Tradable Deficit Permits
Efficient Implementation of the Stability Pact in the European Union 

With improved prospects for growth in Europe comes the opportunity, and the responsibility, of ensuring that the institutions of the European Monetary Union are ready for the challenges that lie ahead.  The most problematic of these institutions is the Stability Pact for Stability and Growth, designed to guarantee the fiscal health of the Union members.  In her paper on tradable deficit permits, Alessandra Casella addresses the problem of enforcing fiscal stability among European countries.

The Pact advocates balanced budgets in the longer term and specifies, for each country, a ceiling for deficit spending of 3 per cent of GDP.  A violation of the ceiling will trigger warnings and possibly penalties.  In this form, the Pact has several problems:  The imposition of the same 3 per cent criterion leaves no room for differences in countries' cyclical phase and could result in excessive costs.  The arbitrariness left in the application of the penalties creates uncertainty and could lead to difficult negotiations with individual countries.  The stringent constraint, combined with discretion in the application of the penalties, emphasizes the countries' loss of sovereignty and is likely to be an obstacle if and when the UK decides to join the EMU.  The Pact needs amending, but any revision should seriously promote fiscal discipline and be at the same time realistic, transparent and predictable. 

Dominique Strauss-Kahn, the French finance minister, has proposed interpreting the deficit ceiling as applying to the aggregate deficit of all EMU members, relative to the Union’s GDP.  This would provide some necessary flexibility, as individual countries could temporarily push their fiscal deficits above the 3 per cent limit.  But it leaves unresolved the difficult question of assigning responsibilities for the aggregate target.  How do we ensure that a country will resort to increased deficit spending only when conditions demand it?   We need to set a “price” that makes the action undesirable, but what is the correct price?   Ideally, this price should reflect the costs endured by the other members because of the action of the deviating country, but it seems impossible to know precisely what these costs would be, at different times and in different economic conditions.  Luckily, we do not need to know:  borrowing from the experience of environmental markets, we should transform the Stability Pact into a system of tradable deficit permits.  The market price of a permit will then reflect accurately the current value of fiscal austerity to the Union.

In a market for pollution permits, the regulatory authority sets the overall pollution limit - the total stock of permits available on the market - and pollution sources sell their permits if their cost of pollution reduction is below the permits’ price, and buy them otherwise.  The market itself generates the incentive to reduce emissions, and  because cuts in pollution occur first where they are cheapest, the target decrease in pollution is achieved at minimum total cost.  The US market for emissions of sulphur dioxide, a contributor to acid rain, is the largest experiment of this kind.  Established in 1990, it targets coal-fired electric utilities in all US states and has succeeded in reducing emissions to approximately 50 per cent of their 1980 levels, at savings estimated at $300 million a year relative to traditional regulations.

The parallel with our fiscal problem is immediate: a system of tradable deficit permits would allocate deficits where their value is higher, making it possible to implement the desired fiscal discipline much more efficiently.  In the scheme’s simplest realization, each year each country is allocated a number of deficit permits, equivalent, for example, to 3 per cent of its GDP.  These permits are entries in special accounts, denominated in Euros and freely tradable.  At the time final fiscal statistics are made public, each country withdraws from its account, and from the system, a sufficient number of permits to cover the year's deficit.  Permits can be banked, and countries can prepare for anticipated shocks and buffer unanticipated ones, but cannot be borrowed from future allocations, to prevent governments from putting off needed adjustments.  Periodic auctions allow governments to buy or sell permits according to their expectations of current and future needs.

Given the general idea of a system of tradable permits, the exact design can vary.  For example, countries with different debt positions can be treated differently, mirroring the fear that deficits from economies with larger outstanding debts may be particularly destabilizing for the Union as a whole.  One plausible scheme would require countries to hold permits that are a multiple of their deficit, where the multiplicative factor is the country's debt to GDP ratio.  Over time, this scheme would lead the EMU countries to debt positions that are progressively smaller and more similar.  And it would do so at the lowest aggregate cost.  Its fundamental virtue is that it exploits countries’ incentives to minimize their costs to insure that the final goal is achieved as efficiently as possible.