# Fiscal Rules: Stocks, Flows and All That

Today’s Euro summit document commits all members to a fiscal rule in which “the annual structural deficit does not exceed 0.5% of nominal GDP.” It also commits to “The specification of the debt criterion in terms of a numerical benchmark for debt reduction (1/20 rule) for Member States with a government debt in excess of 60%.”

I’m on the record as being in favour of numerical benchmarks for debt reduction. Indeed, I argued for a more stringent one than the one-twentieth rule that has been proposed by the Commission and has been adopted today.

However, I wonder whether those proposing the limit of 0.5% of nominal GDP on the structural deficit have thought about what this implies for debt ratios. I take this proposal to mean that the average deficit, going through the cycle, should not be more than 0.5% of GDP.

Now suppose a country consistently ran a deficit of exactly 0.5% of GDP. What would happen to its debt-GDP ratio?

Here’s a little note describing the dynamics of the debt-GDP ratio in a simple world with a constant deficit ratio, d, and a constant growth rate of nominal GDP, g. It shows that the debt to GDP ratio converges over time to (1+g)*d/g. (One could add random fluctuations in the growth rate or the deficit ratio and then the debt ratio would cycle around this long-run average value. Also, the timing assumption could be changed so that the current-period debt is determined by last period’s deficit, in which case the (1+g) would dissappear, but that wouldn’t make much difference to the calculation.)

Let’s assume a modest long-term growth outlook for the Euro area of 3 percent nominal GDP growth, i.e. 2 percent inflation and 1 percent growth in real GDP. In this case, the long-run implication of a 0.5 percent of GDP deficit ratio is a debt-GDP ratio of 1.03*0.005/0.03 = 0.172.

Since 0.5 percent of GDP is to be a maximum for the average deficit, this is a fiscal rule that would see long-run debt-GDP ratios below 17 percent of GDP in all Eurozone member states.

This is, of course, a long way from where we are now in most member states. Many countries currently have excessive debt ratios and there is a need to get debt and deficit ratios down over the medium term. It would take a very long time for countries like Ireland to end up with this very low debt ratio, so these limits may work fine as a medium term rule for high debt countries.

However, taken on its own merits, this rule doesn’t seem to make much sense as a long-run legally binding rule. As an alternative, an average deficit of 1.5 percent of GDP could combine with a nominal growth rate of 3 percent to produce a stable and manageable average debt-GDP ratio of 51.5 percent. This would seem like a more sensible benchmark.

Of course, if a government followed such a policy, normal cyclical fluctuations would likely take the economy above a 3 percent deficit fairly often without in any way jeopardising long-run fiscal stability. So the elevation of a three percent deficit limit to sacred cow status (“As soon as a Member State is recognised to be in breach of the 3% ceiling by the Commission, there will be automatic consequences unless a qualified majority of euro area Member States is opposed”) has little grounding in the actual economics of fiscal stability.

There is little doubt that Europe needs to act to reduce debt levels over the medium term and better institutional fiscal frameworks are required. However, these rules, however much they may appeal to the Swabian housewife instinct, are overly restrictive and have little connection to fiscal arithmetic. They are all the more likely to be flouted in future because of their poor design.

## 36 replies on “Fiscal Rules: Stocks, Flows and All That”

David O'Donnellsays:

As I just noted on previous thread:

Figures such a 0.5, 3.0 and 60.0 are mere abstractions, with no innate validity whatsoever. In crisis time, such rigidities may turn out to be more of a hindrance than an assistance to many EU regions getting out of the present mess; including the one around here.

Principles must Trump Rules if EU to progress.

Georg R. Baumannsays:

…these rules, however much they may appeal to the Swabian housewife instinct…

How much more must they appeal to the prussian technocrats.

Kevin Donoghuesays:

Karl Whelan: “I take this proposal to mean that the average deficit, going through the cycle, should not be more than 0.5% of GDP.”

I took it to mean that the deficit, adjusted for cyclical effects, must be at most 0.5% of (potential?) GDP. Your guess is undoubtedly better than mine, but is there anyone who can tell us what it would actually mean, if it ever became law? Hans-Werner Sinn? Bueller? Anyone?

The Dork of Corksays:

Structual defecits have no relevance in a world with no fixed exchange rates.
Its a term with a 40 year obsolescence already.
Its a abstraction on top of a mistake.

The only mechanism to reduce leverage at the moment is to increase goverment money production – hopefully interest or near interest free.

BeeCeeTeesays:

@Karl,
Having some Swabian housewife tendencies myself, I’d tend to see the lack of flexibility in a 0.5% GDP (or better, in Ireland’s case, GNP) structural deficit as being more positive than negative, even once debt levels move out of scary territory.

