Fiscal rules: tied to the mast?

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Joan Daniel Pina
February 5th, 2012

Homer told how, so as not to succumb to the Sirens' song, Ulysses decided to tie himself to the mast of his ship, ordering his crew to plug their ears with wax. Thanks to this decision, the Greek hero managed to avoid wrecking the ship against the reefs and was able to continue his long journey home. In a similar way, the Spanish government approved two new rules in 2011 that restrict fiscal policymaking by introducing limits to public spending and deficit. In exchange, they hope to be able to achieve fiscal consolidation and ensure the long-term sustainability of their public finances. Will these new fiscal rules help them to achieve this aim?

In addition to exercising a redistributive function and ensuring the provision of public goods, fiscal policy might also be used to cushion the fluctuations inherent in economic cycles. For example, an increase in public spending can prevent a larger fall in economic activity during recessionary periods. This can be offset in boom times with reductions in spending that, in turn, slow up the pace of growth. However, there are some factors that push public spending too high in structural terms. This is the case, for example, of greater spending for electoral purposes or due to excessive optimism regarding how the economy will perform in the future. The adoption of fiscal rules is an attempt to correct these deviations to ensure the long-term sustainability of national accounts and give the fiscal policy decisions taken by public administrations more coherence over time and credibility.

The economic literature points to Sweden, already in the 1930s, as the pioneer in designing a fiscal framework centred on achieving long-term sustainability for its national accounts without affecting the stabilizing nature of fiscal policy. Since then, numerous countries have adopted new rules. According to a report by the International Monetary Fund (IMF), in 2009 there were 57 countries with at least an explicit limit for their public deficit or debt and/or some budgetary items.(1) Among these we find member states of the European Union that, on signing the Stability and Growth Pact (SGP) in 1992, introduced a public deficit limit of 3% of the gross domestic product (GDP). But the credibility and effectiveness of this rule have been seriously damaged as it was not capable of boosting fiscal consolidation during the last expansionary cycle or of preventing the fast deterioration in national accounts after the crisis erupted. The laxness of the deficit rule in expansionary times and the practical absence of mechanisms to encourage the correction of imbalances when limits are exceeded explain its little success. Given this situation, euro area countries have started to design a new fiscal pact that can redirect public debt to more sustainable levels.

According to the same IMF report, the empirical evidence available seems to confirm, in general, that fiscal rules are effective in achieving budgetary discipline and increase the chances of success for fiscal consolidation processes. However, the European case highlights the importance of the details in these rules in order for them to work well. A badly defined rule can divest fiscal policy of the necessary flexibility to dampen economic cycles, intensifying recessions (becoming procyclical) and reducing the public administration's capacity to react to the crisis. But as well as being flexible, an effective fiscal rule must also be precise, easy to implement and must be directly related to the desired final outcome, generally the sustainability of national accounts. It is also essential to define a corrective procedure in the case of non-compliance.

In the case of Spain, the two reforms approved in 2011 regulate public spending and deficit. In the case of public spending, this cannot be higher than the medium-term rise in nominal GDP unless it is accompanied
by discretional rises in public revenue. Excluded from this expenditure are interest payments on debt and non-discretional spending on unemployment benefit. With regard to the second rule, in September 2011 a reform of the Constitution was passed that limits the structural deficit of the public sector – i.e. the total deficit once corrected for the effect of the economic cycle. The structural deficit will not be able to exceed the margins defined by the European Union, in the case these are specified. Similarly, the limit to the structural deficit contained in the Constitution will be established in an organic law pending approval and that will probably be around 0.4% of GDP as from 2020. Of this figure, 0.26 points of GDP will correspond to the structural deficit of the central government and the remaining 0.14 percentage points will correspond to the autonomous communities.(2) These restrictions can only be exceeded in the case of economic recession or in exceptional situations.

A priori, both rules comply with most of the conditions indicated previously as propitious for them to function correctly. Both the use of the structural deficit and medium-term growth in GDP to calculate public spending allow the series' cyclical component to be adjusted, making the rules more flexible. In boom periods, the effort to comply with these rules is greater than if both variables were not cycle-adjusted. Similarly, the deterioration in budget flows associated with economic contractions, due for example to greater spending on unemployment benefit, does not affect the deficit's structural component and reduces the need to adjust the budget. Moreover, elevating the deficit limit to a constitutional level might improve the rule's effectiveness as it makes it difficult to modify. However, the correct design of both measures will have to be evaluated after the European fiscal pact and the state budget stability law have been concluded. The details of their wording will determine their efficacy, as that is where the corrective mechanisms will be established that will be followed in the case of non-compliance of the rules. On the other hand, lack of specificity when defining the exceptions that allow the structural deficit limit to be exceeded and delaying its commencement until 2020 hint at some unknown factors regarding its good functioning.

An interesting exercise that attempts to analyze the effectiveness of the new fiscal rules consists of estimating their effect if they had been in force during the last expansionary cycle. In the graph on the left we can see the evolution of Spain's fiscal balance between 1998 and 2007. As can be seen, this did not exceed the limit of 3% of GDP contained in the SGP and large surpluses were recorded during the last three years. In contrast, the new rule defined for the structural deficit would have only been complied with between 2005 and 2007, which would have forced the public administrations to make a greater effort so as not to exceed the structural deficit of 0.4% of GDP. Similarly, as shown by the graph on the right, the spending limit introduced in the budget framework would have been exceeded throughout these years. According to the Bank of Spain, during that period the average growth in public spending was 7.0% year-on-year compared with the 4.6% that would have been permitted by this fiscal rule.(3)

The use of both rules would have brought about less public spending between 1998 and 2007 and would have forced public administrations to take advantage of expansionary periods to sort out their accounts. The table shows the annual budget balance required to comply with the new fiscal rules during the period analyzed. As can be seen, the structural deficit limit would have been the more restrictive rule during the first few years. In 2001, this rule would have demanded a structural surplus of 0.7% of GDP compared with the deficit of 0.5% observed. From that time on, the spending rule would have been the one that would have forced greater budget containment. The effect that the implementation of these rules would have had on public debt cannot be underestimated. This would have been close to 25% of GDP at the start of the economic crisis. A figure, by 9.1 percentage points, lower than the minimum of 2007, which would have given public administrations much more leeway to tackle the sovereign debt crisis.

In short, both from the theoretical point of view and via a hypothetical exercise, it seems that the design of Spain's new fiscal rules is on the right course in its aim to ensure the long-term sustainability of national accounts without losing the stabilizing nature of fiscal policy. To this end, it is of the utmost importance that both the European fiscal pact and Spain's budget stability law to be approved in the next few months end up defining the aspects that are important for them to function correctly. This would strengthen the ties to the mast of fiscal coherence and would allow the journey to continue towards the consolidation of Spain's national accounts.

(1) See IMF (2009), Fiscal rules – Anchoring expectations for sustainable public finances.

(2) This means that the accounts of local corporations and of the Social Security Administration must be in equilibrium. However, in the case of the latter, the implementing organic law might detail a budget stability target according to the medium and long-term demographic and economic evolution forecasts.

(3) See Banco de España (2011), «La reforma del marco fiscal en España: los límites constitucionales y la nueva regla de crecimiento del gasto público». Boletín Económico. September 2011.

This box was prepared by Joan Daniel Pina

European Unit, Research Department, "la Caixa"

Joan Daniel Pina