The European fiscal compact.

Implications for Romania

Ionut Dumitru Chairman of the Fiscal Council*

February 8, 2012

* The opinions expressed in this presentation are those of the author and do not necessarily represent the views of the Fiscal Council

1. What does the European fiscal compact comprises?

• Part of the Treaty on Stability, Coordination and Governance in the Economic and

Monetary Union - new treaty to be signed by all EU countries except the United

Kingdom and the Czech Republic.

• The treaty aims to strengthen fiscal discipline by introducing automatic penalties

and better enforcement.

• The new treaty includes the requirement that national budgets are balanced or in

surplus. This requirement will be met if annual structural deficit will not exceed

0.5% of GDP.

• Member States will be obliged to introduce the "target for a balanced budget" in

their national legal systems, preferably at the constitutional level. The deadline

for fulfilling this obligation is one year after the entry into force of the Treaty.

• If the public debt is significantly below 60% of GDP and risks in terms of long-

term sustainability of public finances are low, the structural deficit may reach up

to 1% of GDP.

2. Is the fiscal compact enough for the proper functioning

of the Monetary Union? (1)

• The 3% of GDP budget deficit ceiling and the 60% of GDP ceiling for public

debt have always existed, as established by the Maastricht Treaty in 1992.

• The Stability and Growth Pact (1997) - the position of medium-term structural

budget balance to be ‘close to balance or in surplus’.

• The new fiscal pact sets automatic correction rules and penalties when a • The new fiscal pact sets automatic correction rules and penalties when a

country exceeds these limits.

• The Eurozone is an unprecedented currency union in history, sharing only the

monetary policy, without having a fiscal union.

• Successful monetary unions in history are those that have combined the

monetary union with the fiscal one (U.S., Canada, Germany and Switzerland).

• Bordo, Markiewicz and Jonung (2011) – required characteristics for a successful

monetary union:

– an independent central bank that aims price stability

– free trade and movement of production factors and capital

– a common fiscal policy, with strong fiscal rules, member states having a certain fiscal

independence, but fiscal discipline imposed by the financial markets and strengthened

by the rule of “no bail-out” of member states by the federal government

– the existence of strong mechanisms to deal with asymmetric shocks (automatic

stabilizers such as unemployment benefits and progressive income taxation, as well as

transfers from the states less affected by shocks to those most affected).

2. Is the fiscal compact enough for the proper functioning

of the Monetary Union? (2)

transfers from the states less affected by shocks to those most affected).

• The EU budget accounts for slightly above 1% of GDP, a low value, and it is not

used as a stabilization mechanism.

• There are no fiscal transfers between member states when asymmetric shocks

occur, while labor mobility and flexibility in Europe is much lower than in U.S. or

Canada.

• EU member states are quite heterogeneous in terms of economic development

and competitiveness.

3. The fiscal compact impact for Romania

The cyclical and structural deficit

• Actual budget deficit = Cyclical deficit (automatic stabilizers) + structural deficit (discretionary policies)

• Both public revenues and expenditurse have components influenced by the economic cycle. Through its cyclical fluctuations, the budget balance automatically contributes to the “smoothing” of fluctuations in aggregate demand and economic cycle.

• The revenues and expenditure components influenced by the economic cycle act as “automatic stabilizers” smoothing the economic cycle and reducing GDP volatility. “automatic stabilizers” smoothing the economic cycle and reducing GDP volatility. The more progressive the tax system is, the better the action of this mechanism.

• The structural balance represents the fiscal stance when the production factors are at their “normal” level, i.e. when the economy is midway between an economic boom and a recession.

• The economic cycle impact on the cyclical balance is determined by the output-gap and the revenue and expenditure elasticity to changes in the economic activity.

Estimation of potential GDP and GDP deviation from the

potential level – a key element

2.9%

2.6%2.4%

2.6%2.8%

2.0% 2.1%

3.4%

3.8%

4.2%

4.7%

5.3%5.1%

2.7%

2.0%1.9% 2.0%

2.2%

0%

1%

2%

3%

4%

5%

6%

200

220

240

260

280

300

320

340

360

Potentia l GDP growth (rhs) Potentia l GDP (RON bn in 2005 prices) Real GDP (RON bn in 2005 prices)

Note: European Commission estimates, November 2011

-10

-5

0

5

10

15

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

F

20

12

F

20

13

FOutput gap (in %)

