Institutions for Fiscal Stability

This paper reviews the controversy over Europe's Stability and Growth Pact and offers a proposal for its reform. It argues that Europe would be best served by focusing on the fundamental causes of unsustainable debts — public enterprises that are too big to fail, unfunded public pension schemes that are too big to ignore, inefficient and costly labor market and social welfare problems, and budget making institutions that create common pool and free-rider problems — rather than on arbitrary numerical indicators like whether the budget deficit is above or below 3 percent of GDP. It proposes defining an index of institutional reform with, say, a point each for reform of budget making arrangements, reform of public pension schemes, and reform of labor markets and unemployment insurance. Countries receiving three points would be exempt from the Pact's numerical guidelines, since there is no reason to think that they will be prone to chronic deficits. The others, whose weak institutions render them susceptible to chronic deficits, would in contrast still be subject to its warnings, sanctions and fines.(JEL E0, F4)