Rules and risk: Structural reforms and good fiscal institutions are necessary and help

By Guntram Wolff 14 November Interest rates paid on government bonds have diverged sharply across euro area countries. Spain and Italy are among those countries that now pay a significant premium relative to the benchmark Germany. Many commentators have argued that financial market actors act irrationally and bet irrationally against euro area periphery countries. And indeed, massive financial speculation can turn into self-fulfilling crises, which are difficult to counter-act with measures taken at a national level alone. The bazooka evoked by the British Prime Minister Cameron is one option to address this problem. Often overlooked in the debate is, however, the fact that financial market participants do not pick their victims randomly. They do assess underlying economic fundamentals, structural conditions for growth and the quality of institutions. In a recent research paper at Bruegel, co-authored with Anna Iara, we have shown that the quality of national fiscal rules is an important determinant of sovereign bond yields relative to Germany. Investors expect a country to be less risky, when its national fiscal rules are strong. This is particularly important in times of severe market stress as currently. Better fiscal rules can even mean a lower interest rate of as much as one percentage point. Why should fiscal rules have such a strong effect? The main reason is that good fiscal rules reduce fiscal deficits in the future by legally limiting the scope of governments to borrow. Moreover, a clear fiscal framework reduces the possibility of unintended budget slippery and large errors in budget planning that could lead to much larger than anticipated deficits as has recently been the case in Greece. For fiscal rules to have their full effect, it is important that investors perceive them as credible. Ultimately, credibility depends on the commitment of policy makers and the voters at large to really stick to the rules. There are good ways to increase this commitment. A rule that is enshrined in the national constitution makes it much more difficult for the policy maker, to ignore it than a rule that is only enshrined in easy-to-change budget regulations. Indeed, our research shows that the stronger the legal base, the stronger is the market impact of the rule. We also find that clearly defined enforcement mechanisms will help making the rules effective. If the rule, for example, foresees an automatic correction of spending when revenues are lower than planned, then the rule is perceived to be more effective. It may therefore be no accident that sovereign bond yields of Spain have fallen below the level of Italian bond yields. The constitutional change in Spain as regards the structural deficit is a very important and strong fiscal rule that is perceived as credible by markets. In particular the fact that debt service has received a priority over other forms of expenditure is certainly very important for financial investors. Also the expenditure rule commitment is an important element of reform. Arguably, Spanish fiscal policy had suffered from a wrong assessment of the underlying structural deficit and a simple expenditure rule can help to mitigate this problem. More broadly speaking, important structural reforms, including in the labour market, have been enacted in Spain. The effects of these reforms may not yet be visible in the real economy as unemployment is at untenable heights. But financial market actors appear to positively value them as necessary reform steps. In fact, Spanish spreads have recently turned lower than Italian ones and it is likely that the strong political commitment for sound rules and decisive reforms is an important part of the explanation. Overall, it appears clear that credible fiscal rules and decisive reforms to address structural weaknesses of the economy are necessary and help to regain market trust and ultimately growth. In addition, it is also clear that these measures alone cannot be enough. Spain as well as the euro area as a whole needs more accommodative macroeconomic policy. Euro area aggregate demand has fallen significantly and inflation expectations have fallen well below 2 percent. It is therefore important that the ECB soon lowers rates to help boost demand. In addition and more importantly, consumer and investor sentiment has recently been severely affected by the unresolved and lingering uncertainty of the euro area crisis. Euro area heads of state and government need to come up with a clear and credible strategy now to end this uncertainty. Only then will demand pick-up again and growth will resume and only then will we see the beneficial effects
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of the Spanish reforms in the labour market with unemployment falling. Guntram Wolff is the Deputy Director of Bruegel and author of Rules and Risk in the euro area, http://www.bruegel.org/publications/publication-detail/publication/615-rules-and-risk-in-the-euro-area/

Bruegel 2011

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