https://orcid.org/0000-0002-7011-4391
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ABSTRACT
In order to quantitatively assess the potential effects from the ongoing transformation of the fiscal framework of the European Union, we evaluate the economic and public finance stabilization properties of two benchmark fiscal rules using a New Keynesian small open economy model. If these fiscal rules are implemented one at a time, having just an expenditure growth rule tends to yield more stable macroeconomic outcomes but more volatile public finances, as compared to having only a structural balance rule. Much of the quantitative differences in relative volatilities can be accounted for by using a modified public expenditure definition in the expenditure growth rule, in particular the removal of debt service payments. The expenditure growth rule with a strong-enough debt anchor strikes the balance between the short-term macroeconomic stability and the medium-term public debt convergence. There is a welfare gain for households from having only an expenditure growth rule.
Acknowledgments
We would like to thank anonymous referees, António Afonso, Kea Baret (discussant), the seminar participants at Latvijas Banka, Lietuvos Bankas, the European Commission, the Ministry of Finance of Latvia, the Fiscal Discipline Council of Latvia, the Baltic Central Bank Research Meeting 2021, and the conference participants at the 20th Journées Louis-André Gérard-Varet, the 9th UECE Conference on Economic and Financial Adjustments, the 4th ERMEES Macroeconomics Workshop, the Scottish Economic Society 2022 Annual Conference, the 28th International Conference on Computing in Economics and Finance (CEF 2022), and the 2022 Dynare Conference for their helpful comments and constructive suggestions. The views expressed herein are solely those of the authors and do not necessarily reflect the views of Latvijas Banka or the Eurosystem.
Disclosure statement
No potential conflict of interest was reported by the author(s).
Notes
5 The Treaty on Stability, Coordination and Governance in the Economic and Monetary Union, signed by all EU countries except Czechia and the UK.
9 It is now required that a member state with a debt-to-GDP ratio above 60% reduces the gap to this level annually by 5%.
11 Alternatively, Blanchard et al. (Citation2021) suggest abandoning fiscal rules in favour of country-specific standards.
12 Christofzik et al. (Citation2018) consider annual debt-to-GDP corrections of 1.33% (1/75) and 2% (1/50).
13 In particular, when the excessive deficit procedure is opened on the basis of the deficit criterion, the corrective net expenditure path should be consistent with a minimum annual structural adjustment of at least 0.5% of the GDP. The annual minimum adjustment steps of 0.5% of GDP may exclude interest payments until year 2027.
14 The legislative package consists of three documents: a regulation on the preventive arm https://www.consilium.europa.eu/media/70386/st06645-re01-en24.pdf a directive https://data.consilium.europa.eu/doc/document/ST-15396-2023-REV-4/en/pdf and a regulation on the corrective arm https://data.consilium.europa.eu/doc/document/ST-15876-2023-REV-4/en/pdf.
15 Additionally, there is wasteful spending, which is constant and exogenous, and has the role of a residual in the steady state.
16 They need to pay quadratic adjustment costs for holdings in excess of an amount they can hold for free.
17 However, we keep reporting the annual balance-to-GDP ratio in the tables below for the reader's convenience.
18 The alternative measures we considered were: the employment gap , where
is total labour supply and L its value in the deterministic steady state, a measure based on capital and labour utilization rates
and their time-varying equilibria specifications where
and u is the capital utilization rate at time t and the steady-state capital utilization rate, respectively. However, we found that our benchmark specification matches the data the best, since the capital utilization rate is trending in our data sample. Section 7.2 of the Online Appendix compares empirical estimates of the output gap with those generated with our DSGE model in pseudo real time. Our benchmark output gap measure is a popular one used in practice (also in simpler semi-structural models). An alternative approach in DSGE models is also to use the level of output relative to the flexible price output level as the output gap; however, this is more difficult to use in practice, especially given the size of our model, and since our paper tries to answer the research question from an applied perspective, we keep our simple proxy of the output gap.
19 Note that the debt-correction term depends on the deviation of the annual debt-to-GDP ratio from its target for simplicity. Moreover, we have also experimented with using three-year averages of the debt-to-GDP ratio in these fiscal rules. The results reported below remain basically unaltered. See also Footnote Footnote22 as well as Figure 6.4 and Table 6.1 in the Online Appendix.
20 For the expenditure growth rule, our benchmark calibration implies where 4 is used to convert to the quarterly expenditure growth rule and 0.38 is our calibrated government expenditure share in GDP.
21 We have not found much sensitivity of our key results to the calibration of this persistence parameter.
22 About up to a 40pp deviation across all calibrations.
23 This non-linear behaviour is robust to an alternative fiscal rule specification with a 3-year average debt-to-GDP targeting (as practised by the European Commission), instead of targeting the particular period's debt-to-GDP deviation; see Figure 6.4 in the Online Appendix. A minor twist in the behaviour is the need for a stronger debt correction with a longer averaging window.
