EconPol analysis shows all major eurozone countries are over-spending relative to rules for sustainable public finances

In the debate on euro area fiscal governance, the current deficit rules of the EU have repeatedly been criticised to have a pro-cyclical effect, leading to overly lax fiscal policies in good times and a too restrictive regime in bad times. An analysis by EconPol researchers Clemens Fuest (ifo) and Daniel Gros (CEPS) shows that most major EU countries are over-spending at a level not compatible with spending rules for sustainable public finances.

In a paper released today, Fuest and Gros explore the implications of introducing a spending rule to guide public finances in the euro area. The rule stipulates that spending growth should not exceed long term GDP growth unless tax increases finance more spending. For countries with debt levels above 60% spending growth should be less than GDP growth. In the highly indebted Eurozone countries the combination of low growth and the objective of bringing down debt levels towards 60 per cent of GDP in the long term do not allow for much growth in expenditure, they say.

“The extent of over-spending depends of course on the exact values of the parameter of the [spending] rule, but the general result is that these countries are budgeting increases in current expenditure that exceed their long term GDP growth or that are incompatible with the goal of reducing the debt ratio,” they say. “Our results also suggest that spending rules tend to have a greater disciplinary effect in good times compared to deficit rules.

“All the major and highly indebted euro area countries are increasing spending by more than what would be compatible with the official target of the so-called Fiscal Compact, namely to bring debt levels down to a target of 60% of GDP in about 20 years or keep it below that target,” they continue. Germany’s debt is below the 60% threshold but spending growth exceeds long term GDP growth.

“A much laxer variant of the spending rule, allowing half a century to reach the 60% target, would lead to a similar result. Excess spending would be lower but all countries would still spend too much. This is particularly worrying in the case of Italy: the only country where public sector capital stock is falling because consumption of capital far exceeds gross investment spending. But our analysis also shows that the choice of the base year is important. If the base year is 2016 instead of 2017, excess spending would be much lower for some countries, especially France and Italy. Another insight generated by this analysis is that spending rules foster fiscal discipline in good times.”

Rules could be enforced, the authors suggest, by requiring countries to finance spending above the ceiling by issuing accountability bonds (junior government bonds) to increase market pressure and adjust spending. An alternative would be to require automatic increases in taxes, although authors note that this approach has been unsuccessful in Italy.