Stress testing the EU fiscal framework

Igor Masten, Ana Grdović Gnip

Fiscal policies in European Economic and Monetary Union states are being reinforced. This column argues that the cyclically adjusted budget balance will be an imprecise tool for measuring fiscal discipline, and structural deficit rules limits are too stringent. If the official methodology is used to trigger corrective fiscal contractions, it may increase macroeconomic instability.

National fiscal policies in the European Economic and Monetary Union states are subject to common fiscal rules. The Maastricht Treaty requires member states not to exceed a government deficit limit of 3% of GDP and a public debt limit of 60% of GDP. To ensure compliance with these rules, the Stability and Growth Pact (SGP) restrains the structural deficit of member countries to 1% of GDP. If the structural or cyclically adjusted budget is kept close to balance (CABB) or in surplus, it provides, in principle, a safety margin that allows the fulfilment of the Maastricht deficit criterion while enabling the free operation of automatic stabilisers.

This fiscal framework has proved to be too lax to prevent the spread of fiscal imbalances (ECB 2008, 2012), resulting in the sovereign debt crisis. As a response, the EU took a number of measures, among which the Fiscal Compact (designed to foster fiscal discipline) and Six-Pack (to strengthen the SGP) stand out.1 The enforced Fiscal Compact sets a stricter limit for the structural deficit of 0.5% of GDP.

In the refined fiscal framework, the CABB remains the main reference criterion despite doubts that it is an appropriate gauge of discretionary fiscal policy (e.g. Choraqui et al. 1990, Hers and Suyker 2014). Others question its estimation shortcomings (e.g. Alberola et al. 2003, Larch and Salto 2003, Larch and Turrini 2009, McMorrow et al. 2015). In the reinforced EU fiscal framework, we should still question whether the CABB is a reliable measure of fiscal policy stance. As a result, it's still an open question whether the (reinforced) fiscal framework successfully fosters fiscal discipline while allowing member countries to use fiscal policy as a tool of macroeconomic stabilisation.

A simulation experiment

But does the CABB even measure what it is supposed to measure? We ask this in our recent study (Masten and Grdović Gnip 2016). In other words, is the CABB a good measure of discretionary fiscal policy? If it is not, it cannot be a good tool for monitoring fiscal discipline.

To answer, we performed a stress test-like analysis of the EU fiscal framework using a novel simulation experiment. We use a DSGE model with a detailed specification of the fiscal block based on Adolfson et al. (2007). The model is estimated on Austrian data from 1999 to 2009. We use Austrian data because of the stability of its fiscal system, particularly during that period.

The most important advantage of our approach is that is uses a structural model, so we are able to distinguish between automatic and discretionary fiscal policy. The DSGE model is used to generate macroeconomic data needed to estimate the CABB with the official EC methodology, and check whether it is able to identify the true discretionary measures generated by the DSGE model.

We also use the experiment to assess the macroeconomic implications of the two most important EU fiscal criteria: the Maastricht 3% GDP limit on the budget deficit, and the SGP 0.5% of GDP limit on structural deficit.2 Breaching either can, in principle, trigger corrective restrictive fiscal policy measures. This raises two issues.

The first concerns the welfare implications of potential mis-signalling of the breach of the structural deficit threshold. Namely, in cases when the CABB estimated with the EC methodology signals a deficit above the 0.5% of GDP threshold, while in reality it is not so, the EC methodology could trigger pro-cyclical corrective measures that might destabilise the economy.

The second is the appropriateness of the 3% deficit-to-GDP and 0.5% structural deficit-to-GDP ceilings in terms of stabilisation efficiency. We address the trade-off between fulfilling the Maastricht and the SGP deficit criteria by altering the responsiveness of government spending to output gap and to public debt. Doing so allows us to simulate whether the 3% of GDP deficit and 0.5% of GDP structural deficit limits allow for sufficient room for manoeuvre for stability-oriented fiscal policy.

The CABB is imprecise

Our main results show that the official EC methodology performs poorly when it is asked to determine the fiscal policy stance. On average, it wrongly signals either the expansive or restrictive fiscal policy stance roughly 40% of the time (Figure 1). This is true for normal cyclical fluctuations and also in deep and prolonged economic downturns like the Great Recession of 2008. This is because the EC methodology misattributes much of the cyclical variation in the budget balance to discretionary fiscal policy.

Figure 1 Fiscal policy stance occurrence

While our basic model was a small open economy in a monetary union, the results are the same when we model a large country with independent monetary policy.

The SGP fiscal limits are too stringent

The Resolution to the European Council on the SGP specifies:

"[A]dherence to the objective of sound budgetary positions close to balance or in surplus will allow member states to deal with normal cycle fluctuations while keeping the government deficit within the value of 3% of GDP."

We show that, in principle, this is almost true. In our model the budget is balanced over the business cycle, with the deficit exceeding the 3% deficit-to-GDP limit in only 9% of periods. More importantly though, breaching the SGP structural deficit rule is not associated with a violation of the 3% deficit limit in 37% of cases.

Figure 2 Compliance with Maastricht and SGP rules

Therefore the provisions of the SGP seem to be too stringent for compliance with the Maastricht 3% deficit-to-GDP limit.