I’m sure there must be a substantial literature about the relative merits of debt levels that are very low versus debt levels in the region of 50% to 60%. If you are familiar with the literature, and have the time, I think we would all find it educational if you could draw the main plusses and minusses it raises to our attention.

Carsonsays:

What is Ireland’s structural deficit at the moment? Is there a uniformly agreed definition of what elements of a deficit are structural and what ones are cyclical?

Threw this excel sheet together to make the same point Karl, but if you take a look at a few parameter settings, you see the point you make is all the more forceful when we’re far from that steady state, the excel sheet is here: http://dl.dropbox.com/u/1484382/debtfun.xlsx

Also, this is a world where the debt never gets repaid, so the ever-rising stock of debt is something to behold, even if the D[t]/Y[t] ratio does stabilise!

Kevin Donoghuesays:

Sometimes I would prefer to be a more trusting person. But FWIW they following statements strike me as very probably true:

1) Less than five of the Heads who signed up have a good idea what the term “structural deficit” actually means and how it relates to the concept of potential GDP. (Could some enterprising interviewer run a check on Enda?)

2) The term used in the German-language document is not understood by Hans-Werner Sinn in the same sense as Karl Whelan understands the term “structural deficit.”

The positive side to this is that there may still be time for good people to bring some sense into the discussion before the rules are finalised. In that regard I say more power to Karl’s elbow.

Overseas commentatorsays:

When all the 17 Euro Nations ,plus a half-dozen new ones reach the 60% ratio ,it will be time to worry about what to do next.

Gray, Germanysays:

“Structual defecits have no relevance in a world with no fixed exchange rates.”
Oh, yes, they do. Because you either try to keep the confidence of the investors up, or else you inflate your way out of debt. That’s only a choice between Scylla and Charybdis. It’s best to stay out of those dangerous waters.

Shay Begorrahsays:

@Gray, Germany

Because you either try to keep the confidence of the investors up, or else you inflate your way out of debt.

Enter the confidence fairy, wearing lederhosen.

<a href=”http://krugman.blogs.nytimes.com/2011/10/23/more-grim-euro-thoughts/”Krugman, from the 28t of October.

Basically, the ECB pooh-poohs any notion that austerity would have major negative effects on the economy, suggests that it’s quite likely that the confidence fairy will make everything OK

And again from December 2nd

The European fiscal crisis: confidence fairy a no-show

The answer you hear all the time is that the euro crisis was caused by fiscal irresponsibility….But the truth is nearly the opposite. Although Europe’s leaders continue to insist that the problem is too much spending in debtor nations, the real problem is too little spending in Europe as a whole.

German monetarist fanaticism may well destroy the EU as any kind of progressive enterprise.

Gray, Germanysays:

@Shay Tell those stories to the investors who quite obviously don’t have much confidence in GIPSI bonds now. Or how else do you explain the interest rates?

Kevin Donoghuesays:

Okay, maybe I was too cynical. I can’t read German but using Google Translate I’ve tried to figure out how Germans use the term “strukturelle Defizit” and AFAICT it is correctly translated as structural deficit. That still leaves a lot of scope for argument as to how the annual structural deficit is derived from the raw deficit for purpose of enforcing this rule:

General government budgets shall be balanced or in surplus; this principle shall be deemed respected if, as a rule, the annual structural deficit does not exceed 0.5% of nominal GDP.

Is there a generally-accepted methodology for doing such calculations? I suspect not, but I’d be happy to learn that I’m wrong. I dread to think what the lawyers would make of “as a rule.”

For the benefit of those who do read German, here’s that paragraph again:

Die staatlichen Haushalte müssen ausgeglichen sein oder einen Überschuss aufweisen. Dieser Grundsatz gilt als eingehalten, wenn das jährliche strukturelle Defizit generell 0,5% des nominellen BIP nicht übersteigt.

Shay Begorrahsays:

@Gray, Germany

@Shay Tell those stories to the investors who quite obviously don’t have much confidence in GIPSI bonds now. Or how else do you explain the interest rates?

Perhaps the investors think the focus should be on the real economy rather than fetishisising the currency?

Still, I can see your point of view. Your Teutonic Thatcher has dealt with the current crisis of capitalism by making it illegal in future. Perhaps she should consider making cancer illegal too – that should discourage people from becoming ill and save the state millions!

David O'Donnellsays:

Wittgenstein sorted this out years ago during a bender in Dublin: ‘The meaning of structural deficit is how it is used.’

Georg R. Baumannsays:

Perhaps she should consider making cancer illegal too

Shay, there was a small article in the Spiegel today. A traveller was told by staff it is forbidden to use his Laptop in the train’s restaurant. The noise of the keys would disturb guests. He was told to pack it in.

