Fitch: The Most Urgent Policy Priority in the Eurozone is Addressing Disinflationary Trends

As the Eurozone's fiscal rules become more accommodative, complex and less transparent, it is difficult to avoid the conclusion they appear to be headed in the wrong direction.

While the most urgent policy priority in the Eurozone is addressing disinflationary trends, an equally important objective is the restoration of public finances.
In one respect, this should be a relatively straightforward undertaking, since national fiscal positions have long been understood as a "common concern", and accordingly subject to rules on avoiding excessive deficits (beyond 3% of GDP) and public debt levels that are too high (60% of GDP). These reference values were identified in the Maastricht Treaty, and rules governing them have been adjusted and clarified in the various revisions to – and European Commission (EC) guidance on –the Stability and Growth Pact (SGP).

Three Distinct Developments

Over time, however, three developments have called into question the credibility of the Eurozone's rules-based approach to ensuring sound public finances. The rules have been set aside when violated, interpreted so as to accommodate weaker fiscal positions, and become more complex and thus less transparent.
Evolution of the SGP is inevitable, and some changes have not been without merit, but it would be hard to argue that either fiscal discipline or the institutional integrity of the Eurozone – dependent in part on such discipline – has been unambiguously strengthened.

Early SGP rule violators included France and Germany, where fiscal deficits exceeded 3% of GDP in the early 2000s. The most troubling aspect of these transgressions was the decision of the Economic and Financial Affairs Council in late 2003 to put the SGP Excessive Deficit Procedure in abeyance, prompting a legal challenge from the EC, which it eventually won.

Even so, a precedent had been set by the Eurozone's largest member states that the Commission's enforcement of the rules could be challenged by the political considerations of the Council, clearly undermining the notion that the fiscal rules and procedures surrounding them were, in fact, uniformly binding. It is a sobering reminder that it has been more than a decade since commentators first raised the question as to whether the SGP was dead.

Evidence of the accommodation of weaker fiscal positions is available in present day examples. In the EC's January 2015 guidelines on fiscal flexibility within the SGP, details are provided on investment and structural reform clauses, which allow national governments whose plans in these areas meet certain criteria to deviate from their Medium-Term Budgetary Objectives (MTOs) or the path to their MTOs.

The guidelines also reduce the required adjustment towards the MTO if an economy is experiencing "bad times", "very bad times" or "exceptionally bad times". Coming after open pressure from several national leaders, the lenience afforded by the new guidelines can certainly be interpreted as accommodative.

Complexity a Real Challenge

As for the complexity of the Eurozone's fiscal rules and the consequent lack of transparency, the most egregious shortcoming is that it is impossible to assess compliance in real time. By focusing on (unobservable) structural fiscal balances, analyses are dependent on estimates of potential output and corresponding output gaps. The IMF and EC often disagree on countries' output gaps, and they can be subject to significant revisions. In the EC's model, estimates rely on such esoteric variables as trend total factor productivity and the non-accelerating wage rate of unemployment.

EU_gov_fiscal_positions_2015There are two conclusions to be drawn. First, by measuring fiscal performance against targets that cannot be observed readily (or even shortly thereafter), neither financial markets nor the general public can easily hold policymakers accountable. Second, given the vagaries of the data, there is a spurious sense of precision in much of the debate between the EC and national governments on fiscal performance. The margin of error in any component of a forecast structural fiscal balance – let alone the sum of such errors – is likely to be as large as a disputed gap between the EC and national government.

No doubt there will be future crises and other causes of fiscal stress in the Eurozone that will differ from those past. What is less clear is that national governments will abide by one of the aims of the "preventive arm" of the SGP and use intervening good economic times – assuming they do eventually materialise – to create fiscal space that would allow active policy responses within the construct of the rules.

In all likelihood, governments will again seek exceptions to the rules, escape clauses to be added to them or flexible interpretations to allow what would otherwise have been rule violations. A risk, of course, is that a threshold is eventually crossed beyond which fiscal discipline is insufficiently credible to support the needs of a common currency area. It is difficult to avoid the conclusion that Eurozone fiscal rules seem to be headed in the wrong direction.
 
(Fitch Ratings/www.balkans.com)