Guarding the public finances: the power of fiscal rules

By on 14/03/2019 | Updated on 14/03/2019
By eluding the EU’s fiscal rules, Greek politicians helped set up the country’s downfall when the credit crunch hit (Image courtesy: underclassrising/Flickr).

When politicians are feeling virtuous, they introduce fiscal rules. When they succumb to temptation, they break them – and the public suffers the consequences. Gavin O’Toole explores their power and their pitfalls 

Italy recently looked set to implement a set of “bad fiscal policies led by populists”, says Grégory Claeys, research fellow at the Bruegel think tank in Brussels. But the EU’s fiscal framework kept a lid on the governing coalition’s ambitions – helping to preserve both Italy’s public finances, and by extension the EU’s fiscal stability.

Italy’s anti-establishment ruling coalition, comprising the Five Star Movement and Northern League, had planned expansionary policies financed by raising the budget deficit – the gap between government spending and income – to 2.4% of GDP in 2019.

EU rules oblige member states to keep the ratio of their deficit to GDP below 3%, and public debt under 60% of GDP. But Italy’s debt already stands at a breathtaking 132%; and the European Commission calculated that if the Italian government held its course, its deficit in 2020 would hit 3.1%. So the commission threatened to impose penalties, and the Italians changed their plans – cutting their planned deficit to 2.04%.

“Europe’s fiscal rules are by no means perfect, but at least what the Italian example showed us is that they managed to avoid extreme deviation – so in that sense they worked,” comments Claeys.

What are fiscal rules?

The dispute drew attention to the use of fiscal rules to govern public finances – a topic examined in a recent assessment by the IMF, which examined their effectiveness in 90 countries.

Fiscal rules constrain economic policymakers by setting targets for government spending and debt, in order to contain pressures to overspend and hence keep debts manageable.

The IMF identifies four main types of rules in use: debt rules that set a limit on the stock of public debt; budget balance rules that limit the deficit, constraining the annual growth of public debt; expenditure rules that curb spending; and revenue rules that set ceilings on taxation.

Each has different effects. But the overall aim is to help policymakers maintain fiscal ‘discipline’, in the parlance of international financial institutions, by responding to the so-called ‘deficit bias’ – the tendency of governments to run excessive deficits and accumulate ever more debt, often in response to public pressure to spend more on services, benefits and subsidies.

Who polices them?

The champions of fiscal rules say that they send signals to financial markets that governments intend to be fiscally responsible, thereby reassuring investors and enhancing a country’s creditworthiness. This enables it to borrow more cheaply, for lenders are confident that the government will have the money to pay them back.

So whilst some rules – such as the European Union’s governing the behaviour of members of the Eurozone – are policed and enforced, market pressures also create a stronger incentive for countries to obey their own rules. Once a government has set down a line governing its own behaviour, markets tend to see any breach of those lines as a sign that the government may be untrustworthy – and thus the interest rates they charge for loans rise. Market pressure of this kind was a key factor in the Italian government’s retreat.

Garry Young, director of macroeconomic modelling and forecasting at the National Institute of Economic and Social Research, says that when markets are concerned about the sustainability of a fiscal position, a government must pay attention.

“It is not just other countries that are concerned about the Italian debt being too high, but the markets as well,” he explains. “This recent spat between Italy and the European Commission saw the cost of Italian government borrowing rise, which suggests the markets lacked confidence in Rome and whether they really mean to have a sustainable fiscal position in the long-run.”

As well as the threats of punishment or pricier borrowing, governments are encouraged to stick to their rules by the negative results of excessive borrowing. High debt levels can limit growth by limiting states’ ability to invest: IMF research indicates that every 10% rise in the debt-to-GDP ratio slows growth by 0.2 percentage points. And outside the Eurozone, countries that are tempted to expand their money supply to pay off debts often end up suffering from high inflation rates.

Saving governments from themselves

Governments tend to sign up to fiscal periods in times of plenty, knowing that they should set aside some of their surplus for harder times. Many even create ‘fiscal councils’ to monitor compliance: Italy’s version, the Ufficio Parlamentare di Bilancio, played a key role in challenging its populist government’s spending plans.

“Fiscal rules can also help countries better weather an economic crisis by acting as a ‘buffer’, because they help to ensure governments avoid excessive spending – for instance during boom periods – that exhausts the fiscal reserves that it needs in a recession,” says Luc Eyraud, the lead author of the IMF’s recent assessment of fiscal rules, a deputy division chief in the Fiscal Affairs Department and now its mission chief on Benin.

And whilst few governments stick rigidly to their own rules, they do have an impact: IMF research on 140 countries from 1985–2015 indicates that deficits averaged 2.1% of GDP in the absence of rules, against 1.7% in their presence.

Gordon Brown, pictured in 2008 – as the financial crisis undid his political legacy (Image courtesy: World Economic Forum/Andy Mettler).

Writing the rulebook

National fiscal rules proliferated in the 1990s, when OECD governments began to rein in historical debts and vest control of monetary policy to independent central banks. The launch of the euro created a tier of supranational fiscal rules in the EU, within a rulebook called the Stability and Growth Pact. And rules have also grown apace outside Europe, being adopted by emerging economies such as Argentina, Brazil, Colombia, India and Pakistan since 2000.

The global financial crisis in 2007–08 spawned what the IMF calls a “second generation” of rules across the world, which aim to be more flexible than those in place beforehand.

Countries have also increasingly adopted multiple rules: in Europe, for example, the average country has six fiscal rules, and many non-European countries have three or more.

Multiple rules can greatly complicate fiscal policy, and the IMF advises policymakers to adopt simple frameworks around two rules: a rule to ensure debt is manageable; and an “operational rule” – such as an expenditure or a budget balance rule – to enable the government to achieve its debt objectives by guiding budget decisions.

