. In the final version of the treaty, we now have a provision which relaxes marginally the budget balance requirements for countries which have debt levels significantly below 60 percent. Does this then solve the problem?

The answer is that, while the new provision helps, it does not resolve the fundamental contradiction between the new treaty and the European Union’s long-standing 60 percent debt limit. The new provision (article 1(d)) permits countries with a debt/GDP ratio “significantly below” 60 percent and “where risks in terms of long-term sustainability of public finances are low” to run structural deficits not exceeding 1 percent of GDP. It is, however, a matter of simple budget arithmetic to see that overrides the 60 percent debt limit. For a country with a long-term nominal growth rate of 4 percent, for example, a 1 percent structural deficit implies the long-term reduction of the debt/GDP ratio to 26 percent. If the nominal growth rate is 6 percent, a 1 percent structural deficit limit will push debt down ultimately to a mere 18 percent of GDP. Depending on national circumstances (in particular, the extent of long-term demographic-related fiscal pressures), these are likely to be levels well below what is required by fiscal sustainability. Moreover, they have the perverse effect that countries with the fastest growth rates — and therefore the greatest need of public infrastructure — will be required to maintain lower levels of debt.*

A more logical approach would have been to apply the balanced budget rule only to countries with excessive debt levels. In such an approach, a balanced budget rule would act as a mechanism for forcing a gradual reduction of excessive debt levels (when macroeconomic conditions permit).

Even here, however, there is a problem. The European Union has already quite recently put in place new rules for the mandatory reduction of excessive debt levels. I refer to the component of the “six pack” reforms which requires countries with debt levels in excess of the 60 percent limit to reduce excess debt by one-twentieth each year. The new balanced budget rules will mean that there will be two quite different rules which specify the minimum rate at which countries with excessive debt levels are required to reduce the debt. For example, for a country with a debt/GDP ratio of 100 percent and a 4 percent rate of nominal GDP growth, the new balanced budget rule will mandate that debt be reduced by 3.35 percent per year. By contrast, the one-twentieth rule requires a reduction of 2 percent per year. There is absolutely no logic in having two different and contradictory rules governing debt reduction.

It is clear, therefore, that the new balanced budget rule remains fundamentally inconsistent not only with the long-established European Union debt limit (60 percent) and deficit limit (3 percent), but also with the new rule governing the rate of reduction of excessive debt. Yet the text of new treaty makes repeated references to these rules, as if all it were doing is to reinforce them.

 

* In the short to medium term, it helps in this context that the rules set out in the new treaty will be mandatory only for countries which have already adopted the euro. Newer EU members which continue to use their own national currencies will thus in the short run be bound by the treaty provisions only if they choose to be so bound.

3 Responses to “Balanced Budget Rule Finalized: Basic Problem Remains”

  1. Mauro says:

    Sharp as usual, Marc! When you made the arithmetic examples, I had shivers along my spine: when will we see growth levels of 4-6% of GDP in Europe again?

  2. Marc says:

    Thanks Mauro. Of course, nominal growth of 4% is only real growth of 2% if there is an inflation rate of 2%. And the nominal growth example of 6% is more relevant to the newer EU countries in the East. But you’re right — any growth looks a bit optimistic for the core of the EU in the immediate future!

  3. JP Dumas says:

    What is interesting in Mr. Robinson’s paper is the inconsistencies between all these fiscal rules. Official Economists are like Lawyers, they create new rules but never cancel old ones.

    The first inconsistency was the two Maastricht rules: a debt ratio<60% and a fiscal deficit<3% of GDP. Needless to say that lax countries (France for ex.) choose the second one over the first one. A 3% deficit was considered as a right, and a target (when there was a deficit60%.

    May I remind that today: 1) out of 17 euro countries, five have a debt ratio60%. This is not consistent with a monetary union.

    2) The debt situation of euro countries is closer to emerging-country debt than US, because euro countries do not borrow in their own currency (they do borrow in €, but the ECB will not finance them in case of default (they are closer to Argentina than US, therefore even a maximun debt ratio of 60% is per haps too high ).

    3) The idea that nominal growth will take care of debt reduction, as it was the case after second WW is wrong. There is no fiscal space available in euro countries (so Keynesian policy is not possible), there debt ratio is>80% of GDP (wich implies lower long-term potential real growth, Rogoff) and inflation is no more possible.

    4) So the main issue for euro countries is to go back to a 60% public-debt ratio through a fiscal (primary) surplus. The maximum structural fiscal deficit rule of 0.5% of GDP seems to me pertinent (of course it should not apply to the five small virtuous countries and is in contradiction with the 3% deficit rule…)