their way to economic variables via the longer-term supply-side effects. It does not
necessarily mean that ‘letting the automatic stabilisers work’ will lead to superior
economic outcomes as such. Fiscal policy that refrains from manipulating spending or
taxes at every economic turn shields the economy from further shocks. Fiscal policies
ought to focus attention on the longer-term effects of fiscal policy, rather than
destabilising it.
5.5 Conclusion
Recent years have seen the launch of excessive deficit procedures to Portugal, France and
Germany, and later for several other EU Member States. The reasons for the breach of the
deficit rules in recent years are still open to discussion. A variety of political and
economic factors probably underlie the increase in public deficit and debt ratios. The
revised Pact loosens the numerical limits and leaves more room for a country-specific
interpretation of the medium-term budgetary objective. First, it allows for a gradual
adjustment effort under unfavourable economic conditions, as long as consolidation
continues in good economic times. Second, the revised Pact also attributes more
importance to the quality of the budget adjustment. The revised Pact provides for the
implementation of structural reforms that carry temporary budgetary costs, but which
through positive supply-side effects enhance the structural balance and thus the long-term
sustainability of public finances.
This chapter takes a first step in developing an economic indicator of discretionary fiscal
stance that takes into account both the cyclical short-term and the long-term supply side
aspects of fiscal policy. We analyse the budgetary outlook for France, Germany, Portugal,
and Spain by uncovering underlying past trends in revenue and expenditure. Our
approach combines insights from the growing empirical literature on the effects of fiscal
policy modelled via structural VARs with statistical methods for cyclically adjusting
fiscal balances. Our approach innovates on existing evidence in using a mixture of short
and long-term restrictions to identify economic and fiscal shocks in a small-scale
empirical model in output and fiscal variables. This allows for permanent shocks to
determine trending behaviour of output and fiscal variables à la Blanchard-Quah.
Discretionary fiscal adjustments are captured by filtering out the fiscal balance for
cyclical reactions of budget items following Blanchard and Perotti (2002).
The model-based indicator we develop shows that pre-EMU consolidations have in last
instance been based mainly on revenues. The slippages of the recent years owe to the
unwinding of these measures without accompanying spending cuts. This showed up in
larger deficits when economic conditions worsened, and a ‘ratcheting up’ in the size of
government in economic booms. Recent corrective measures seem to rely mainly on
increasing revenues again. The procyclical bias in fiscal policies has not been eliminated.
Governments implement bad policies in good times. Fiscal policy induces additional
economic fluctuations and contributes to aggregate macroeconomic instability. As a
consequence, the short-term effects of fiscal policy outweigh supply side effects in the
longer term. A Pact that counters these policy reversals can lead to more sensible policies
that also focus on the long-term quality of public finances.
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