When fiscal rules were enacted in the European countries, critics questioned whether the rules would be effective in achieving fiscal stabilization. For several decades the European countries have experimented with different fiscal rules to limit deficits and debt, at both the national and supranational level. Much of this criticism was focused on the institutional setting within which the rules were enacted.
One of the strongest critics was Charles Blankart. Blankart argued that the fatal flaw in the fiscal rules in most European countries is the absence of a ‘no-bailout’ rule. He predicted that without a ‘no-bailout’ rule, the fiscal rules would not be credible limits on the debt issued by European governments.
Blankart’s predictions regarding the effectiveness of fiscal rules was based on the experience with debt brakes in Switzerland. Debt brakes impose constraints on deficits and borrowing in Swiss cantons, as well as the national government. The precedent for ‘no-bailout’ rules was set in the bankruptcy of Leukerbad, a municipality in the Wallis canton. Leukerbad sued, arguing that the canton should assume their financial obligations. The court ruled against the municipality, and required private creditors to assume the losses. This set the precedent that local jurisdiction were responsible for their own finances. As a result no level of government in Switzerland can count on a bailout when they can’t meet their obligations. Blankart maintains that this precedent motivated the cantons and the federal government to enact debt brakes. Over the years these debt brakes have enabled the Swiss to significantly reduce debt, achieving a debt-to-GDP ratio well below the 60% tolerance level set by the European Union.
Blankart predicted that the absence of ‘no-bailout’ rules would make it difficult for other European countries to enact effective debt brakes comparable to that enacted in Switzerland. He was especially critical of the role for the European Central Bank (ECB). In assuming he risk of debt issued by the individual European countries. When the ECB announced the plan to support the debt issued by member nations, interest rates on their debt decreased.
However, significant differences in the interest rate on debt issued by the European governments has persisted in the long run. In the countries that have been most successful in enacting debt brakes, such as Switzerland and Sweden, interest rates on long term debt have fallen below zero. For the Eurozone countries as a whole the interest rate on long term debt is forecast at about 2% in 2018. For heavily indented countries, such as Portugal and Greece, the interest rate is forecast at more than double that for the Eurozone countries as a whole. Thus, despite the support from the ECB, the heavily indebted countries must pay a hefty premium on their debt compared to that issued by the more prudent European countries.
The conventional wisdom is that the differential in interest rates on long term debt issued by European countries reflects the monetary policies pursued by the ECB and central banks in these countries. As the ECB tightens monetary policy the forecast is for higher interest rates on long term debt issued by member nations. This tighter monetary policy is predicted to have a spillover effect, putting pressure on the central banks to tighten monetary policy and boost interest rates. But this forecast ignores the impact of divergent fiscal policies pursued in the different European countries.
Divergent fiscal policies pursued in the different European countries has impacted what Blankart refers to as dynamic credence capital. For several decades the European countries with effective debt brakes and ‘no-bailout’ rules have accumulated dynamic credence capital. As these fiscal rules are successfully implemented over time citizens gain confidence in the ability of the government to pursue prudent fiscal policies. As the debt is reduced the direct interest burden on citizens is of course reduced. But also, citizens perceive that the government is able to pursue stabilization policies in periods of recession or other emergency, without incurring deficits and burdensome debt. These countries have carved out the fiscal space to pursue discretionary monetary policies. The lower risk premium on public debt is reflected in lower interest rates on debt issued in the private sector as well. This creates a favorable business climate for investment and capital formation in the long term. We would expect these countries with lower debt burdens to achieve higher rates of economic growth, and that is borne out by recent growth trends in the European countries.
The opposite trends are evident in the more profligate debtor European countries, such as the southern Eurozone countries. Although these countries have had some success in addressing their debt crisis in rent years, they continue to incur deficits and accumulate debt at an unsustainable rate. Without the intervention by the ECB, they would most likely have defaulted on their debt. The efforts to enact debt brakes in these countries have failed because these rules lack credibility. Over time a deterioration in dynamic credence capital is reflected in higher risk premiums on their debt issue. With high levels of debt these countries do not have the fiscal space to pursue discretionary countercyclical policy. The business climate in these countries is not attractive to new business investment. As we would expect, the hollowing out of private investment capital is accompanied by retardation in their economic growth.