The fiscal compact and national ownership.

• Author: Benczes, Istvan
• Position: Report

Introduction

With the adoption of the new Treaty on the EMU's Stability, Cooperation and Governance (TSCG), Europeans have decided to introduce new fiscal rules in an era when most of the countries in the world suspended the use of rules as a response to the outburst of the 2008 economic and financial crisis. The European Union (EU), however, seems to insist on the usefulness of fiscal rules. The European Commission, in fact, has claimed that domestic fiscal rules should become an indispensible part of the new economic governance structure of the Economic and Monetary Union (European Commission 2010). The TSCG serves exactly this purpose by imposing compulsory deficit and debt rules from above on the member states of the euro-zone.

The European Union played a pioneering role in the adoption of fiscal rules. Member states of the Economic and Monetary Union abandoned national currencies and delegated monetary policy onto a supranational level. Fiscal policy has remained, however, in the hands of national governments as basically the sole economic stabilisation tool. Since such an asymmetry in the conduct of economic policy can easily reinforce moral hazard in the form of overspending, the founding fathers of the EMU established a solid set of fiscal rules, which were explicitly named in the Maastricht Treaty and were subsequently strengthened by the Stability and Growth Pact later on (i.e., the annual deficit cannot be higher than 3 per cent of the GDP, and the debt ratio should be below 60 per cent or declining towards the target ratio). (3)

While all these previous attempts, along with the 2011 reform of the Stability and Growth Pact (the adoption of the so-called "six-pack"), introduced fiscal rules on a supranational level, the TSCG (to be more precise, its fiscal compact) requires participating countries to adopt rules in their own national legislation, preferably in their constitutions. It is, therefore, high time to analyse the effectiveness of the domestic fiscal rules that were adopted earlier by the member states.

In fact, member states became heavily engaged in adopting fiscal rules on the national level right from the very beginning of the so-called Maastricht process, that is, from 1991 onwards. Accordingly, the present study raises the following interrelated questions: To what extent did the EU member states rely on national fiscal rules before the crisis? Were these domestic rules successful enough in eliminating deficit bias? And, based on these results, is it rational to expect the fiscal compact to become an effective disciplining mechanism in the future?

While the main argument for the introduction of domestic fiscal rules has always been the buttressing of the accountability and credibility of national fiscal policy-making, the current study shows that a relatively large portion of domestic fiscal rules were adopted only after the start of deceleration of the debt-to-GDP ratios as part of a wider fiscal consolidation programme; that is, national ownership was an integral part of domestic rule-adoption. Accordingly, it might be reasonable to argue that it was not the rule itself which managed to stabilise public finances, but rather the strict political commitment to comprehensive consolidation efforts. Consequently, the fiscal compact can be effective only if national ownership of the new fiscal rules is granted.

Following the short introduction that specifies the puzzle and the research questions, section two provides a literature review on the positive political economy of deficit bias and on the effectiveness of fiscal rules. Section three provides a critical assessment on the design of the newly adopted fiscal compact. Section four turns to the empirical analysis of fiscal rules that were adopted by EU states between 1990 and 2004/2007. Section five elaborates on the discussion of the main findings of the empirical study. The last section addresses the question whether the newly adopted Treaty on the EMU's Stability, Cooperation and Governance can be effective enough in the future in light of the previous results on domestic fiscal rules.

Literature review

In neoclassical economics public deficit and debt are considered as a natural consequence of fluctuations in economic activity (Barro 1974 and 1979). Political economy literature, however, applies a different approach to fiscal deficit and debt. It assumes that fiscal deficit is more than the result of business cycles. Instead, authors argue that a deficit bias prevails; i.e., there is a general tendency towards excessive spending in democratic societies (Alesina and Perotti 1995).

Deficit spending becomes persistent because elected politicians face incentives which induce them to spend more (or tax less) than the socially optimal level (see especially Drazen 2000; Persson and Tabellini 2000). One of the earliest rationalisations of deficit bias claimed that voters faced structural-institutional deficiencies, which made them unable to internalise the costs of extra public spending. Consequently, governments are strongly motivated to manipulate the structure of public revenues and expenditure (Buchanan and Wagner 1977).

