09 February 2012

Nils Bernstein: The fiscal compact

Speech by Mr Nils Bernstein, Governor of the National Bank of Denmark, at the hearing on the fiscal compact conducted by the European Affairs Committee of the Danish Parliament in Copenhagen.

"The new element is that there will be even more focus on the structural budget balance and that the commitment to fiscal discipline will be anchored in national legislation. The structural balance is the cyclically adjusted budget balance stripped of the effects of cyclical developments and special circumstances. In Denmark’s case, special circumstances include pension yield tax, proceeds from North Sea oil and this year also reimbursement of early retirement contributions. In future, it will be a requirement that the structural deficit for a single year does not, as a main rule, exceed ½ per cent of GDP, and that any substantial deviation will trigger an automatic adjustment mechanism to restore the structural deficit to balance or surplus. As I have already mentioned, these provisions are to be incorporated into national legislation. At a later point, the Commission will issue guidelines for the content of the automatic adjustment mechanism. Indications are that it will be an obligation to take action, not an automatic mechanism as such. The structural deficit is an expression of the “sustained” balance situation, be it a budget deficit or surplus.

Until now, the main focus area – besides observing the 3 per cent requirement for the actual budget balance – has been to ensure continuous annual improvement of the structural balance by at least 0.5 per cent of GDP forMember States not observing the medium-term objective of balance or surplus. In practice, one of the weaknesses has been that the adjustment process has been too slow. Another weakness has been that the structural balance was overestimated in the good times before the financial crisis. The value of  current account deficits, housing bubbles and loss of competitiveness as indicators that output and employment were well above the underlying potential was underestimated.

"This pattern has exacerbated the deficit during the cyclical downturn so that, on aggregate, debt has increased over the business cycle. If the government budget must, as a main rule, be structurally in balance every year, this reduces the likelihood that the total debt grows over time. Deficits in bad times must be matched by surpluses in good times.

Under the existing Stability and Growth Pact, the structural balance has mainly been used to lay down a medium-term objective – that is, a target to be met sometime in the future. And by then things will have improved, or so we assume in our planning. Now the structural balance will be an annual target which can only be deviated from in exceptional circumstances or in the event of a severe economic downturn.

Will the new fiscal compact mitigate the debt crisis?

First and foremost, the new fiscal compact is aimed at preventing a recurrence of the present situation in the euro area – with a debt crisis in several euro area Member States that is threatening to spread. Here it could be argued that serious observance of the existing rules combined with responsible macro-economic and macro-prudential policies could have provided the same result. The fiscal compact and other initiatives will ensure that deviations are to a larger extent exposed – and addressed."

Full speech

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