Portugal was the second country (after Greece) to ratify the fiscal compact treaty (together with the ESM). The fiscal compact will be implemented under the auspices of the European Court of Justice which will monitor the national rule’s compliance with the treaty. Some key elements of the fiscal treaty are effectively already in force since December 2011 as elements of the revised Stability and Growth Pact (SGP) included in the “Six-Pack” legislation which was adopted by all EU 27 members. The following elements are of particular importance: first, the 3% overall deficit ceiling under the threat of fines (the burden of proof is now on the deficit country); second, the target structural medium-term objective (MTO) determined by the EU Commission for each country separately but mostly within a structural deficit target range of between -1% and 1% of GDP—Portugal’s MTO is set at -0.5% (see medium-term budgetary framework background); and third, the gradual reduction of the public excess debt over 60% by 1/20th per year, applied over a three-year average and after a three-year grace period upon achievement of the 3% deficit target.
Simulation Exercise
In order to simulate the counterfactual public debt, deficit, and growth dynamics of the Portuguese economy if the debt and fiscal rule constraints were in place since 2001, we adapt the model developed in a recent paper by Snower, Burmeister, Seidel (2011): Dealing with the EZ Debt Crisis: A Proposal for Reform. In this paper the authors model the 1/20 debt rule by specifying countercyclical fiscal deficit dynamics under a government budget constraint in addition to tax expenditure, revenue and output equations applied to the Greek economy. In this exercise we calibrate the same model to Portuguese parameters (I have tried calibration to other peripheral countries as well with similar results).
The debt rule in this model is designed to address the following challenges: first, the proposed fiscal rule must ensure adequate government financing at all times, including be sound enough to justifiably secure external fiscal support from EZ partners in emergencies; second, the rule enforcement must be credible and effective; third, the government retains fiscal autonomy in order to secure democratic acceptance; fourth, the rule should prevent damaging pro-cyclical overheating/austerity cycles and be dynamically consistent.
In addition, this debt rule design contains the following elements and constraints—first, definition of debt rule elements:
- the country’s long-run debt ratio (i.e. 60% of GDP as per SGP);
- the fiscal convergence rate towards the 60% debt target (i.e. 1/20 per year in normal times);
- the degree of fiscal counter-cyclicality (i.e. how much of the economic cycle should be smoothed with countercyclical fiscal policy). The budgetary sensitivity factor for Portugal is calculated at 0.45 by the EU Commission).
- fiscal multiplier: we use our own (lower bound) estimate of 0.8.
Note that this rule does not include an explicit 3% headline deficit or a 0.5% structural deficit target (the so-called medium-term objective) as in the EU fiscal compact. Therefore, the debt/deficit performance under this debt rule allows comparisons with the more stringent fiscal compact.
Second, the credible implementation of this counter-cyclical fiscal rule requires an independent body to estimate the country’s business cycle and determine the government’s deficit or surplus that is consistent with the debt rule. Ideally, the independent debt commission would have veto power over the government’s fiscal decisions in order to ensure that the rule is implemented properly against incentives to overspend in good times or bend the rules for political purposes. In this context, the EU Commission is keeping a database of the independent fiscal institutions in EU countries, where applicable, and scores these institutions’ degree of independence and authority with respect to the budgetary decision-making process along a number of criteria, including their scope, tasks, status and influence. Under Germany’s Schuldenbremse (debt brake), for example, the “stability council” ensures compliance with the rule among the regions whereas output gap estimation will follow the commonly agreed guidelines at EU level.
(Note that the EU Commission also calculates a standardized fiscal rules index, ranking domestic fiscal rules of EU countries using information on (i) the statutory base of the rule, (ii) room for setting or revising its objectives, (iii) the body in charge of monitoring respect and enforcement of the rule, (iv) the enforcement mechanisms relating to the rule, and (v) the media visibility of the rule).
Simulation Results
The results of our simulation are shown in Figures 1 and 2:
Figure 1: Actual Deficit, Fiscal Rule Simulation and Actual Output Gap (% of GDP)
Source: IMF, Eurostat, RGE calculations
Figure 2: Debt under Fiscal Rule and Actual Debt Performance (% of GDP)
Source: IMF, Eurostat, RGE calculations
Conclusions
The main conclusions of this exercise are as follows:
Compared to the actual deficit performance, the binding debt rule avoids pro-cyclical deficit spending as in 2001-2005 as shown in Figure 1. In normal time, this ensures that the deficit is reduced when the output gap shrinks thus allowing the debt level to shrink during the upswing instead of growing further (Figure 2). Portugal would at least have met the crisis with a more solid initial debt position had the rule been in place. The disciplining role of independent fiscal institutions is further acknowledged in recent research by Jeffrey Frankel of Harvard University.
The severity of the 2008 crisis would in any case have led to a suspension of the debt rule as otherwise the negative output gap would have been a multiple of the observed performance during 2009-2010. Indeed, whereas the rule prescribes a fiscal expansion starting 2011, the aggressive pro-cyclical adjustment underway is bound to weigh heavily on growth in the next few years. In the absence of any debt monetization option, however, there is no real alternative to reducing primary deficits although the degree of front-loaded austerity is debatable.
Even in normal times, the more rigorous fiscal rule implementation takes its toll on growth: average growth from 2001-2011 under the debt rule simulation is -0.2% as compared to 0.5% in actual numbers. Therefore, the switch to the debt rule must be accompanied by structural reforms to enhance potential growth in the medium term and ideally by looser monetary policy to compensate for the additional fiscal drawback in the short term. More generally, these fiscal constraints also highlight the need for countercyclical fiscal policy at the regional level via a common EZ budget, for example.
The average 2001-2011 fiscal deficit under the counter-cyclical debt rule amounts to 2.8% as compared to the effective 4.6%. That said, even under the new rule a strict 3% deficit ceiling is difficult to adhere to in recessions (including in normal times) unless at the cost of even slower growth and a larger output gap. Similarly, the average structural deficit in Portugal from 2001-2011 according to Eurostat was 5% of GDP — a far cry from the 0.5% envisaged by the fiscal compact and the MTO.
Assuming a larger fiscal multiplier, average growth would suffer more according to the model specification, unless counterbalanced by a more ample degree of fiscal counter-cyclicality during periods of fiscal consolidation. In this regard, the potential output estimation methodology and the parameter calibration bears an important impact on the room for fiscal maneuver. For instance, one drawback of standard potential growth estimation via HP-filter, for example, emerges with asymmetric business cycles (e.g. double-dip recessions) that could introduce a downward bias to potential growth estimates, thus implicitly reducing the room for countercyclical stimulus allowed under the debt rule.