Can debt limits save the euro?

September 5, 2011

European leaders have been confronting their continent’s debt crisis by pushing for new limits on how much borrowing countries can do, part of a trend across much of the world toward balanced budget amendments and similar restrictions.

But economists say there is scant evidence that such constraints do much good.

About 80 countries have imposed legal limits on how much their politicians can spend, tax or borrow. In a handful of cases, they have written restrictions into their constitutions. Germany did that in 2009, and Spain is headed the same way after its lower house of parliament Friday approved a balanced budget amendment. France is also considering the idea.

French President Nicolas Sarkozy and German Chancellor Angela Merkel have recommended similar measures for all 17 nations that share the euro currency as the region battles a crisis over public debt that is putting its financial system — and the entire monetary union — at risk.

The track record of these fiscal rules has been mixed, even as they have become more widespread over the past 15 years, according to studies by the International Monetary Fund and others.

Most prevalent in Europe, these restrictions are also a feature of currency unions in the Caribbean and parts of Africa. Some get good grades. A Swiss constitutional amendment helped the country control debt that was rising during economic stagnation in the 1990s, analysts conclude. A Chilean set of laws is also well regarded for insulating the government budget from swings in the price of copper. So is an Australian program that requires officials to budget in four-year cycles and keep their accounts balanced over time.

Other experiences have been disappointing. Germany is trying a constitutional amendment for the second time after finding that its initial one in the 1980s did not prevent debt from rising over time. Japan, which is rare among Asian countries for having a legal debt limit, has waived the law virtually every year since 1947 and has run up more debt relative to the size of its economy than any other country.

The issue of stricter budget rules has been a perennial one in the United States. The government’s debt ceiling was always raised to accommodate borrowing until this year, when a standoff over the limit almost prompted a federal default. Meanwhile, Republican lawmakers have continued to push for a balanced budget amendment to the constitution.

The IMF has concluded that fiscal limits can help focus public attention on the need for budgeting discipline but won’t stand in the way if a politician wants to find a work-around.

“The use of fiscal rules is on average associated with improved fiscal performance,” the IMF concluded in a 2009 survey. The study said rules can help frame public expectations, give politicians a rationale for unpopular decisions and boost a country’s standing among investors.

But the IMF and others who have studied the issue say that it is hard to tell whether fiscal rules on their own do any good. They became more common in the 1990s, often adopted during or directly after a debt or public spending crisis. The IMF found that they may simply reflect a nation’s newfound “fiscal rectitude” — serving less as a constraint on public decisions than as a statement of what a society has decided it should do anyway.

“Establishing rules is very visible and sends a strong commitment. Assessing how it actually affects performance is more difficult,” said Douglas Sutherland, an economist with the Organization for Economic Cooperation and Development.

University of Maryland political scientist Allen Schick, in a review of fiscal rules done for the OECD, noted the paradox: The rules tend to be either so weak that they have no effect or so strict that they will eventually be ignored. Ultimately, he wrote, a country’s underlying politics and the state of the economy will have more influence.

“Rules fortify politicians who want to be fiscally prudent, but they do not stand in the way of those who are determined to spend more or tax less than the rules allow,” he concluded. He noted a U.S. Government Accountability Office study that found that Australia, Germany, Japan, Mexico and the United Kingdom adopted budget rules during austerity drives in the 1990s but quickly slipped back into deficit spending.

One thing is clear: All bets are off in a crisis. A quarter of the countries with fiscal rules set them aside during the recent recession, and another quarter had so much flexibility that they could spend or borrow whatever they wanted, according to an IMF survey.

In Europe, members countries of the euro zone agreed in 1997 that their annual deficits would not exceed three percent of their annual economic output and that total debt would be no more than 60 percent. But by 2002, when the common euro currency was fully introduced — and membership had been safely granted — the agreement was derided as “stupid” by the head of the European Commission, and France and Germany, the two largest economies, broke the rules.

Average euro-zone public debt is now about 90 percent of annual output.

Spain’s proposed constitutional amendment is modeled after Germany’s, calling for a 60 percent debt limit. The limit, however, is to be applied to debt levels averaged over the course of economic cycles, which allows for greater latitude.

The IMF advocates this flexible approach so that government surpluses in better years can offset higher spending and reduced revenue in downtimes. This can also keep governments from cutting spending during recessions, which could aggravate the downturn. The law also has an escape clause.

Alvaro Nadal, secretary for economy and employment for Spain’s opposition Popular Party, said that is meant to allow higher public spending in the event of a natural disaster.

But he added that Spain would welcome the discipline that the amendment would require. Spain wants to follow Germany’s lead, he said, and earn the same trust with investors. “It’s a strict rule,” Nadal said, “but we want that reputation.”

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