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After months of deliberations, the European Commission has finally published its proposal for a reform of the Stability and Growth Pact (SGP), which is briefly presented in Buti et al. (2022) and fully spelled out in European Commission (2022). The proposal, which member countries will examine, includes two major improvements and five main shortcomings.
The first improvement is to structure the procedure around the projected evolution of public debt. This is the right concept, as long argued by many economists (e.g. Martin et al. 2021, Wyplosz 2019). Fiscal discipline is fundamentally an intertemporal issue, not the year-after-year ‘deficit below 3%’ that fatally undermined all previous versions of the Pact. Debt must be sustainable, which means that it eventually converges toward a moderate level (say, 60% of GDP or less).
The second improvement is to differentiate countries according to their pre-existing debts. This naturally follows from the first improvement and avoids all countries being treated according to their annual deficits in the same way, applying the same rules to low- and high-debt countries. Even though the Commission has long recognised the need to move in this direction, and often did so in practice, the formal rule did not, which often led to bizarre contortions.
These conceptual breakthroughs, although obvious and long overdue, cannot be overappreciated. It is a pity, then, that the proposed implementation is marred by seriously flawed arrangements.
First, the debt path is to be established by the Commission using the well-established debt sustainability analysis (DSA). The DSA simply consists in using cumulated government budget constraint, an accounting identity, to describe the evolution of the debt over a specified horizon. The horizon must be long enough to approximate the formal definition of debt sustainability (technically, the transversality condition). The Commission proposes a four-year horizon, which can be extended to seven years under some conditions (more below), but the computation is based on a ten-year horizon. This is a reasonable compromise....
more at CEPR