24 Note that in the model and thus also in the results discussed below we always have three fiscal rules active: one for public consumption expenditure, one for public investment expenditure, and one for government transfers. One might suspect that the results can be different if only one of these rules is active at a time. In particular, it might be argued that public investment expenditure should not be touched in order not to harm future growth prospects. Similarly, the amount of government transfers cannot be easily or quickly changed, when a government faces political or economic pressure to reduce total government spending, so that it could only adjust government consumption expenditure effectively. However, it turns out, using unreported results available from the authors upon request, the outcomes we are going to discuss below are qualitatively robust and quantitatively not much different from the number and kind of fiscal rules active in the model (we do not consider public investment as a single rule, as it is unlikely in policy practice). One just has to adjust the fiscal rule parameters (by making them larger in absolute value) in order to keep the volatility of the public debt-to-GDP ratio unchanged, relative to the benchmark calibration with all three fiscal rules.
25 Relative to the estimated shocks, we are downscaling all the estimated shock standard deviations by 20% (or variance by 36%), as the shocks are estimated to Latvian data and Latvia experienced an exceptionally large boom-bust cycle in the first decade of this century so that the simulation results would be more tailored to the post-2009 recession period (and to more stable economies).
26 As a robustness check, Table 6.1 in the Online Appendix reports the results for the alternative specification of fiscal rules, where the government is targeting a 3-year average debt-to-GDP deviation from its target, instead of the particular period's debt-to-GDP targeting. The results are similar.
27 Also, given a roughly symmetric distribution of debt-to-GDP from its target (observed in ), this measure shows roughly how many times a 90% interval of debt-to-GDP ratio deviations (in both positive and negative direction) from its target is wider under the expenditure growth rule, compared to the structural balance rule.
28 Public investment averaging yields small improvements in public investment stability in stochastic simulations for typical public investment shocks. We return to this topic during the discussion of the golden rule below.
29 In the simulation with faster debt convergence, the debt-correction term is made twice stronger. Absent the expenditure growth targeting, this would imply speeding up the rate of annual debt-to-GDP gap correction from 1/25 to 2/25. Yet, the presence of the expenditure growth target alters the actual rate of debt convergence in a non-linear way.
30 We have experimented with both alternative Taylor rule specifications and alternative macroeconomic shocks, including their assumed persistence parameters.
31 We confirm this result also by excluding interest payments from the structural balance rule and verifying that in this case much of the superiority of the expenditure growth rule in stabilizing macroeconomic outcomes disappears.
Additional information
Notes on contributors
Ginters Bušs
Ginters Bušs holds a Doctor of Engineering (Dr.sc.ing.) degree in Information Technology from Riga Technical University, a Master of Social Sciences degree in Law with distinction from the University of Latvia and a Master of Economics degree from Central European University in Hungary. He has studied economics also at Duke University in the USA and Ghent University in Belgium. He joined Latvijas Banka in 2011 as a Senior Econometrician in the Monetary Research and Forecasting Division of the Monetary Policy Department, later as Principal Econometrician. Ginters is the author of the Latvian DSGE model, many scientific studies, articles and Macroeconomic Developments Report scenarios. He has also developed the GDP forecasting system at Latvijas Banka and previously - the Central Statistical Bureau of Latvia. He represents Latvijas Banka in the Working Group on Econometric Modelling of the European System of Central Banks.
Patrick Grüning
Patrick Grüning holds a PhD from Goethe University Frankfurt in business administration (2015) and a “Diplom” degree in mathematics (2009). His doctoral dissertation was prepared within the Ph.D. in Finance program at the Graduate School of Economics, Finance, and Management of Goethe University Frankfurt and carries the title “Essays on Asset Pricing with Contagion, Endogenous Growth, and Long-run Risk”. During his studies he visited the Sauder School of Business at the University of British Columbia for 6 months (2011/2012) and spent a semester at the University of Wisconsin-Superior (2006).Patrick Grüning joined the Monetary Policy Department of the Bank of Latvia in October 2021. Before his employment at the Bank of Latvia he worked at the Bank of Lithuania from September 2015 to June 2021 and at the Research Center SAFE of Goethe University Frankfurt (now the Leibniz Institute for Financial Research SAFE) from March 2013 to August 2015. He is engaged in research on climate change economics, fiscal policy, macro-finance, and asset pricing.
Oļegs Tkačevs
Oļegs Tkačevs is a Principal Economist at the Bank of Latvia. His main research activities include fiscal and structural policies, competitiveness and trade. In the past he represented the Bank of Latvia in the ESCB Working Group of Public Finance. During the great recession period he closely cooperated with counterparts from the IMF and EC on fiscal consolidation strategy and recommendations for structural reforms. In 2012 and 2013, he was an NCB expert at the Directorate General Economics of the European Central Bank. He holds a Ph.D. in Economics from the University of Latvia.