Europe | (Fiscal) Rules vs discretion

Summary

The rules versus discretion debate is back on the table, focusing not only this time on monetary policy (where central banks are having a hard time convincing the markets that inflation will return to target), but also on the reform of European fiscal rules.

Key points

• Key points:
• The reform of fiscal rules has been debated for years among international institutions and economists, and over time a certain consensus has emerged on a few key points.
• Most would agree that it is better to focus on debt reduction than on the fiscal deficit target; better to minimize the use of unobserved variables (although some type of cyclical adjustment will inevitably have to be made); better to provide a degree of flexibility so as to avoid heavy adjustments during times of crisis; and better to use the public spending to GDP ratio (net of tax changes) as an adjustment variable than the structural deficit.
• The European Commission suggests a four- to seven-year framework for reducing debt paths based on its Debt Sustainability Analysis (DSA), where negotiated public expenditure paths would be proposed for countries with excessively high debt.
• And, importantly, the resulting action plans cannot envision the entire adjustment taking place at the end of the period —so as not to pass on the burden to the next government— although it is unclear how this aspect could be implemented.
• Germany, for one, is proposing annual reductions in the debt ratio for heavily indebted countries (of 1 percentage point of GDP per year). This has the advantage of being supremely simple, but runs the risk of being rather scattershot and of requiring excessive adjustments in times of crisis.

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