Debt Sustainability and Economic Convergence of Euro-Area Member States: Challenges and Solutions

Written by | Wednesday, May 20th, 2015

Paolo Mauro (Peterson Institute of International Economics)

The Eurozone is at risk of long-term economic stagnation. Neither the European Central Bank’s (ECB) expansionary monetary stance, nor the sharp decline in oil prices can remove this risk. In addition, the public debts of Europe’s economies have reached the highest levels since the end of World War II. The reduction of fiscal deficits is a great challenge in the light of a expected increase of expenditures due to the aging population. The crisis has shown that it is important to maintain a low level of countries’ indebtedness in order to enable them to launch fiscal stimuli during an economic recess. As to the uncertainties regarding economic growth over the next ten to twenty years, a fiscal correction is necessary to stabilize or to reduce the public debt share of GDP. One obvious way in which this can be achieved is the introduction of growth-linked bonds in every single country. A main prerequisite for their emission is the trust in official statistics and independence of national statistical agencies from political power – it is here where Eurostat could play a crucial role.

The fiscal plans must be based on long-term visions and realistic prognoses of economic growth. If there is a decrease in economic growth over the next few years, we will have to admit that we are poorer than we had thought. One of the political challenges will be the limitation of the overall growth of public spending with regard to a milder tempo of production growth. Regarding the high level of youth unemployment and fiscal deficits, the social security contribution for youth and labor taxation should be lowered. Public spending should support the growth potential of the economy by increasing expenditures for items, which generate new jobs, e.g. for infrastructure or education. For this purpose, it would be appropriate to carry out their evaluation and assess which expenditures are redundant.

The critics of the Stability and Growth Pact erroneously see it as the cause of fiscal savings and therefore they call for its abolition. The fiscal policy is limited by stronger and less foreseeable powers of financial markets. Although the current architecture of fiscal rules is becoming ever more complicated, it still has an important function, which is why it should be simplified and explained to wider public while keeping its content unchanged. In January, the Commission submitted a detailed guidance explaining the implementation of the existing rules. It has become clear from the Commission’s statement that the Pact’s flexibility will be provided in exchange for structural reforms whose impact is, however, difficult to estimate. The escape clauses should therefore be rather based on numerical criteria.

(The study can be downloaded here)

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