The costs and benefits of additional public spending are not necessarily distributed evenly amongst the members of a society. Transfers are paid to well-defined and targeted groups, whereas costs are burdened on the entire community of taxpayers. The discrepancy between costs and benefits--often called as the common resource pool problem--ends up in excessive and permanent deficit (Hagen 1992; Hagen and Harden 1996). A distributional conflict can evolve, however, not only amongst geographical constituencies (Weingast et al. 1981) or line ministries (Stein et al. 1999) but also between generations: current generations can increase their consumption today by borrowing at the cost of future generations (Cukierman and Meltzer 1989).

Debt can also be manipulated in a strategic way by incumbents with the aim of constraining future governments' room for spending (Alesina and Tabellini 1990; Aghion and Bolton 1990; Persson and Svensson 1989; Tabellini and Alesina 1990). Governments may also find it beneficial to manipulate economic variables (including fiscal ones) in order to increase their chances of winning the next elections. Traditional political business cycle theory assumes myopic voters and adaptive expectations (Nordhaus 1975), whereas rational expectations-based models assume the existence of asymmetric information with regard to the ability of the incumbents (Rogoff 1990).

Asymmetric information may prevail even within a coalition government if parties cannot agree on the share of costs of a fiscal consolidation. War-of-attrition models predict that consolidation evolves only if the marginal benefit of additional waiting becomes equal with the marginal cost of delaying reforms further (Alesina and Drazen 1991). In their normative models, both Bertola and Drazen (1993) and Drazen and Grilli (1993) have claimed that crises eventually can be interpreted as beneficial, since they make incumbents reluctant to wait any further with the implementation of reforms.

In comparative political science, a strong positive correlation has been identified between the type of political regimes (presidential versus parliamentary regimes) on the one hand and the size of the general government (and to a lesser extent deficit) on the other hand (see for instance Lienert 2005; or Persson, Roland and Tabellini 2000). By investigating the fiscal performance of a large sample of democracies between 1960 and 1998, Persson and Tabellini (2002) found that there was a tendency for a higher rate of redistribution in proportional electoral systems than in winner-takes-all regimes. The latter, however, provided more targeted transfers, mostly in swinging districts.

In a more recent study, Persson, Roland and Tabellini (2007) argued that the political and electoral regimes played only an indirect role in determining public deficit and debt. What mattered, instead, was the quality of governance. The authors claimed that there was a wide variety of fiscal performance even within a single country, where regime characteristics must be the same for a relatively longer period of time. Fabrizione and Mody (2006) found such a claim robust especially in the context of Central and East European countries.

Rules in fiscal policy have been introduced in order to contain deficit bias. By definition, fiscal rules are legal or non-legal numerical constraints on budgetary aggregates such as debts, deficits, expenditures or, more recently, revenues (Kopits and Symansky 1998). Fiscal rules are supposed to anchor the expectations of private agents, as rules are expected to establish credibility and strengthen trust amongst economic agents (Kopits 2001). (4) Originally, rules were introduced in the context of monetary policy (Friedman 1959). Following the demise of Keynesian macroeconomic policy, rational expectation models claimed that it was rational for policy-makers to renege on their ex ante promises in order to bring about higher social welfare in the short run (see especially Lucas 1976). Due to such time-inconsistent decisions, discretionary policies might not always be superior to rules (Kydland and Prescott 1977; Barro and Gordon 1983).

As far as the effectiveness of fiscal rules as constraints on excessive spending is concerned, empirical evidence is rather mixed. The ambiguity stems from several sources. For instance, Budina et al. (2012) claim that it is not clear what constitutes a fiscal rule because definitions are rather vague. (5) Others (see especially Kennedy and Robbins 2001) argue that due to sharp trade-offs amongst the main objectives of fiscal rules, such as flexibility, credibility and transparency, it is hardly possible to determine what effectiveness means exactly.

Uncertainty prevails in terms of the impacts of rules, too...