Cyclical and structural component of public

revenues and expenditure

-5

0

5

10

15

-10

0

10

20

30

40

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

F2

01

2F

20

13

F

Cyclically adjusted total revenue (% of GDP)

� The cyclical component of revenues is higher than

the cyclical component of expenditure

Note: European Commission estimates, November 2011

-10

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

F

20

12

F

20

13

F

Output gap (%)

Cyclical component of revenue (% of GDP)

Cyclical component of expenditure (% of GDP)

Cyclically adjusted total revenue (% of GDP)

Cyclical component of revenue (% of GDP)

Total revenues (% of GDP)

-10

0

10

20

30

40

50

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

F2

01

2F

20

13

F

Cyclically adjusted total expenditure (% of GDP)

Cyclical component of expenditure (% of GDP)

Total expenditure (% of GDP)

Actual deficit, structural deficit and the cyclical deficit

-10

-8

-6

-4

-2

0

2

4

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

F2

01

2F

20

13

F

-10

-5

0

5

10

15

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

F

20

12

F

20

13

F

Note: green hatched areas designate periods when output gap is positive (economy is growing above potential)

European Commission estimates, November 2011

� When the economy grows above potential (positive output gap), a cyclical budget surplus is recorded

and the actual deficit is lower than the structural deficit ���� the risk that policy makers implement

expansionary policies by increasing public expenditure based on temporary income (of cyclical nature)

� Pro-cyclical discretionary fiscal policy has abolished the economic cycle stabilization role of automatic

stabilizers.

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

F2

01

2F

20

13

F

Cyclically adjusted net lending (% of GDP)

Cyclical component of expenditure (% of GDP)

Effective budget deficit (% of GDP)

Cyclical component of net lending (% of GDP)

Output gap (%)

Cyclically adjusted net lending (% of GDP)

The new rule imposes a very strict control over public

finances, with advantages and disadvantages

Advantage: very low risk of pro-cyclical fiscal

policies.

� For example, if the rule would have been applied in the past,

in 2008 when the economy was growing above potential, a

budget surplus of 2.5% would have been required instead of

an actual deficit of 5.7%

Disadvantage: reduced fiscal space during

recessions.

-2.9

-5.7

1.92.5

-0.4

-8

-6

-4

-2

0

2

4

recessions.

� In Romania, the structural deficit limit of 0.5% of GDP will

likely be reached before the actual government deficit equals

3% of GDP (Romania may have budget deficits of 3% of GDP

only in times of extreme crisis - negative output gap of about

8.3%)

Note: deficit recalculated by the relation: -0.5% + cyclical deficit (% of GDP)

Source: own calculations based on European Commission estimates, November 2011

-9.0-10

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

F

2012

F

2013

F

Effective budget deficit (% of GDP)

Deficit recalculated based on the fiscal rule (% of GDP)

The size of automatic stabilizers in the European economies

Change in percentage points due to an increase in output gap of 1 p.p.*

0.60

0.49

0.47

0.30

-0.30

-0.20

-0.10

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

* For the budget balance, the graph presents the impact as % of GDP

Source: AMECO, author’s estimates

� Compared with other European countries, the government’s ability to contribute to the smoothing of

fluctuations in the business cycle through automatic stabilizers is relatively low for Romania.

Romania would need stronger discretionary fiscal stimulus (structural deficit) during recessions.

-0.30

Danemarca

Olanda

Suedia

Finlanda

Belgia

Germ

ania

Franta

Italia

Zona Euro

Luxemburg

UE27

Slovenia

Austria

Ungaria

Irlanda

Spania

Marea Britanie

Grecia

Polonia

Cipru

Rep. C

eha

Bulgaria

Portugalia

Malta

Estonia

Romania

Slovacia

Letonia

Lituania

Revenue Expenditure (-) Budget balance

The size of automatic stabilizers is closely related to the tax

system and public sector as share of GDP

DK

NE

SW

FI

BE

DE

FR

IT

LU

EU27

SE

AU

HU

UKEL

PL

CY

CZPT

MT42

47

52

Structural component of

expenditure

(% of potential GDP, average 2001-

2011)

Source: AMECO, author’s estimates.

