Date published: Jan 2022
SUERF Policy Brief, No 262
by Ginters Bušs, Patrick Grüning and Oļegs Tkačevs
Download: SUERF Policy Brief, No 262 (0.58 MB)
We evaluate the properties of two fiscal rules – the structural balance rule and the expenditure growth rule – using a DSGE model. Having just the expenditure growth rule tends to yield more stable macroeconomic outcomes, but more volatile public finances, as compared to having only the structural balance rule. Much of the quantitative differences in relative volatilities can be accounted for by the modifications of the public expenditure definition in the expenditure growth rule, e.g., the removal of debt service payments. Strong-enough debt correction for either fiscal rule contains public debt volatility at little expense to macroeconomic stability in the long run. The households’ welfare gain from having the expenditure growth rule instead of the structural balance rule is 4–5%.
In addition, the EU fiscal framework has failed to reduce public debt and avoid fiscal procyclicality (European Fiscal Board, 2019).
These issues have triggered discussions on revisiting the EU fiscal framework and simplifying the rules, suggesting having just one operational rule. The literature has identified that the expenditure growth rule may be the preferred fiscal rule (Benassy-Quere et al., 2018; Claeys et al., 2016; Darvas et al., 2018; German Council of Economic Experts, 2017; European Fiscal Board, 2019).
It is easier to communicate to the public that the government expenditure will grow in line with the long-term potential growth rate than explain the output gap and its revisions – the construct entering the structural balance rule.
Yet, a downside of the expenditure growth rule is its dependence on the initial level of public expenditure and its weaker relation to debt stability (among others, due to expenditure exclusions); consequently, having an explicit fiscal medium-term anchor, that is, a government debt target, is recommended (Symansky et al., 2008).
Therefore, several proposals (Benassy-Quere et al., 2018; Claeys et al., 2016; Darvas et al., 2018; German Council of Economic Experts, 2017; European Fiscal Board, 2019) suggest an EU fiscal framework based on a reference value for public debt with an operational annual limit for the public expenditure growth. To improve the quality of public finances and safeguard public investment, the European Fiscal Board (2019) proposes a golden rule by excluding growth-enhancing expenditure from fiscal rules.
For this purpose, in Bušs, Grüning and Tkačevs (2021) we employ a rich New Keynesian small open economy fiscal model (the closest study to ours is Andrle et al., 2015).
The selected key findings are as follows.
Here we stochastically simulate the model economy for a long time (10 thousand quarters) and observe volatility of the economic variables under the alternative fiscal rules (Table 1).
Table 1. Standard deviation of macroeconomic variables for the expenditure growth rule relative to the structural balance rule
Notes: Each number is a relative standard deviation of a particular variable for the expenditure growth rule, compared to the structural balance rule. A number below unity means that the standard deviation of a series is smaller for the expenditure growth rule, and vice versa. GDP, consumption, investment and inflation are in annual growth terms. Source: Bušs, Grüning and Tkačevs (2021).
An alternative to accounting for debt service payments in the expenditure growth rule is to strengthen the public debt correction term.
Figure 1. Government debt correction strength, and its effect on macroeconomic stability
Notes: The government debt/GDP correction strength in our benchmark calibration is set to 1/25th of the debt deviation from its target per year. Source: Bušs, Grüning and Tkačevs (2021).
Several advanced economies have recently experienced a decline in public investment, which may have deteriorated the state of public infrastructure. Also, tackling the emerging issues related to climate change, digital transformation of the European economy, and post-Covid recovery would benefit from a boost in public investment. An exclusion of public investment from fiscal rules – the so-called golden rule – was proposed, among others, by the European Fiscal Board (2019).
In our paper, we compare the golden rule version of both fiscal rules with their benchmark specification in a deterministic simulation of a persistent and sizable increase of public investment of up to 20%.
Figure 2. The expenditure growth golden rule
Source: Bušs, Grüning and Tkačevs (2021).
