5 FISCAL POLICY
5.4 Flaws Relating to the Balanced Budget Requirement
Further reservations relate to the requirement of a balanced budget over the cycle. Even if it is accepted that the budget should be balanced over the cycle, there is little reason to think that the extent of the swings in the budget position will be similar across countries. What reason is there to think that a swing in the deficit to a maximum of 3 per cent of GDP is relevant for all countries? Countries will differ in the extent to which their GDP varies in the course of a business cycle and in the extent to which the budget position is sensitive to the business cycle. Buti et al. (1997) found that the budget balance is negatively linked to GDP growth, but in a way that varies between countries, with estimates of changes in the deficit to GDP ratio of up to 0.8 per cent and 0.9 per cent for the Netherlands and Spain, respectively, for a 1 per cent slowdown in growth. The notable feature is the differences amongst countries.
Macroeconomic policies of the European economic and monetary union 177 The next question is whether there is any reason to think that an (on average) balanced budget is compatible with high levels of employment – indeed, whether it is compatible with any level of employment (including the NAIRU). A well-known identity (though one generally forgotten by advo- cates of the SGP) drawn from the national income accounts tells us that (Private Savings minus Investment) plus (Imports minus Exports) plus (Tax Revenue minus Government Expenditure) equals zero:
(S− +I) (Q−X) (+ T−G)=0. (10.1) Individuals and firms make decisions on savings, investment, imports and exports. For any particular level of employment (and income), there is no reason to think that those decisions will lead to
(S− +I) (Q−X)=0. (10.2) But if they are not equal to zero, then (G – T), the budget deficit, will not be equal to zero, since
(G−T)= − +(S I) (Q−X). (10.3) The SGP in effect assumes that any level of output and employment is consistent with a balanced budget (G – T = 0), and hence compatible with a combination of net private savings and the trade position summing to zero.
But no satisfactory justification has been given for this view. Two possible arguments could be advanced. First, it could be argued that budget deficits cannot be run for ever as the government debt to income ratio would continu- ously rise and that would be unsustainable. Hence governments eventually have to run balanced (on average) budgets. However, that depends on whether the post-tax rate of interest (on government bonds) is greater or less than the growth rate, the debt to income ratio being unsustainable in the former case but not in the latter. Further, it relates to the size of the primary deficit, which is the deficit that excludes interest payments. It is the overall budget deficit which is the target of the SGP, and it can be readily shown that an average 3 per cent budget deficit and a 60 per cent debt ratio are compatible and sustainable, if the rate of growth of money GDP is 5 per cent (which is not an unreasonable assumption and could arise from, for example, 2.5 per cent inflation and 2.5 per cent real growth).16 In general, a 3 per cent budget deficit would be compatible with a sustainable debt ratio of 3/g, where g is nominal growth rate.
Second, some form of Say’s Law could be invoked to the effect that intended savings and investment are equal at full employment (or, modified
for foreign trade, domestic savings plus trade deficit equals investment). Even if Say’s Law held (which we would dispute), what is required here is that the level of private demand could sustain the supply-side equilibrium, that is the non-accelerating inflation rate of unemployment, and the NAIRU does not correspond to full employment. In particular, there is no reason to think that a balanced budget position is compatible with employment at the level given by the NAIRU.
This equality can be viewed in another way. Suppose that the condition of balanced budget is imposed; it then follows that
(S− +I) (Q−X)=0. (10.4) If (as is likely) S > I, then Q < X. Hence a country would be required to run a trade surplus (and hence run a capital account deficit with the export of capital to other countries). A budget in balance would imply that net private savings (S – I) is equal to the trade surplus (X – Q), which in turn is equal to the capital account deficit. It can first be noted only some countries can run a trade surplus, and that must be balanced by others which run a deficit. This would then imply that some countries would have positive net private savings and others negative private savings. Countries that are able to run a trade surplus (at high levels of employment) can, in effect, export their ‘excess’
savings, but that cannot be the case for all countries.
