Fiscal policy rules in the Economic and Monetary Union

The European Union uses different instruments to coordinate and supervise the economic and fiscal policies of the Member States. The aim is to combat and correct trends weakening economic growth in the Member States and to enhance economic stability in the EU as a whole. The focus in the coordination is on policy areas where impacts might be felt across the Union. The EU has established particularly strict procedures for fiscal policy, Governments use fiscal policy to manage general government revenue and expenditure and thus also the national economy as a whole.

Economic convergence has been a key objective in the efforts to build a closer union

Achieving economic policy coordination between the Member States was already stated in the Treaty of Rome, which established the European Economic Community (EEC) in 1957. In the Treaty of Maastricht, which established the European Union (EU) in 1992, it was also agreed that an economic and monetary union (EMU) would be created. With EMU, a number of EU countries introduced a single currency and the responsibility for monetary policy was transferred from the euro area countries to the newly established European Central Bank.

Fiscal policy, the second key economic policy area, remained the responsibility of the Member States. However, in a protocol annexed to the Treaty of Maastricht, a set of fiscal policy rules was laid down for the Member States. Under these rules, which are still in effect, the public debt to GDP ratio should not exceed 60% and the deficit in general government finances should not exceed 3% of the GDP. Since then, the rules have been made more detailed and comprehensive.

There are many reasons for agreeing on common rules. It is important to ensure that the Member States adhere to a rules-based fiscal policy because in a highly integrated union, a budgetary crisis in one country may also cause difficulties for other Member States. The coordination of monetary and fiscal policy, which became more complicated with the establishment of the Economic and Monetary Union, also made it important to establish common rules. In addition to ensuring that the rules are observed, fiscal policy supervision also provides a framework for an exchange of views between the Member States, which may also promote stable economic growth.

Fiscal policy in the EU is guided by the Stability and Growth Pact

The Stability and Growth Pact, which was adopted in 1997, is a compilation of the fiscal policy rules of the European Union. It consists of a resolution of the European Council and regulations on the preventive and corrective arms of the Stability and Growth Pact (1466/97 and 1467/97). The purpose of the preventive arm is to enhance the supervision and coordination of economic policy so that the Member States would not accumulate excessive budget deficits or debts. The corrective arm also aims to prevent excessive general government debts and deficits and to speed up the corrective process if problems arise. The fiscal policy rules cover all areas of general government finances, which in Finland comprise central government, local government and social security funds.

The Stability and Growth Pact was revised in 2005, 2011 and 2013. The changes introduced in 2005 made the rules more flexible, while the updates of 2011 and 2013 increased coordination and supervision and made the rules more binding in response to the problems caused by the financial crisis. The purpose of the Fiscal Compact, introduced in 2012, is to ensure closer economic policy coordination between the Member States. In 2012, Finland adopted the Fiscal Policy Act (869/2012) in which the National Audit Office was designated as the body supervising compliance with the fiscal policy rules

The purpose of the fiscal policy rules is to keep general government debt and deficits under control

The three-per-cent limit to the deficit in general government finances and a limit of 60% to the public debt to GDP ratio, which are laid down in Treaty establishing the European Union, are the key indicators set out in the corrective arm of the Stability and Growth Pact. Deficit and debt levels are monitored on the basis of statistics and forecasts. However, exceeding the reference values does not necessarily mean that a Member State is in breach of the rules as the situation is evaluated on a comprehensive basis and consideration is also given to such matters as the excess being only temporary. This means that assessing compliance with the criteria is not always a straightforward matter.

The medium-term objective (MTO), specified for each Member State, is the key component in the preventive arm of the Stability and Growth Pact. It is expressed as a target level for the structural deficit or surplus. Under the Stability and Growth Pact, the MTO is set for three years at a time so that it guarantees a margin of safety in relation to the three-per-cent deficit reference value. The target is also laid down in the Fiscal Policy Act. Individual Member States have different medium-term objectives, depending on their economic situation.

The fulfilment of the MTO is evaluated on the basis of two separate criteria. First, it is assessed whether the targeted structural balance has been achieved or whether general government finances in the Member State have progressed towards the targeted balance as required. The structural balance describes the general government financial position (difference between revenue and expenditure) in relation to the value of GDP when the impact of business cycles and temporary and non-recurring measures has been eliminated from the nominal financial position of general government. In other words, the purpose of the structural balance is to describe the general government balance that cannot be explained by business cycles or non-recurring revenue and expenditure items. The idea is that Member States should take into account the capacity of their public sector with the existing economic structures. The aim is to limit excessive structural deficits because they are considered a threat to long-term sustainability of general government finances.

With regard to the second criterion (expenditure benchmark), an increase in general government expenditure is compared to the expenditure limit set for it. If the MTO for the structural balance is fulfilled, expenditure may increase in accordance with the ten-year average of growth in potential output. Potential output describes the GDP trend or the long-term economic growth path. If the MTO is not achieved, the allowed expenditure growth rate is set so that it supports the fulfilment of the MTO. When the expenditure benchmark is calculated, no limit is set for spending that cannot be controlled through economic policy. Investment expenditure and expenditure that is funded with corresponding growth in revenue may also be increased.

In its publication Vade Mecum on the Stability and Growth Pact, the European Commission gives its interpretation of how the rules laid down in the Stability and Growth Pact should be observed. The publication is a comprehensive source of guidelines for calculating and interpreting different indicators. The European Commission, the Ministry of Finance and the National Audit Office evaluate compliance with the Stability and Growth Pact on the basis of these guidelines.

Compliance with the rules is evaluated within the framework of the European Semester

Economic policy coordination between the EU Member States is in accordance with a yearly European Semester and the euro area budget period supplementing it. As part of the European Semester, Member States present their fiscal and structural policy plans to the European Commission and the Council for evaluation and these two bodies give Member States recommendations and supervise their implementation. The recommendations given to Finland have concerned such issues as the implementation of the social and health care reform, offering more incentives for work and the establishment of the credit register.

Compliance with the Stability and Growth Pact is evaluated within the framework of the European Semester, on the basis of stability programmes (prepared in spring) and the preliminary budget plans (submitted in the autumn).

The rules framework is complex and should be updated

There has been criticism of the EU fiscal policy rules and most of it has focused on the calculation of the structural balance and the complexity of the rules. The calculation of the of structural balance is based on economic forecasts and an evaluation of the business cycle. However, as it may take years before an overall picture of the past economic trends can be produced, the real-time measurement of the structural balance involves a great deal of uncertainty. This means that using structural balance as a key fiscal policy indicator also involves uncertainty.

In the 2000s, the efforts to update the rules framework have focused on ensuring that the framework would provide a better tool for steering fiscal policy and that the Member States would implement the rules more effectively. There is now more flexibility in the system so that better consideration could be given to conditions in individual countries. However, as a result, the rules framework has become complex and non-transparent, which threatens its credibility and can make Member States less willing to comply with it. Simplifying the fiscal policy rules is included in the development plans of the Economic and Monetary Union and is scheduled for the period 2020–2025.