The Dork of Corksays:

@Gray
I don’t believe in privatised money so you are barking up the wrong tree.
If they want to invest let them do so in credit money at their own risk / return comfort zone.
Term loans , Bank bonds etc.
The domestic CB primary job should be about keeping the money supply stable , not bailing out their friends & usual suspects at the money values expense.
I despise False Fiscal conservatives.

Shay Begorrahsays:

@Georg R. Baumann

Truth be told I always found the German love of rules endearing. The late Gerry Ryan had a lovely story about trying to sneak on to a tram in Germany without paying (while a penniless emigrant) and a stout example of German citizenry sternly reprimanding him and explaining that if Gerry would not pay for his own ticket the god burger would have no choice, no choice at all, but to buy his ticket for him.

I did not understand until the global financial crisis that this obsession with escaping from trouble with strict rules might have a less rational, much less charming side.

Shay Begorrahsays:

Correction: Obviously Gerry Ryan was threatened/rescued by a responsible burgher and not the divine mince meat patty. Double typo shame.

grumpysays:

At the risk of being boring, could I yet again bang on about how particularly stupid a rigid 3% deficit limit is for states that have (through being small, open, or whatever) a greater likelyhood of larger swings in GDP – kind of ‘high beta economies’.

@ grumpy

Surely you’re not suggesting a one-size-fits all policy won’t work in across a heterogeneous variety of states?

The Dork of Corksays:

@Gavin
Thats why they want to destroy nation states and mould us into a devastating blandness something akin to their Dream / our nightmare – the US of A.

Kevin Donoghuesays:

@grumpy, solution is simple: anschluss; problem solved.

Kevin Donoghuesays:
Shay Begorrahsays:

@Gavin Kostick

Surely you’re not suggesting a one-size-fits all policy won’t work in across a heterogeneous variety of states?

You misunderstand the logical compact that underpins the new EU, and to which we are all now parties.

In the new EU all problems will be obliged to conform to the legally permitted solutions. Those national problems that do not conform to the available policy options will henceforth be known as the unavoidable consequences of being part of a currency union in a globalized economy where maintaining investor confidence, adhering to strict market discipline, paying our debts and protecting the value of the Euro is key to success.

The success of what is not covered in this posting.

Bryan Gsays:

@DOD et al.

“Principles must Trump Rules if EU to progress.”

Germans don’t trust themselves to do principles, that’s why they do rules. A colleague had a theory that Germans were at heart extremely disorganized and prone to irrationality, and that’s why they had so many rules – without them everything would simply fall apart. There’s definitely something to that.

I’m surprised that the Fiscal Compact Treaty doesn’t also include changing the EU flag from 12 gold stars to 12 gold crosses. I think that would nicely capture both the new found puritan protestant spirit of austerity, and the modern day cross of gold on which everyone seems so determined to crucify themselves.

@ Bryan G, n all

“I think that would nicely capture both the new found puritan protestant spirit of austerity”

The dream:

Kevin Donoghuesays:

For those who (like me) want some sense of where this deal came from and where it may lead:

WILL Schuldenbremse enter the French or Italian languages the way “kindergarten” has become part of English? Perhaps. On December 5th the German chancellor, Angela Merkel, and the French president, Nicolas Sarkozy, agreed that the 17 euro-zone countries should insert a German-style “debt brake” into their constitutions. That, say Europe’s first couple, will help prevent a recurrence of the crisis that threatens the euro’s survival. The European Court of Justice should verify that all the national Schuldenbremsen pass muster.

Read the whole thing, as the perfesser would say:

http://www.economist.com/node/21541459/print

jmgsays:

Another translation for the german word Bremse is gadfly. “Debt gadfly” instead of “Debt brake”. Sounds better to me.
If you want to know more about the german Schuldenbremse you can read an article in the monthly report of the Bundesbank for October 2011. It is in german, but will be translated into english. Then it will be available here:
http://www.bundesbank.de/volkswirtschaft/vo_monatsbericht_aktuell.en.php

Kevin Donoghuesays:

@jmg, Thanks I’ll look out for it.

Jon Ihlesays:

Schuld also means ‘guilt’, ‘responsibility’ or ‘fault’, as in ‘Wer ist am Schuld?’ – ‘Who is at fault?’ The word ‘debt’ in English and the Latin derived languages is much less freighted with moral implications: all come from ‘debere’ – to owe (sometimes ought, must or should).

David O'Donnellsays:

@jmg Jon Ihle

Wittgenstein would approve …

The KinderGarten Summit …

[…] ratio of 20% would be implied. As has been pointed out by a number of commentators (see Karl Whelan here and Com McCarthy here ) this is likely to take a very long time, and in any case would result in […]

[…] to fulfil that role. The fiscal compact states a maximum permissible deficit of 0.5% of GDP. It is easy to work out that with modest growth of say 3% then the deficit rule will result in a long term debt to GDP […]