When the law’s an ass

While there is general agreement that rules can be valuable, they can also create problems.

By curbing public investment, for example, they risk suppressing growth. Multiple rules become complicated to enforce, generating confusion that can offer politicians opportunities to manipulate figures through creative accounting. And they often fail to consider how changing demographics or economies will affect future revenues and demand for services, and thus debt levels.

Business cycles – trends of economic expansion and contraction – also affect the ways that rules operate. One response is cyclical rule-making, which aims to build buffers in good times and allow fiscal policy to support the economy in bad times: so-called ‘counter-cyclical’ policy.

Bending the rules

But even the best rules can be played by politicians when it suits them. One notable example of this weakness came in 2005, when the former UK Chancellor of the Exchequer, Gordon Brown, was accused of fiddling his own “Golden Rule” – which stipulated after Labour came to power in 1997 that the budget had to be balanced over the economic cycle.

In 2005, the Treasury pushed back its original estimate of when the cycle had begun from 1999 to 1997 – yielding a fiscal position measured over the cycle which allowed Brown to up his borrowing. “It was ridiculous that revisions to a period five or six years earlier were being used to give the government room to spend more at that particular time,” comments Gary Young.

And the story didn’t end well for Brown, who ran a deficit from 2003 until the credit crunch hit in 2008 – driving down tax revenues and forcing him to radically increase spending. Assailed by the Conservatives for not “fixing the roof whilst the sun was shining”, he lost the only election he fought as prime minister in 2010.

As Kristina Budimir, a research associate at the Liechtenstein Institute, notes: “If the economic situation is not very good then politicians expand spending to fill the output gap, and then the debt ratios rise. And then, if a normal economic situation follows, they will not try to pay the debt but will continue to spend as usual.” Most political leaders are simply not very good at fixing the roof whilst the sun is shining.

Complexity and public pressure

So fiscal rules can be valuable in encouraging political leaders to manage the public finances responsibly – but as Luc Eyraud points out, they’re far from perfect. “We found three main problems,” he says. “First, too many rules create overlap, inconsistency and confusion. Second, if a rule is too rigid, it may not allow you to address changes in the macroeconomic or fiscal environments – so you want some flexibility. The third big problem is compliance: rules are not very well complied with.” 

This last point is, ultimately, one for elected leaders – but as Kristina Budimir points out, they can come under a lot of pressure to bend the rules. “The median voter decides how much we spend and how high the taxes, social security contributions [etcetera] will be,” she comments. And in Europe, at least, “the median voter is now very old and will always vote for high retirement benefits, high taxes, and high social security contributions – and hence high expenditure.” Fearful of being outflanked by more populist opponents, many politicians are reluctant to deny the public what it wants on these fronts.

It is partly due to this problem that, in the sample of fiscal rules systems examined by the IMF, they were complied with only around half of the time. Some have even suggested that the number of breaches of the EU’s rules means that rules-based governance may have reached its limits.

Lessons from history

However, it’s not hard to find examples of occasions on which the bending of fiscal rules has brought catastrophe to those applying the pressure. Gordon Brown’s Labour Party, of course, paid a high political price for allowing the perception to be created that his much-touted commitment to “prudence” was only skin-deep. And the fate of Greece, which for some ten years has endured the longest recession ever to hit an advanced capitalist economy, provides another salutary lesson.

For the Greek government entered the Eurozone by subverting the EU’s fiscal rules, hiding its true debt and deficit figures in order to meet the entry requirements – and continuing to conceal key aspects of its finances after joining. The truth was revealed when the Great Recession arrived in 2009, exposing the true weakness of Greece’s public finances; and the revelations over its misleading use of data seriously weakened the confidence of investors and other EU members. Had Greece stuck closely to the EU’s fiscal rules, its entry to the euro might have been delayed; but its economy and public finances would have proved far more resilient when the financial crisis hit, and it could have retained the trust of key partners.

So even if fiscal rules aren’t perfect – and even where compliance is compromised – it’s generally better to have them, and to seek to follow them, than to give up on the idea. The IMF points to research suggesting that rules can influence fiscal outcomes in positive ways even when broken.

Flawed but valuable

“A lot of people say that rules do not work because they are not complied with,” comments Eyraud. “But what would have happened without the rule? Rules can create what we call a ‘magnet effect’, attracting policymakers towards a deficit target or threshold. Because of this attraction effect, a lot of countries would do worse without the rules than with them.”

And it’s easiest to generate this magnet effect, the IMF says, where rules have been well designed. That means broad coverage of a budget to avoid loopholes, setting budget limits based on sound calculations – and political acceptance.

“There are three characteristics of good rules,” concludes Eyraud. “First, simplicity, because if rules are too complicated nobody can understand them. Second, we want them to be flexible – but not too much! And the third characteristic is enforceability, meaning that policymakers need to have the right incentives to apply them.”

And from the examples of Greece and the UK, it’s clear that those incentives can’t come in the form of delayed punishment for breaching the rules; for politicians face up-front political pressures. So set up a fiscal council – and make sure it’s ready to kick up a stink.

Political leaders may find its challenges uncomfortable. But their inconvenience is vastly outweighed by the pain of populations who must pick up the pieces after their former leaders, keen to steer round their own financial rules, have driven their public finances into a massive pothole.

About Gavin O’Toole

Gavin O’Toole is a freelance writer and editor in London. He has written for leading newspapers, magazines, wire services and business schools about financial markets, business and regulation around the world. He has a particular interest in international relations, and a specialism in Latin American affairs. He has conducted research on this region’s political economy and has also published a number of books about its politics and natural environment. His latest title, Environmental Security in Latin America, will be published by Routledge in September 2017.

One Comment

  1. jim says:

    Well written & quite informative.

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