ABSTRACT
Europe is undergoing two major transitions – demographic and economic. First, the populations of many European countries are ageing rapidly as their baby-boom generations approach and enter retirement, human longevity continues to increase, and fertility rates remain well below replacement. Second, 16 European countries have joined in a monetary union (EMU) by adopting the euro as a common currency, and more countries are to join the EMU during the next few years. The objective of monetary union is to eliminate exchange rate risks and streamline product pricing and price comparisons of similar goods and services across member nations to induce greater competitive efficiencies. Entering a monetary union implies surrendering control over monetary policymaking, but all current and prospective EMU nations would largely retain sovereignty in setting fiscal policies – except for the loose overall constraints set under the latest Maastricht agreement. Both transitions will place tremendous but conflicting pressures on Member States’
domestic national budgets. Decision makers will face growing demands to increase public expenditures and fulfil promises of retirement and health care benefits to retirees precisely when growth in labour forces and tax bases slows. That points towards larger future fiscal deficits and growing debt levels. At the same time, policymakers will face growing pressures from the ‘EMU club’ to maintain low deficits, prevent increases in interest rates, and maintain European investment levels. Exercising proper economic stewardship during these twin transitions will become more difficult if policymakers remain poorly informed about the likely consequences of making alternative policy choices. To streamline the process of monetary union, prospective EMU member countries
adopted the Stability and Growth Pact in 1997 (SGP-97). Along with the Treaty of the European Union, SGP-97 provided the framework of rules for coordinating fiscal policies across EMU members – both current and prospective ones. It was generally accepted that without such coordination, Member States would have stronger incentives to follow ‘shortsighted’ fiscal policies causing chronic budget deficits and higher debt-to-GDP ratios. If carried too far, such policies would erode the European Central Bank’s ability to maintain the euro’s purchasing power. If high deficits ultimately cause faster inflation, it would only neutralize the advantages of establishing a monetary union. Beginning in 2002, however, the SGP-97’s deficit and debt constraints and its preventive
and corrective mechanisms proved unacceptable.2 SGP-97 called for corrective fiscal policies to be adopted if a breach of deficits or debt limits appeared imminent regardless of the Member State’s position in the business cycle and potential for GDP growth. A revised Stability and Growth Pact has now been in effect since March 2005 (SGP-05). It incorporates
constraints and objectives (time paths of future deficits and debt) tailored to each member country’s economic conditions. The revised agreement introduces greater flexibility in implementing the SGP’s con-
straints and allows implementation of preventive and corrective mechanisms to be deferred in case a member country faces temporary economic difficulties. Some observers claim, however, that although SGP-05 continues to define constraints in terms of traditional deficit and debt-to-GDP levels, it really represents an abandonment of the original objectives underlying those constraints (Feldstein 2005; Wierts et al. 2006) of preventing excessive discretion in fiscal policies. If correct, this would constitute good news. This chapter’s thesis is that traditional fiscal measures – annual deficits and debt-to-GDP levels – are both potentially misleading indicators of a country’s fiscal stance. The SGP-05 also calls for the development of long-term fiscal indicators for policy sur-
veillance of Member States. This effort should consider recently developed fiscal measures that are theoretically sound and policy relevant. They would better inform EU policymakers of the condition of each Member State’s current fiscal stance and provide a basis for an apples-to-apples comparison of the policy options and trade-offs that each country faces. The bad news is that many member countries and EMU policymaking bodies appear to be a long way from developing appropriate long-term fiscal accounting measures and from developing a consensus on whether they should be part of formal preventive mechanisms. This chapter first addresses issues relating to the proper accounting and reporting of the
government’s net prospective payment obligations. It compares alternative long-term measures of a country’s fiscal stance and discusses their theoretical soundness, applicability to budget reporting, and ability to reveal information about the true economic choices that policymakers face. Four types of measures are considered – traditional deficit and debt measures, accrual accounting measures and two measures based on actuarial accounting. The latter include generational accounting and fiscal and generational imbalance measures. The chapter argues for the adoption of fiscal and generational imbalance measures by
integrating these measures into existing country budget reports. It provides brief examples of how fiscal and generational imbalance measures could help policymakers to define the feasible set of policy choices and the trade-offs involved in selecting from among them. This chapter also attempts to quantify the size of the long-term fiscal challenges con-
fronting EU countries by reporting estimates of fiscal imbalances (FI ) for 23 EU countries. The FI estimates suggest sizable gaps between the fiscal shortfalls reported under traditional backward-looking debt and deficit measures and those implied by forward-looking fiscal imbalance measures. The chapter concludes by suggesting that European countries need to undertake a third
transition – to step back from the current broad provision of social insurance programmes and allow greater scope for individual determination and private provision of these services. Introducing this important element in structural reforms by encouraging significant reductions in public spending commitments appears to be the only economically feasible way of addressing future fiscal challenges. The alternative of increasing taxes and imposing additional regulatory restrictions on member countries to preserve the status quo in social protection programmes is likely to prove counterproductive.
