This paper provides evidence of fiscal procyclicality, excessive deficits, distorted budget composition and poor compliance with fiscal rules in the euro area.
CONCLUSION
This paper shows that some of the fiscal challenges faced by the EA are rooted in distorted political incentives—at both the national and supranational levels. Using real-time data from stability programs, the paper provides evidence on a range of fiscal policy biases, including procyclicality, excessive deficits, and compositional distortions. The results also suggest that the presence of national and supranational fiscal rules has not successfully alleviated these biases, which have continued to prevail following recent reforms of the fiscal framework. The evidence of bias in applying the rules (as a function of country size) is not as conclusive.
The importance of distorted incentives is a very simple result, but it has far-reaching implications that have not yet been fully acknowledged in the reform of fiscal institutions. One extreme and dangerous manifestation of these distortions is the expressed perception by many analysts that European fiscal governance releases countries from their national responsibilities. Nothing could be further from the truth: fiscal policy is, first and foremost, a national responsibility. The combination of this misperception with the predominance of the national dimension of politics constitutes a dangerous mix.
One of the main lessons from the paper is that the most sophisticated improvements in the design of the framework will not bear fruit unless they also garner political and public support. By strengthening the economic basis of the rules, reform of the SGP has made significant progress, but efforts should continue on two fronts—right design combined with right incentives. It is possible and desirable to have a stronger system of incentives, including gradual and proportionate sanctions and clear benefits for compliers. In the longer term, a lasting solution must combine market discipline and stronger fiscal governance. Fiscal union will, if it happens, be an aspect of a comprehensive architecture accompanying bank and capital markets unions. It would reflect political choices in Europe.
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