EU fiscal rules have never been fully coherent. The adoption of constitutional rules requiring European governments to run permanent structural balanced budgets – pursuant to the treaty currently being negotiated in Brussels – will, however, make them totally incoherent and contradictory.
The problem is the lack of consistency between rules governing debt and those governing deficits.
The EU's long-standing rule for debt sets an upper limit of 60 percent of GDP. The case for such an upper limit to debt is strong. It recognizes that, while excessive levels of debt/GDP get governments into trouble, recourse to moderate levels of debt/GDP for long-term infrastructure financing is entirely legitimate. The fact that, even before the global financial crisis pushed debt up, many countries ignored the 60 percent limit points to a problem of enforcement, rather than conception.
If you are going to permit moderate levels of debt/GDP, any permanent rule concerning the budget balance must be compatible with that. This is the principle of stock/flow consistency. A balanced budget rule is, however, equivalent to setting a long-term target of reducing debt/GDP ratio to zero. With a balanced budget, the stock of debt remains constant and the debt/GDP ratio inexorably fall as nominal GDP grows.
This statement needs to be qualified marginally. Because the rule under discussion would require "structural" balanced budgets – that is, budgets which are balanced on average across the business cycle – it would permit the short term accumulation of debt during recessions on the condition that such debt is promptly paid off during the upswing of the business cycle. The additional qualification is that structural balanced budgets is to be interpreted as permitted very small structural deficits up to 0.5 percent of GDP. However, these are minor points. The key point is that long-term debt to finance infrastructure would be largely banned, and any permitted debt levels will be very low and largely comprised of short term cyclical debt. A rule requiring structural balanced budgets would therefore be completely inconsistent with the 60 percent debt limit.
If one wishes to preserve a role for debt in long-term infrastructure financing, it is necessary to permit countries which have moderate levels of debt to run small structural deficits. This allows the stock of government to grow broadly in line with the growth of the economy. For example, assuming trend rate of nominal GDP growth is 4 percent, a structural deficit averaging 2.3 percent of GDP would be consistent with limiting debt to a 60 percent of GDP.
Of course, none of this applies to countries like Italy and France which have allowed their debt to reach levels way in excess of the 60 percent limit. If debt is too high, balanced or surplus budgets may be needed for some years to reduce them. But this does not justify making balanced budgets a permanent rule. Nor does it justify imposing the balanced budget rule on the eight European countries – mainly in Scandinavia and the Baltics – which have debt levels well below 60 percent. Neither now nor at any stage in the past has European fiscal sustainability required governments to aim to eliminate public debt.
A permanent balanced budget rule would be a radical change for the worse from the deficit rule set out in the Maastricht treaty. This rule – honored mainly in the breach – sets 3 percent of GDP as the upper limit for deficits, to be breached only during "severe recessions". The 3 percent deficit limit – which in practice requires that the structural deficit not exceed 2 percent of GDP (given that the average elasticity of the budget balance with respect to GDP in Europe is 0.48) – is not dramatically inconsistent with the 60 percent debt limit.
It might be argued in defence of the proposed new balanced budget rule that it will simply give force to the long-standing clause of the EU Stability and Growth Pact which calls upon governments to maintain budgetary positions "close to balance or in surplus". But this clause never had operational force. Its main significance is as evidence of the EU's chronic inability to understand not only the principle of stock/flow consistency, but even the need for multiple flow objectives to be mutually consistent. The same is true of the European Council guidelines which have for some years called on member countries to target structural surpluses or deficits not exceeding one percent of GDP – notwithstanding that , as noted, the 3 percent debt limit is consistent with structural deficits as large as 2 percent.
The core fiscal sustainability challenge for much of Europe today is to get public debt down to sustainable levels, while at the same time reducing the level of pension and similar age-related expenditure obligations. Rather than constitutional balance budgets, the best approach would be to concentrate on strengthening the enforcement of the 60 percent debt limit and on making it mandatory (once macroeconomic conditions permit) for countries to gradually reduce current excessive debt levels back below 60 percent. This is, however, exactly what the so-called "six pack" of fiscal measures passed by the European parliament late last year does. Based on sound technical work by the European Commission's bureaucrats, these new measures give the 60 debt limit real force, as well as setting mandatory requirements for the reduction of excessive debt over time.
The "six pack" reforms differ from, and are superior to, the proposed balanced budget rule in another important respect: they acknowledge the impracticality of setting European-wide rules for the structural budget balance. Calculating the structural balance requires adjusting the actual budget balance for the effects of business cycle on government revenues and expenditure. The methodology for doing this is reasonably reliable in countries with mature economies such as Germany and Switzerland. It is, however, essentially impossible to reliably estimate the structural budget balance in countries undergoing rapid economic transition, such as Poland and the Baltic states. For precisely this reason, the "six pack" reforms proposes to tackle the problem indirectly. Recognizing that the key reason for the long-term failure of so many European countries to control their structural deficits has been the constant upward drift of expenditure, the "six pack" imposes a new expenditure rule limiting the growth of aggregate expenditure to the trend rate of GDP. Regrettably, however, this sophisticated approach looks like being in effect overridden by the simplistic doctrine of balanced budgets.
Why the sudden shift to a budget balance rule? Because Germany believed that the European-wide adoption of its own misconceived new constitutional balanced budget rule was the way of calming frightened financial markets. But the surge in yields which hit countries such as Italy and Spain late last year was the reaction to immediate banking system problems which were never going to be resolved by European commitment to a rule which is not planned to take effect for some years to come.