Macroeconomic consequences

The stringency of the SGP provisions, combined with a weak capacity of the CABB to capture discretionary fiscal policy measures, yields suboptimal conditions for macroeconomic stabilisation. The official EC methodology mis-signals the violation of the SGP structural deficit limit in about 25% of cases. Mis-signalling is even more pronounced during the Great Recession. Triggering corrective measures (fiscal tightening) in such cases leads to increased volatility of GDP growth.

Figure 3 Structural deficit rule performance

Note also that in our simulation, stabilisation efficiency of fiscal policy is independent of the phase of the business cycle or monetary policy stance. In other words, the fiscal multiplier is constant in time. The fiscal multiplier, however, can increase in recessions (Auerbach and Gorodnichenko 2012) or when the central bank instrument is at the zero lower bound (Woodford 2010). This would reinforce our results.

Policy mis-signalling

Our results indicate that the EC methodology for CABB estimation tends to attribute much of the automatic variation in the budget to discretionary policy measures. As a consequence, the EC methodology frequently fails to identify the true fiscal policy stance. It also frequently fails to correctly signal potential violations of the SGP limit on structural deficit. If the official methodology is used to trigger corrective fiscal contractions in order to comply with the SGP, it results in increased macroeconomic instability.

Our results reflect the specifics of our model, and so alternative specifications might yield numerically different results. On the other hand, this is a standard model which is empirically realistic, and our results apply equally to small and large economies alike. Large economies potentially have an impact on the ECB's monetary policy. We believe that our simulation experiment is a realistic environment for policymakers, and there are two policy implications.

Implication 1: The CABB estimation methodology needs revision

Explicitly incorporating a structural description of discretionary fiscal policy would help. One possible suggestion is an expenditure fiscal rule in a fully-fledged macroeconomic model. This could easily be complemented with a representation for the discretionary part of budget revenues.

Implication 2: The SGP limits are too tight for effective fiscal stabilisation

Allowing for a bigger role for discretionary policy could enhance the stabilisation efficiency of fiscal policy without jeopardising compliance with the Maastricht Treaty. For a large set of the parameter values in the expenditure fiscal rule, relaxing the 0.5% SGP limit actually increases the probability of compliance with the Maastricht 3% limit on total deficit. In other words, allowing for a more active fiscal policy would simultaneously increase macroeconomic stability and the sustainability of public finances. It is important to note that we obtain this result in a model with relatively small fiscal multipliers.

We do not attempt to provide an exact alternative specification of the SGP structural deficit ceiling, but our model nevertheless suggests that a revision of the SGP provisions to allow for a more active fiscal stabilisation might increase the overall robustness of the EU fiscal framework.

Whatever the policy implications, a robust fiscal framework should always remove the fiscal spending bias observed in many developed economies. That said, our analysis shows that a more active discretionary policy is possible for EU members with a debt-to-GDP ratio significantly below 60%. For these countries the structural deficit limit can be relaxed to 1%.

We think that this deserves more detailed study, especially because the reinforced EU fiscal framework will be implemented permanently in national legislation, and even at the constitutional level.

References

Adolfson, M, S Laseen, J Linde and M Villani (2007), “Bayesian Estimation of an Open Economy DSGE Model with Incomplete Pass-Through”, Journal of International Economics 72(2), pp. 481-511.

Alberola, E, J M Gonzales Minguez, P Hernandez de Cos and J M Marques (2003), “How cyclical do cyclically-adjusted balances remain? An EU study”, Revista de Economia Publica 166(3), pp. 151-181.

Auerbach, A and J Gorodnichenko (2012), “Measuring the output responses to fiscal policy”, American Economic Journal: Economic Policy 4(2), pp. 1-27.

Chouraqui, J C, R Hagemann and N Sartor (1990), “Indicators of Fiscal Policy: A Re- examination”, OECD Department of Economics and Statistics Working Paper No. 78.

ECB (2008), “Ten Years of the Stability and Growth Pact”, ECB Monthly Bulletin, October.

ECB (2012), “A Fiscal Compact for a Stronger Economic and Monetary Union”, ECB Monthly Bulletin, May.

Hers, J and W Suyker (2014), “Structural budget balance – A love at first sight turned sour”, CPB Brief No. 2014/07, CPB Netherlands Bureau for Economic Policy Analysis.

Larch, M and M Salto (2003), “Fiscal Rules, Inertia and Discretionary Fiscal Policy”, European Economy Economic Papers No. 194, European Commission.

Larch, M and A Turrini (2009), “The cyclically-adjusted budget balance in EU fiscal policy making: A love at first sight turned into a mature relationship”, European Economy Economic Papers No. 374, European Commission.

Masten, I and A Grdović Gnip (2016), “Stress testing the EU fiscal framework”, Journal of Financial Stability (in press).

McMorrow, K, W Roeger, V Vandermuelen and K Havik (2015), “An assessment of the relative quality of the Output Gap estimates produced by the EU’s Production Function Methodology”, EC Discussion Paper No. 020, December.

Woodford, M. (2010),”. Simple analytics of the government expenditure multiplier”,. NBER Working Paper No. 15714.. Cambridge: National Bureau of Economic Research.

Endnotes

[1] The Fiscal Compact embraces the fiscal part of the Treaty on Stability, Coordination and Governance and runs in parallel with the Six-Pack that covers not only fiscal but also macroeconomic surveillance in the EU. Both include strengthened provisions from the SGP.

[2] To be precise, the SGP allows a structural deficit up to 1% of GDP, but the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union (Fiscal compact) makes the same provision more stringent, and formalises the limit at 0.5% of GDP.