Figure 3. Higher public debt levels raise economic volatility
Source: Bušs, Grüning and Tkačevs (2021).
See the rest of our findings and the details in the paper. Some of our other findings are:
Andrle, M., Bluedorn, J. C., Eyraud, L., Kinda, T., Brooks, P. K., Schwartz, G. and Weber, A. (2015). Reforming Fiscal Governance in the European Union. IMF Staff Discussion Notes 15/9, International Monetary Fund.
Benassy-Quere, A., Brunnermeier, M., Enderlein, H., Farhi, E., Fratzscher, M., Fuest, C., Gourinchas, P.-O., Martin, P., Pisani-Ferry, J., Rey, H., Schnabel, I., Veron, N., di Mauro, B. W. and Zettelmeyer, J. (2018). Reconciling risk sharing with market discipline: A constructive approach to euro area reform. CEPR Policy Insight 91.
Bušs, G., Grüning, P. and O. Tkačevs (2021) "Choosing the European Fiscal Rule", Working Papers 2021/03. Latvijas Banka; available here.
Claeys, G., Darvas, Z. and Leandro, A. (2016). A proposal to revive the European Fiscal Framework. Bruegel Policy Contribution No. 2016/07.
Coibion, O., Gorodnichenko, Y. and Ulate, M. (2017). The Cyclical Sensitivity in Estimates of Potential Output. NBER Working Papers 23580, National Bureau of Economic Research, Inc.
Cordes, T., Kinda, T., Muthoora, P. S. and Weber, A. (2015). Expenditure Rules; Effective Tools for Sound Fiscal Policy? IMF Working Papers 15/29, International Monetary Fund.
Darvas, Z., Martin, P. and Ragot, X. (2018). European fiscal rules require a major overhaul. Bruegel Policy Contribution No. 2018/18.
European Fiscal Board (2019). Assessment of EU Fiscal Rules with a Focus on the Six and Two-pack Legislation.
Eyraud, L., Debrun, X., Hodge, A., Lledo, V. D. and Pattillo, C. A. (2018). Second-Generation Fiscal Rules; Balancing Simplicity, Flexibility, and Enforceability. IMF Staff Discussion Notes 18/04, International Monetary Fund.
German Council of Economic Experts (2017). Towards a forward-looking economic policy. Annual Report.
International Monetary Fund (2014). Public expenditure reform: Making diffcult choices. Fiscal Monitor.
Kamps, C., Leiner-Killinger, R. D. S. N., Ruffer, R. and Sondermann, D. (2014). The identification of fiscal and macroeconomic imbalances - unexploited synergies under the strengthened EU governance framework. Occasional Paper Series 157, European Central Bank.
Kamps, C. and Leiner-Killinger, N. (2019). Taking stock of the functioning of the EU fiscal rules and options for reform. Occasional Paper Series 231, European Central Bank.
Symansky, S. A., Debrun, X. and Epstein, N. P. (2008). A New Fiscal Rule; Should Israel "Go Swiss". IMF Working Papers 08/87, International Monetary Fund.
About the authors
Ginters Bušs is a principal economist at Latvijas Banka with research interest in business cycles. He holds a Doctoral degree in Information technology and a Master’s degree in Economics.
Patrick Grüning is a principal economist at Latvijas Banka with research interest in Macro-Finance and Economics of Climate Change. He obtained his doctoral degree from Goethe University Frankfurt in February 2015.
Oļegs Tkačevs is a principal economist at Latvijas Banka with research interest in fiscal policies, international trade and competitiveness. He obtained his doctoral degree in Economics from the University of Latvia.
SUERF Policy Briefs (SPBs) serve to promote SUERF Members’ economic views and research findings as well as economic policy-oriented analyses. They address topical issues and propose solutions to current economic and financial challenges. SPBs serve to increase the international visibility of SUERF Members’ analyses and research. The views expressed are those of the author(s) and not necessarily those of the institution(s) with which the author(s) is/are affiliated.
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