IRESCY

BGEE

RO

SKLV

LT

32

37

0.20 0.30 0.40 0.50 0.60

Structural component of

expenditure

(% of potential GDP, average 2001

2011)

Automatic stabilizers (pp)

In the medium and long term, the actual deficit is equal

to the structural deficit

Last economic cycle

(1999-2011)

Last two economic

cycles (1995-2013)

Average of the budget deficit

(% of GDP) -3.8 -3.7

Average of the cyclical

component (% of GDP) 0.0 0.0

Average of the structural

Source: Calculations based on estimates of the European Commission, November 2011

� On average over an economic cycle (and the long-term average), the effective budget deficit

should to 0.5% of GDP

Average of the structural

deficit (% of GDP) -3.8 -3.7

Public debt: what is the optimal level?

0

20

40

60

80

100

120

140

160

Esto

nia

Bulg

aria

Rom

ania

Sued

ia

Litu

ania

Ceh

ia

Slov

acia

Slov

enia

Leto

nia

Finl

anda

Polo

nia

Ola

nda

Span

ia

Aus

tria

Ger

man

ia

Fran

ta UK

Belg

ia

Irla

nda

Port

ugal

ia

Italia

Gre

cia

Public debta (% of GDP, Q3 2011)

EEBG

RO

SE

LT

CZSK SILV FI DKPLNL

ESCYMT ATDE

EU27HU FRUKEA BE

IEPT

ITGR

0

20

40

60

80

100

120

140

40 60 80 100 120 140

Publ

ic d

ebt

(% o

f G

DP,

Q3

20

11

)

GDP per capita in 2010 (% of EU27 average)

Source: calculations based on Eurostat data

In the medium and long term, the 0.5% of GDP ceiling for the structural deficit leads to lower public debt (as %

of GDP). In about 20 years, assuming an average GDP nominal growth rate of 5%, public debt will reach 20% of

GDP.

Long-term dynamics of public debt (% of GDP)

10.0

15.0

20.0

25.0

30.0

35.0

40.0

45.0

2012

2014

2016

2018

2020

2022

2024

2026

2028

2030

2032

2034

2036

2038

2040

2042

2044

2046

2048

2050

2052

2054

2056

2058

2060

0.5% of GDP structural def icit

0.7% of GDP structural def icit

1% of GDP structural def icit

Improving EU funds absorption is a must

European Commission payments to member states under the Cohesion

Policy 2007-2013 ( the situation from October 2011)

Source: EUROPE’S SOURCES OF GROWTH - Presentation of J.M. Barroso to the European Council of October 23, 2011

Note: total payments from the EU budget as% of total allocations for 2007-2013.. The figures include the prepayments that are between 7.5%

and 11% for a Member State

EU funds absorption is an enormous stimulus for the economy (for 1 leu own

resources – budgetary deficit – public expenditure amounting 20 lei can be

made), which is crucial in the context of discretionary fiscal policy

constraints imposed by the new fiscal pact and the small size of automatic

stabilizers!!!!!!!

The necessity to increase the efficiency in public spending

0

1

2

3

4

5

Rom

ania

Esto

nia

Ceh

ia

Luxe

mbu

rg

Bulg

aria

Polo

nia

Irla

nda

Litu

ania

Span

ia

Slov

enia

Fran

ta

Ger

man

ia

Aus

tria

Investment expenditure (% of GDP, 2001-2010 average)

World Economic Forum, The Global Competitiveness

Report 2011-2012

� Important financial resources allocated for public

investment expenditure, but:

� there is a strong sentiment that the infrastructure

progress was very small

� poor infrastructure remains a critical problem for

Romania

Source: computations based on Eurostat data Source: computations based on Eurostat data

0

1

2

3

4

5

6

7

Rom

ania

Bulg

aria

Polo

nia

Slov

acia

Ung

aria

Cehi

a

Aus

tria

Fran

ta

Ger

man

ia

Infrastructure quality index (GCI 2011-2012)

2001-2010 average)

4. Concluding remarks

• The new fiscal pact includes as a major advantage for Romania the introduction of a strict fiscal discipline, thus avoiding the pro-cyclicality of discretionary fiscal policy.

• Disadvantage - the use of discretionary fiscal policy, especially in times of recession, is limited, while the automatic stabilizers are relatively too low to be enough in stabilizing the economy.

• The 0.5% of GDP structural deficit ceiling is more restrictive for Romania than the 3% of GDP ceiling for actual deficit.

• Possible solutions:• Top priority - urgent and substantial increase of EU funds absorption

• increase efficiency of public expenditure

• increasing the magnitude of automatic stabilizers

• In the medium and long term, the 0.5% of GDP ceiling for the structural deficit leads to a substantial reduction of the public debt (as % of GDP). Is this desirable for an economy like Romania’s economy?