Economic surveys and country surveillance

Economic survey of the Euro Area 2007: Putting fiscal policy back on track

 

Contents | Executive Summary | How to obtain this publication |   Additional information

The following OECD assessment and recommendations summarise Chapter 3 of the Economic survey of the Euro Area published on 4 January 2007.

See also the excerpt "Fiscal Surgery without Killing the Patient".

Contents                                                                                                                           

Countries need to prepare for the fiscal impact of population ageing

In a number of countries, fiscal policies are falling well short of what is needed given the pressure that population ageing will put on public finances. While fiscal developments compare relatively well to other major economies, they fall short of outcomes in the best performers. There has been little overall fiscal improvement since the adoption of the euro, although the situation in some countries has improved. The area-wide debt level is almost unchanged as a proportion of GDP and the budget deficit has increased. In 2005, five of the 12 member countries had deficits around or above the 3% limit, including the three largest economies. On the positive side, another five were close to balance or in surplus. While the area-wide deficit for 2005 came in lower than expected and should do so again in 2006 it is likely to be some years before the euro area is close to balance or in surplus, and even that will not occur without greater efforts towards fiscal consolidation. For that reason, it is important that any revenue windfalls during the upswing are used to pay down debt. Since public finances are not yet in a sustainable position in the majority of countries, any planned tax reforms or expenditure increases should take into account the effect on long-term sustainability.

Large structural primary surpluses are required to stabilise debt
Structural primary surpluses required to bring debt to 60% of GDP by 2050(1)

1. Assuming that the government primary balance declines mechanically over time under the impact of long-term cost pressures, the calculation determines what level of primary surplus is needed in 2006 to ensure a 60% debt ratio in 2050.
Source: OECD (2006), OECD Economic Outlook: Statistics and Projections - online database and OECD calculations.

The window of opportunity for consolidation should not be missed

The 2005 stability programmes were not ambitious enough given the cyclical upswing. National budget plans for 2006 showed little improvement over the previous year. Among the countries that were not in the excessive deficit procedure (EDP), few planned to do more than the benchmark half per cent per annum adjustment asked for under the Stability and Growth Pact (SGP). At the same time, the planned budgetary consolidation in EDP countries has been broadly in line with the provisions of the Pact. One of the reasons why the Pact was reformed in 2005 was to boost incentives to consolidate in good times. The window of opportunity during the current upswing should not be missed, and programmes should be better specified and more frontloaded than they were in 2005.

The revised Pact is more sensible and gives more room for economic judgement, but this should not be mis-used as a way to postpone the hard decisions

The changes to the Pact after the enforcement mechanism broke down led to reforms in the preventive and corrective arms with the aim of improving its national ownership and credibility. Deficits above 3% of GDP may be permitted in some cases and countries have more time to reduce them. The new rules specify special factors to be taken into account, including structural reforms as well as any “other relevant factors”, under the restriction that the breach of the 3% limit is judged to be small and temporary. However, since the 2005 reform, all deficits in excess of 3% of GDP have been considered excessive, even when it was by a small margin and without countries invoking the application of other relevant factors. Member states in excessive deficit are requested to achieve a minimum annual budgetary effort of 0.5% of GDP in cyclically-adjusted terms, net of one-off and other temporary measures. Concerning the preventive arm of the Pact for countries not in excessive deficit, there is no minimum required adjustment, although an annual adjustment of 0.5% of GDP as a benchmark is requested. Slower adjustment can be acceptable in economic bad times, and more can be requested in good times. However, this is subject to the difficulties of a forward-looking assessment of cyclical conditions. Hence, it is uncertain whether the revised Pact will fully deliver on this count, or whether it will confirm concerns expressed by some that it may allow quite limited adjustment for quite some years. However, it is encouraging to note that, according to the 2005 update of the stability programmes, most member states have agreed to achieve the benchmark annual adjustment of 0.5% of GDP. Overall, the extra room for judgement in the Pact should be used only when clearly warranted on economic grounds.

Balancing the budget: regular annual good resolutions (1)
General government balance in the euro area as a per cent of GDP(2)

1. The various vintages of the stability programmes were released over the following periods: 3rd 2000/01, 4th 2001/02, 5th 2002/03, 6th 2003/04, 7th 2004/05 and 8th 2005/06.
2. Excluding UMTS licence proceeds.
Source:   European Commission/Eurostat and OECD (2006), OECD Economic Outlook: Statistics and Projections - online database.

