The feasibility of Europe's fiscal compact

By Jeffrey Frankel

At the start of 2013, the eurozone's "fiscal compact" entered into force, owing to its ratification Dec. 21 by a 12th country, Finland, a year after German Chancellor Angela Merkel prodded eurozone leaders into agreement. The compact - technically called the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union - requires member countries to introduce laws limiting their structural government budget deficits to less than 0.5 percent of GDP (or less than 1 percent of GDP if their debt/GDP ratio is "significantly below 60 percent"). So, will this new approach work?

A limit on the "structural deficit" means a country can run a deficit above the limit to the extent, and only to the extent, that the gap between revenue and spending is cyclical (that is, its economy is operating below potential due to temporary negative shocks). In other words, the target is cyclically adjusted. The budget-balance rule must be adopted in each country, preferably enshrined in their national constitutions, by the end of 2013.

The aim is to fix Europe's long-term fiscal problem, which has been exacerbated by three factors: the failure, since the euro's inception, of the eurozone-wide Stability and Growth Pact (SGP) to enforce deficit and debt limits; the crisis that erupted in Greece and other countries on the eurozone periphery in 2010; and the various bailouts that have followed. There is no reason to doubt the member states will follow through and adopt national rules by the end of the year. The problem is what comes after that: the risk the fiscal compact will founder on precisely the same shoals as the SGP.

Ever since the eurozone was established, its members have issued official fiscal forecasts that are systematically biased in the optimistic direction. Other countries do this, too, but the bias among eurozone countries is, if anything, even worse than it is elsewhere.

During an economic expansion, such as in the 2002-07 period, governments are tempted to forecast the boom will continue indefinitely. Forecasts for tax revenue and budget surpluses are correspondingly optimistic and so hide the need for fiscal adjustment. During a recession, such as in 2008-12, governments are tempted to forecast their economies and budgets will soon rebound. Since forecasting is subject to so much genuine uncertainty, no one can prove the forecasts are biased when they are made.

But, if forecasts are biased, fiscal rules will not constrain budget deficits. In any given year, governments can forecast that their growth rates, tax revenues and budget balances will improve in subsequent years, and then argue the following year that the shortfalls were unexpected.

Framing the budget rules in cyclical terms, while highly desirable in terms of its macroeconomic impact, does not help to solve the problem of forecast bias. In fact, it can make the problem worse. In a year when a forecast for the structural budget deficit turns out to have been overly optimistic, the government can still claim its own calculations show the shortfall to have been cyclical rather than structural. After all, estimation of potential output - and hence the cyclical versus structural decomposition of the fiscal position - is notoriously difficult, even after the fact.

Perhaps it will help that, under the fiscal compact, the rules are to be adopted at the national level, as opposed to the SGP, which operated on the supranational level. A look at the various rules and institutions that European countries have already tried shows that some work and others do not.

Creating an independent fiscal institution that provides its own budget forecasts works, insofar as it reduces the bias in deficit projections. When forecasting while in violation of the eurozone's Excessive Deficit Procedure, eurozone members with an independent budget-forecasting institution have a mean bias that is 2.7 percent of GDP smaller at the one-year horizon than members without such an institution.

It would be better still if governments were legally bound to use these independent forecasts in their budget plans (borrowing an innovation from Chile). But, regardless of how well-designed the rules are, clever and determined politicians can find ways around them. One trick is privatization of government enterprises, which reduces the budget deficit in a given year on a one-time basis, but might increase the deficit in the long run if the enterprise had been profitable. Another trick is to legislate tax cuts that are "temporary," in order to make future revenues look larger, despite the intention to make the cuts permanent before they expire.

Other things being equal, the right institutions can curb pro-cyclical fiscal policies - tax cuts and spending hikes during booms and austerity during downturns - in the short run, while helping to deliver debt sustainability in the long run. These institutions include independent fiscal-forecasting agencies, combined with the cyclically adjusted budget targets that the eurozone's fiscal compact mandates. Much can go wrong even if such mechanisms are in place; but, as the history of the SGP illustrates, the risk is higher if they are not.

- Jeffrey Frankel is professor of capital formation and growth at Harvard University.

© Project Syndicate, 2013