The U.S. can learn much from the experience of European countries that have enacted new fiscal rules to address their debt crises. Debt brakes were adopted by the European Union for member states in the Stability and Growth Pact of 1997, and in the subsequent Fiscal Compact. Each of the Eurozone countries subsequently adopted their own unique debt brake. The term debt brake is used to refer to this broad set of fiscal rules enacted at both the supranational and national level in the Eurozone countries.
When debt brakes were introduced in the Eurozone counties critics questioned whether these fiscal rules would be credible in solving their debt crises. Divergence in the success with debt brakes in the different Eurozone countries generated even more controversy regarding the credibility of these fiscal rules. Some critics focused on design flaws that became apparent as the debt brakes were implemented. Other critics argued that more important than design flaws, is the institutional setting within which the debt brakes are enacted, and that that institutional reform is a prerequisite for debt brakes to be effective. In this paper we explore this issue with reference to debt brakes proposed for the U.S.
The Critique of Debt Brakes in the Eurozone Countries
The German debt brake was the model used in designing the debt brake adopted by the European Union. A number of economists questioned whether this debt brake would be effective in addressing the debt crises in these countries. Oates (2005) concluded that for the German debt brake to be effective would require “a fundamental reform of political and fiscal institutions to alter the whole structure of incentives for budgetary decisions making” (Oates 2005, quoted in Mause and Groeteke 2012, P 297).
In their (2012) study Mause and Groeteke were pessimistic regarding the prospects for new constitutional debt brakes in the European countries. They questioned whether the German debt brake introduced in 2009 was a credible commitment to fiscal stabilization, given the institutional environment in that country. Further, they questioned whether the new debt brake proposed for the European Union would prevent future fiscal crises and bailouts, absent fundamental institutional reform.
Mause and Groeteke (2012) maintained that the effectiveness of a debt brake depends not only on its specific design, but also on the institutional environment. Rather than designing new fiscal rules, they argued that the focus should be on institutional reforms, including: “a functioning capital market, a functioning interjurisdictional competition (including jurisdictions with tax and spending autonomy), the existence of an insolvency law for jurisdictions, and a credible no-bailout rule…” (Mause and Groeteke 2012, p. 298).
Mause and Groeteke (2012) offered a credibility test to determine whether or not the institutional environment in which fiscal rules are embedded make them a credible commitment to fiscal stabilization. Applying a credibility test provides not only insight into the potential for a credible debt brake in the U.S., but also policy implications for institutional reforms.
Blankart (2015) was even more skeptical of the effectiveness of debt brakes in the absence of institutional reforms.
“The lessons for the Eurozone are clear. Fiscal discipline is not possible without a strong-no-bailout constitutional provision which is observed and upheld. Creditors must know that when they lend to particular EU governments they bear the risk which is determined by the credit-worthiness of that government. It is from this starting point that fiscal discipline will follow. There is no point in directly imposing fiscal discipline from above through limits on debt and borrowing. Apart from the resentment this creates, it has not been and will not be effective in promoting sound fiscal policies.”
Fiscal Rules and ‘Dynamic Credence Capital’ in the Eurozone Countries
Compliance with these new fiscal rules, and success in addressing their debt crises, varied considerable in the different Eurozone countries. At one extreme are countries, such as Greece, that have either defaulted on their debt, or where the threat of default has resulted in very high rates of interest. At the other extreme are countries, such as Switzerland, where debt brakes at both the national and subnational level have been effective in reducing and eliminating debt far below the tolerance levels for debt set by the European Union (Merrifield and Poulson 2016a, 2018).
Many factors contributed to the compliance with and effectiveness of new fiscal rules enacted in the Eurozone countries. A major factor was ‘dynamic credence capital’, a term introduced by Charles Blankert (2011, 2015). ‘Dynamic credence capital’ is the belief that prudent fiscal rules are followed by elected officials. The belief grows through application of fiscal rules over time, and debases itself when the rules are disregarded. The concept of ‘dynamic credence capital’ is an extension of the theory of rational expectations applied to fiscal rules, as well as fiscal policy.
Blankart (2011, 2015) argues that there is a reason for the growth of ‘dynamic credence capital’ in Switzerland. The Swiss debt brake was complemented by a ‘no bailout’ rule. The ‘no bailout’ principle means that the federal and cantonal governments cannot count on the Swiss central bank to bail them out. It also means that each canton and municipal government cannot count on other jurisdictions to bail them out. When several cantons encountered financial problems due to losses in their cantonal banks in the 1990s, they were left on their own. Some municipalities, such as Leukerbad were forced into bankruptcy. When the creditors sued, the federal court ruled that neither the central government, nor the cantonal government, was obliged to bail them out. This set a clear legal precedent that Swiss governments must take responsibility for their own fiscal affairs, and not count on government bailouts when they encounter financial crises. It also sent a message to creditors to practice due diligence in assessing the creditworthiness of government borrowers. With this ‘no bailout’ rule in place, the elimination of government deficits and debt accumulation has built ‘dynamic credence capital’ in Switzerland over time.
Blankert (2011, 2015) maintains that the ‘no bailout’ rule motivated the Swiss cantonal and federal government to enact effective debt brakes. Further, he argues the absence of a ‘no bailout’ rule is the flaw that explains the ineffectiveness of debt brakes enacted in other Eurozone countries. He concludes that without a ‘no bailout’ rule in place debt brakes and other fiscal rules ae likely to be unsuccessful.
At the national level this form of capital market discipline has become more important since the financial crisis. The Eurozone countries that enacted debt brakes with ‘no bailout’ rules were able to reduce debt below the debt tolerance level, building confidence that the government would enforce the rules (Merrifield and Poulson 2016a, 2018).
An efficient capital market reinforces a debt brake by charging higher interest rates on jurisdictions that incur deficits and accumulate debt, compared to jurisdictions that balance their budgets and limit debt. Over time the trends in dynamic credence capital’ have become more important in determining interest rates on government debt. Credit markets responded to this ‘dynamic credence capital’ by reducing the risk premium on their government bonds. In the Eurozone countries that enacted these rules successfully the interest rate on long term government bonds has trended downward for several decades, and in recent years has converged toward 0% (Gosh et al. 2013; Botev et al. 2016; Lo and Rogoff 2015; Fournier and Fall 2015; Fall and Fournier 2015; Fall et al. 2015; Turner and Spinelli 2013).
The financial crisis that began in 2008 was accompanied by sharp divergence in the interest rate on long term bonds in the Eurozone countries. At that time the finance ministers in these countries assumed that each member state was responsible for the debts incurred by their banks as well as government debt. Credit markets responded with sharp increases in the interest rates on long term bonds issued by Southern Euro countries, including Greece, Italy, Spain, and Portugal (see figure 1).
Figure 1. Long Term Interest Rates 2008-2016
In 2012 the European Central Bank announced a new plan to in effect guarantee full bailout of European governments, regardless of whether or not the governments complied with debt brake rules. This spreading of risk by the European Central Bank was accompanied by a downward trend in interest rates on long term bonds. But, the divergence in long term interest rates in the Eurozone countries has persisted. In countries implementing debt brakes and ‘no bailout’ rules interest rates have converged toward 0%. In countries that have been less successful in implementing these rules interest rates are higher, reflecting the greater risk premium on their debt (Blankert 2011, 2015).