The imposition of an upper limit of 3 per cent of GDP on the size of the budget deficit and the declaration of the aim of a balanced budget over the cycle represented a significant tightening of the fiscal position as compared with the 3 per cent of GDP target for the budget deficit in the Maastricht Treaty convergence conditions. In those conditions, the 3 per cent was to be achieved at a particular point in time: under the SGP the 3 per cent limit is to be exceeded only under extreme conditions. Although no justification was ever given by the European Union for the choice of 3 per cent in the convergence conditions, others advanced two arguments. Buiter et al. (1993), for example, suggested that the choice of the 3 per cent figure for the deficit to GDP ratio arose from a combination of advocacy of the so-called ‘golden rule’ (that current expenditure should be covered by current revenue) and that ‘EC public investment averaged almost exactly 3% of EC GDP during 1974–91’ (ibid. p. 63). Others have suggested that the 3 per cent figure corresponded to the range of deficits run by a number of countries, notably Germany, and was achievable.17 These possible justifications remind us of two points. The first is that, typically, governments have run budget deficits.
The imposition of a balanced budget requirement represents a major depar- ture from what governments have done in the past. The second is that governments invest, and it is generally accepted that governments can and
Macroeconomic policies of the European economic and monetary union 179 should borrow to fund their investment programmes. The SGP imposes the requirement that governments generally fund their investment programmes from current tax revenue.
A balanced budget (on average) means, of course, that current govern- ment expenditure will be much less than tax revenue since that tax revenue would also need to cover interest payments on debt and to pay for capital expenditure. In the UK, this has been cast in terms of the so-called ‘golden rule’ of public finance, which is taken to be that ‘over the economic cycle the Government will borrow only to invest and not to fund current expendi- ture’ (Treasury, 1997, p. 1), though capital consumption (depreciation) is regarded as current spending so that it is net capital formation which can be financed by borrowing. The ‘public debt as a proportion of national income will be held over the economic cycle at a stable and prudent level’ (ibid.).
Furthermore, ‘The fiscal rules focus on the whole of the public sector, because the debts of any part of the public sector could ultimately fall on the taxpayer. Looking at the whole public sector also removes incentives to reclassify activities simply to evade prudent constraints on borrowing’ (ibid., p. 16). Thus the use of fiscal policy to regulate aggregate demand in the economy is much reduced, if not entirely removed, especially in the direc- tion of stimulating the economy. It is therefore argued that ‘Discretionary fiscal changes should only be made if they are demonstrably consistent with achievement of the Government’s fiscal rules over the economic cycle’
(ibid.).
The general stance of the SGP with its requirement of an overall bal- anced budget and maximum deficit of 3 per cent of GDP is a deeply flawed one. There is no reason to think that a balanced budget position is consist- ent with high levels of employment (or indeed with any particular level of employment). Furthermore, there is little reason to think that the 3 per cent limit can permit the automatic stabilizers to work, and striving to reach the 3 per cent limit in times of recession is likely to push economies further into recession. The balanced budget requirement does not allow govern- ments even to borrow to fund capital investment projects. Additional reservations include the separation of the monetary authorities from the fiscal authorities. The decentralization of the fiscal authorities inevitably makes any effective coordination of fiscal and monetary policy difficult.
Since the ECB is instructed to focus on inflation, while the fiscal authorities will have a broader range of concerns, there will be considerable grounds for conflict. A serious implication of this is that the SGP is in danger of becoming the ‘instability’ pact. This suggests a need for the evolution of a body which would be charged with the coordination of EMU monetary and fiscal policies. In the absence of such a body, tensions will emerge in the real sector when monetary policy and fiscal policy pull in different direc-
tions. The SGP in effect resolves these issues by establishing the domi- nance of the monetary authorities (ECB) over the fiscal authorities (national governments).
The SGP seeks to impose a ‘one size (of straitjacket) fits all’ fiscal policy, namely that, over the course of the cycle, national government budgets should be in balance or slight surplus with a maximum deficit of 3 per cent of GDP.
It has never been shown (or even argued) that fiscal policy should be uniform across countries. The SGP imposes a fiscal policy which in the end fits nobody. For, actually, there is no reason to think that what is in effect a single fiscal policy (balanced budget over the cycle) is appropriate for all. The April 2003 Monthly Bulletin of the ECB is, nonetheless, very explicit. It clearly, and forcibly, suggests that ‘the Stability and Growth Pact provides a robust and flexible framework within which any strains on public finances can be addressed and budgetary discipline is secured …. It remains essential that both the commitments made in the stability programmes and the requests to further improve fiscal positions, as subsequently agreed in the ECOFIN Coun- cil, be implemented in full. This will help to build confidence in the fiscal framework and anchor expectations about the future macroeconomic envi- ronment’ (ECB, 2003c, p. 6).18 This argument has been repeated time and time again in the ECB Monthly Bulletin since then; even after the event described in subsection 5.3 above, which led to the SGP being discredited.