A Simple and Flexible Alternative to the Stability and Growth Pact Deficit Ceilings

The Maastricht Treaty and the Stability and Growth Pact (SGP) provide the institutional framework that regulates fiscal policies within the European Monetary Union. Adopted in 1997, the SGP has been reformed in 2005 and may be amended again soon. In this paper we review the working of the SGP and we advocate a new approach to foster fiscal discipline in the Union. Our analysis is based on a simple theoretical model of a monetary union where myopic discretionary fiscal policies generate excessive debt accumulation in steady state and inefficiently delayed debt adjustment following a shock. Borrowing from the literature on monetary policy games, we advocate the adoption of a flexible debt targeting approach. We show that, by setting a long-term debt target and by raising the political cost associated to deviations from the optimal pace of debt reversal following a shock¸ institutional design induces the fiscal policymaker to implement unbiased discretionary responses to shocks. Even when left with full discretion to decide the initial policy action, the fiscal policymaker will never choose an “excessive” deficit if he will then be induced to reverse it at the optimal speed.  Our results call for the de facto demise of deficit ceilings, that cause inefficient stabilisation in the face of adverse shocks but in normal times allow countries to satisfy the ceiling even if policies are relatively undisciplined. Can these arrangements be replaced by more efficient ones? It should be made clear we are not proposing just to adopt a different numerical rule for the pace of debt reversal, to be enforced as the SGP. In fact, such numerical rules are inevitably bound to introduce excessive rigidity in an uncertain macroeconomic environment. In our view, since fiscal policy decisions lie at the heart of the electoral competition in modern democracies, the power to discipline policymakers ultimately rests in the hands of national voters. Institutional design should therefore raise the political cost of implementing inefficient policies. This can be achieved by increasing the transparency of the decision-making process, making it easier for national voters to understand the long-term consequences of fiscal policies. In practice, we call for a substantial strengthening of the Pact preventive arm, assigning clearer and more focused supervision tasks to the European Commission and calling for a more active role of national Parliaments whenever a disagreement arises between the Commission and a national government. Just as our modelling approach is inspired to the theoretical analysis of flexible inflation targeting schemes, our proposal borrows from empirical evidence on the behaviour of central banks that adopted inflation targets and carefully designed their communication strategies as a device to strengthen their reputation and protect their independence.