The Maastricht treaty decrees that as long as a country meets the twin criteria of the ‘excessive deficit procedure’ (a government budget deficit below 3% and public debt below 60% of GDP), its public finances will be regarded as ‘sustainable’. But neither the treaty nor the Stability Pact provide clear guidance for evaluating the public finances of a country violating these criteria – for judging whether it has taken adequate adjustment measures and whether it is moving in the right direction.

Since many of the EMU countries violate the twin criteria, a more operational interpretation of sustainability is needed to judge a country’s readiness for EMU membership and to monitor members’ public finances once EMU begins. A recent CEPR Report by Roberto Perotti, Rolf Strauch and Jürgen von Hagen formulates such a definition, one that rests on four principles: controllability; attacking the problem at source; a distinction between short-run symptoms and long-run sources of non-sustainable deficits; and the proposition that institutional weaknesses are the sources of such deficits.

The Report argues that policy-makers are usually more concerned about situations where governments lose control of spending and are heading towards an unavoidable, disruptive adjustment than about any particular level of public debts or deficits. It is precisely such sudden adjustments that might cause difficulties for the conduct of monetary policy under EMU. The Report’s interpretation of sustainability thus focuses on the issue of control over government spending, revenues and the deficit rather than a vague intertemporal budget constraint. The implication is that a sustainable deficit reduction is one by which the government regains reliable and lasting control over its budget.

Empirical evidence suggests that if fiscal consolidations are to achieve lasting success, they must attack the problem at its source. A non-sustainable deficit can usually be traced back to one or two critical elements of the budget, such as wage expenditures or transfers. Successful fiscal consolidations achieve a significant reduction in those elements. This implies that any assessment of the sustainability of a country’s public finances requires a disaggregate view of its government budget – one that determines on which side of the budget the deficit emerged and under which budget items.

But budget numbers can only be the symptoms of non-sustainable fiscal policies. Behind the numbers are the real causes of the problem, which are usually linked to weaknesses in a country’s economic policy institutions. Most importantly, flaws in the decision-making rules and practices regarding public monies lead to the emergence of excessive spending and deficits.

The Report considers two aspects of this: fragmentation of the budget process; and the spread of ‘non-decisions’ coupled with weaknesses in other economic policy institutions. The former occurs when representatives of particular spending interests are allowed to make spending decisions without considering the full cost of public policy programmes. Empirical evidence suggests that fragmentation is an important source of excessive government deficits.

Fragmentation can be overcome by strengthening elements of centralization in the budget process – designing rules and institutions that force policy-makers to take a comprehensive view of the costs and benefits of their programmes. There are two important approaches in practice: delegation of significant budgetary powers to a ‘strong’ finance minister; and the use of contracts focusing on spending and deficit targets among the relevant decision-makers.

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 programmes and fixing the parameters of entitlements by laws outside the budget process. Such 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 their constituencies.

In the context of sustainability, non-decisions make the controllability of the budget depend on the qualities of institutions outside the annual budget process, for example, labour market or welfare institutions. This implies that where non-decisions cannot be eliminated, the reform of other economic policy institutions must become an important element of the process of restoring sustainability. The European Council has recently recognized this principle by asking the Italian government to undertake reform of its national pension system as a condition for entering EMU.

The Report concludes that institutional reforms are an important part of a country’s effort to regain sustainability, and that governments can and should be asked to undertake such reforms when they have violated the twin criteria. How does this framework suggest that assessment of a country’s public finances should proceed? The Report proposes a five stage process:

• Does the country’s deficit show a sufficient change in the right direction, where ‘sufficient’ means at least 0.5% of GDP? If not, the country remains at stage 0.
• A sufficient move in the correct direction has occurred. Has the country reduced (increased) the ratio of spending (revenues) to GDP by at least two-thirds of the increase (decline) it experienced in the years when the deficit emerged?
• Sufficient action on the right side of the budget has been taken. Has the country reduced (reversed the decline of) the principal elements of spending (revenues) that led to the growth of spending (decline in revenues) during the emergence of the deficit?
• Sufficient action has been taken to address the symptoms of the deficit. Has the government identified the institutional weaknesses leading to the emergence of the deficit and addressed them, at least informally?
• The underlying weaknesses have been identified. Has the government engaged in institutional reforms to overcome these weaknesses?

These stages need not follow in a strict sequence but instead represent qualitative stages of the process. The questions at stages 0, 1 and 2 are straightforward to answer on the basis of budgetary statistics. The questions at stages 3 and 4 are more difficult to assess, rely on more qualitative information and can lead to more contentious debate. In view of this, the Report advocates that a country should not be declared to have regained sustainability unless it passes stage 2 at least.

Applying this procedure does not result in a tightening of the Stability Pact’s excessive deficit procedure. Instead, it provides a broader and more qualitative approach than the Pact’s focus on aggregate budget numbers. The keys to sustainability are a disaggregate view of the budget and a close scrutiny of institutions.

Following EU traditions, it may be argued that the monetary union has no business interfering with a member’s public finances, and much less with its economic policy institutions. But, the Report concludes, if sustainability is an important condition for the success of EMU, it must be accepted that the EMU members have a legitimate interest in monitoring the fiscal policies of their fellow members at a level that goes beyond the aggregate deficit, and to demand structural and institutional adjustments where necessary.

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