The fiscal criteria of the Maastricht Treaty render a dichotomous interpretation of sustainability and von Hagen argued that the Treaty gives no clear guidance for evaluating the public finances of a country violating these criteria, i.e., for judging whether or not it has taken adequate measures of adjustment, and whether or not it is moving in the right direction. These questions are also left open by the more recent Stability and Growth Pact. As the beginning of EMU draws nearer, a more developed interpretation of sustainability is necessary to guide the judgements regarding a country's readiness for membership in EMU, and for a continuous monitoring of members' public finances once EMU has started.

Von Hagen outlined a practical framework for evaluating sustainability. Policy-makers tend worry more about situations where governments lose control of spending and deficits and are heading towards an unavoidable, disruptive adjustment than about any particular level of public debt. Thus, the report’s interpretation of sustainability focuses particularly on the issue of controllability and considers a sustainable deficit reduction where the government reliably and lastingly regains control over its budget.

There is overwhelming empirical evidence demonstrating that the lasting success of fiscal consolidations depends critically on following the principle of attacking the problem at the source. Successful, i.e. lasting, fiscal consolidations come with a significant reduction in those elements that led to the emergence of a fiscal problem in the first place. An implication is that an assessment of the sustainability of a country's public finances requires a disaggregate view of its government budget, since just looking at aggregate spending, revenues and the deficit is insufficient for making a valid assessment.

However, budget numbers can only be the symptoms of non-sustainable fiscal policies. Behind these numbers are the real causes which can commonly be linked to weaknesses of a country's economic policy institutions. Fragmentation of the budget process and the spreading of non-decisions are the most prevailing institutional deficiencies. Fragmentation of the budget process occurs, when representatives of particular spending interests in society are allowed to make spending decisions. Hence, fragmentation can be overcome by strengthening rules and institutions of the budget process that force policy makers to take a comprehensive view of the costs and benefits of public policy programs. Non-decisions occur in the budget process when governments leave the determination of spending and deficits to variables outside their direct control. Examples are the indexation of spending programs and fixing the parameters of entitlements by laws outside the budget process. Non-decisions reduce the budget process to a mere forecasting exercise of exogenous events, while allowing policy-makers to avoid tough decisions that might be unpopular with the electorate. Non-decisions make the controllability of the budget depend on the qualities of institutions outside the annual budget process, e.g., labour market or welfare institutions.

The report proposes that, based on these insights, an analytical procedure focusing on fiscal developments and their institutional underpinnings is utilised to evaluate the sustainability of a country's public finances after a violation of the double standards:

• Does the country shows a sufficient reduction of the deficit, where sufficient means at least one-half of 1% of GDP?
• Has the country ‘forcefully’ redressed the source of the deficit problem. ‘Forcefully’ means that the country reversed the ratio of spending or revenues to GDP by at least two-thirds of the change it experienced in the years when the deficit emerged.
• Spending and revenues should be disaggregated. It is necessary to investigate whether the country has reduced the principal elements of spending or increased the revenue source that led to the rising deficit.
• Then, at the subsequent stage consider if the country has identified the institutional weaknesses leading to the excessive deficit
• Given the necessity to address the problem at the sources, the report advocates that a country should not be declared having regained sustainability unless it has passed the third stage.

Applying this procedure provides a broader and more qualitative approach than the mere focus on aggregate budget numbers than the Excessive Deficit Procedure or the Stability and Growth Pact. The keys to sustainability are thus a disaggregate view of the budget and a close scrutiny of institutions. If sustainability is an important condition for the success of EMU, then it must be accepted that EMU has a rightful interest in monitoring fiscal policies of the member states at a deeper level than just the aggregate deficit, and to demand structural and institutional adjustments where necessary.

Notes for Editors:

CEPR is a network of over 450 Research Fellows based throughout Europe, who collaborate through the Centre in research and its dissemination. CEPR helps its Research Fellows to develop projects, obtain their funding, administer them and disseminate their results. The Centre’s research ranges from open economy macroeconomics to trade policy, from the economic transformation of Central and Eastern Europe to regionalism in the world economy. The views expressed in the discussion meeting are the authors’ own. Neither CEPR nor ECARE take any institutional positions..

Jürgen von Hagen is Professor of Economics at Universität Bonn, and Director of Zentrum für Europäische Integrationsforschung (ZEI). He is also a Research Fellow in CEPR’s International Macroeconomics programme.

‘Sustainability of Public Finances’
Roberto Perotti, Rolf Strauch and Jürgen von Hagen

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