31 January 2022

SUERF: Pledge or pretext? Lessons from the Fiscal Compact

Since inception, enforcement of the EU’s Stability and Growth Pact has been a challenge. Unless member states concluded on their own that following EU rules would be to their advantage, the effect of external constraints has been limited.

 Branded by the fallout of the global financial crisis, in 2012 22 EU member states took a leap of faith and signed the Fiscal Compact, an intergovernmental agreement aimed at backing EU fiscal rules with national arrangements. The main objective of the initiative was to strengthen ownership through a national correction mechanism triggered in case public finances deviate from ‘the path of virtue’. While design choices vary considerably across countries, our analysis reveals distinct patterns: better compliance tends to be associated with superior design elements of the correction mechanism, with a better overall quality of governance and a stronger media presence of independent fiscal institutions (IFIs). Economic growth can make up for a less sophisticated design. Our analysis also indicates that many countries linked the trigger of the correction mechanism to EU decisions rather than to independent assessors at the national level. This choice defeats the original purpose of the correction mechanism.

Introduction

Religion and EU fiscal rules – forgive us the analogy – both define a path towards redemption: religion for our souls, fiscal rules for government debt. Following the path of virtue is a question of conviction that no external constraint can match. In the case of religion we call it faith, in the case of fiscal rules national ownership.

The EU’s fiscal framework, the Stability and Growth Pact (SGP), is a very clear case in point. Since its inception, the Commission and the Council exhibited a considerable degree of forbearance in applying the EU rules and found it difficult to impose sanctions on countries that had significantly departed from the recommended fiscal path. As a result, public finance developments diverged across member states largely reflecting national preferences: some managed to follow a more prudent course of action safeguarding or building fiscal space to react to economic shocks, others recorded consistent increases in government debt relative to GDP leaving little room for manoeuvre when times turned bad.

In light of this experience, reinforcing national fiscal frameworks became the key theme in the aftermath of the Great Financial Crisis. In 2012, 22 EU member states signed an intergovernmental agreement, the Fiscal Compact2 that came on top of other ambitious reforms of the EU fiscal rules. The contracting parties committed to introducing national rules and institutions that would (i) be consistent with the main thrust of the SGP; and (ii) fix any deviation from the path of virtue by way of an automatic correction mechanism. What could be stronger and more credible than a formal commitment enshrined in national law?

In the context of the ongoing economic governance review at the EU level3, the Secretariat of the European Fiscal Board has taken a closer look at how the national correction mechanisms have been designed and implemented. To ensure an impartial view, we consulted independent fiscal institutions (IFIs) in the EU member states that signed the Fiscal Compact. While setting out general principles, the Compact left considerable leeway for national authorities to design the correction mechanism. The actual diversity can be used to identify elements that enhance or hinder compliance. This piece summarises the main findings of a more comprehensive study published as ZEW discussion paper (Larch et al. (2021)).

The Fiscal Compact: a leap of faith?

The idea of strengthening compliance with EU fiscal rules through national ownership played a crucial role in the aftermath of the Great Financial Crisis of 2008-09. The conviction had gained ground that ownership could only be improved if on top of professing the respect of EU rules, member states put in place institutions and processes at the national level that would be consistent with and ensure respect of EU rules. Already the budgetary frameworks directive of the so-called six-pack reform of 2011 asked EU member states to adopt national provisions specifying consequences in the event of non-compliance with their own numerical rules.

The Fiscal Compact of 2012 was a particularly important step towards national ownership for at least two reasons. First, by signing the Compact member states agreed to design and adopt, preferably at the constitutional level, a national fiscal rule ensuring a rapid convergence of the budget balance towards the country’s medium-term objective (MTO) where the latter should not exceed a deficit of 0.5% of GDP in structural terms. Second, the Compact asked member states to complement the national rule with a correction mechanism to be triggered automatically in the event the structural budget balance deviates significantly from the medium-term objective or the adjustment path towards it.

Given that in several member states key elements of the national fiscal framework predated the Fiscal Compact (e.g. structural budget balance rules and national IFIs already existed in several countries), and with a view to respecting the diversity of national administrative settings and legal traditions, no one-size-fits-all model was imposed. Instead, the Commission was empowered to detail common principles for the design of the correction mechanism, which emphasise four key elements4: (i) legal status set to be of higher order than the budget law; (ii) well-defined circumstances for triggering the mechanism; (iii) pre-determined rules to frame the size and timeline of the fiscal adjustment; and (iv) role of national IFIs in monitoring all relevant aspects of the mechanism, and in particular its triggering, progress and extension, all under the aegis of the comply-or-explain principle.

Despite these jointly agreed common principles, there are significant differences in the design of the correction mechanism across the 22 countries that signed the Fiscal Compact. This heterogeneity can be used to identify elements of best practice, especially as regards the correction mechanism, which was introduced to effectively ensure compliance with fiscal rules. Our analysis identifies four crucial dimensions of national correction mechanisms directly linked to their perceived or potential deterrence effect and where strong patterns emerged (see also Graph 1):

• Clarity of the national provisions, i.e. a summary assessment by IFIs on how precisely the conditions for triggering the mechanism and the subsequent procedural steps are defined in national legislation (clearly; mostly well; vaguely).
• Automaticity, i.e. whether the triggering of the correction mechanism has full automaticity or constrained in some ways.
• Orientation of the correction mechanism, i.e. whether the correction mechanism can be activated ex ante based on a high risk of a significant deviation or only ex post.
• Legal status, i.e. whether the national provisions were adopted as an ordinary law or at a higher legal level (the latter category combines the constitutional amendments, cardinal laws with qualified majority quorums and special legal arrangement in federal states, such as internal stability pacts).5

Graph 1: Design features of national correction mechanism


Source: Survey of the EFB Secretariat

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