All in all, the framework has moved towards more economic judgement within the rules-based framework. It is reasonable to wait more time before fully evaluating the results. The potential advantage is that it may improve national “ownership” of the Pact’s objectives and rules because authorities are no longer enforcing a system widely regarded as mechanical and inflexible. Fiscal assessments now have more economic focus and greater emphasis can be given to debt levels and long-term sustainability. A good example has been that some countries have set even more ambitious medium-term objectives than required. High debt countries also tend to have more ambitious medium-term objectives than other member states. These are clear improvements. The potential downside is that the Pact could become toothless by providing more room for excuses, arguments and delay. It has already faced a small test with the 2005 stability programmes, and the outcomes were mixed. On the positive side, there has been more peer pressure on member states, less argument with the Commission’s assessments and less use of creative accounting and overly optimistic forecasts. It is also positive that, in the context of the 2005 reform of the Pact, ministers have made a strong commitment to avoid pro-cyclical policies in good times. However, it is uncertain whether the reforms will deliver on their key objective of encouraging permanent fiscal improvement during an upswing. And while high debt countries tend to be amongst the ones that have set themselves more demanding medium-term objectives, their planned speed of adjustment towards these benchmarks is no faster than for other countries.

Public finances need to be put on a sustainable path

The most important reforms are required at the national level:

  • Some countries need to be more ambitious. Greater efforts are required not just to make public finances sustainable but also to boost growth in the longer term. Governments often want to wait before tackling a fiscal problem, yet the economic and political costs of delaying reform are becoming large. Moreover, international experience suggests that getting the fiscal house in order is almost a pre-condition for reaping the rewards of structural reform. There have been rare exceptions, but in most cases reforming economies took off only after the deficit had been brought down. That may be because fiscal consolidation demonstrates that a government is serious about reform, generating confidence in the whole process.
  • National institutions should be reformed where necessary to put more emphasis on medium-term fiscal frameworks, including expenditure and debt targets, greater transparency, better accounting practices (including accounting for implicit liabilities such as unfunded pensions), independent forecasts and external watchdogs. Governments could also produce medium-term fiscal projections on a no-policy-change basis because in many cases the current approach “predicts” a balanced budget to be just around the corner without specifying what policy measures will get them there, thus painting too rosy a picture.


The Community-level framework can support efforts by member states in the following ways:

  •  Concentrate efforts on high-debt countries, taking into account debt dynamics and sustainability, as they are the ones that are of greatest concern for the smooth functioning of the monetary union. Avoiding the free-rider problem was one of the main reasons for having area-wide fiscal rules in the first place.
  •  Structural reforms should not be used as an excuse to delay fiscal adjustment. Structural reform is an ongoing process, not a one-off effort with temporary impacts on the deficit. In any case, in most but not all structural reforms the initial negative fiscal impact tends to be small and is dwarfed by the longer-term savings.
  • Prepare the stability programmes earlier in the year. Experience shows that a top-down process on the budgetary procedure can help finance ministers resist the pressures from spending ministries. Therefore some member states have proposed bringing the European timetable for stability programmes forward to April or May so as to precede national budgets. The hope was to shape the national debates, which usually take place in the northern autumn. However, in other member states this would not be helpful. Alternative ways to strengthen budgetary surveillance are therefore being explored.
  • Enforce the rules. International experience with budget rules shows that fiscal prudence is seldom delivered without political buy-in by individual governments. Community-level policymakers therefore need to have realistic ambitions for what can be achieved with fiscal machinery such as the SGP. But as a corollary, since the framework has been made more flexible, it should be well enforced.
  • Finally, highlighting the long-term sustainability of fiscal positions in member states would help financial markets to discipline the poor performers. This has happened, with cross-country spreads on government bonds widening in 2006.

How to obtain this publication                                                                                      

The Policy Brief (pdf format) can be downloaded. It contains the OECD assessment and recommendations but not all of the charts included on the above pages.

The complete edition of the Economic survey of the Euro Area 2007 is available from:

Additional information                                                                                                  

For further information please contact the EU Desk at the OECD Economics Department at eco.survey@oecd.org. The OECD Secretariat's report was prepared by David Rae and Boris Cournède under the supervision of Peter Hoeller.

 

 

 

 

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