Institutions for Fiscal Stability

This paper reviews the controversy over Europe's Stability andGrowth Pact and offers a proposal for its reform. It arguesthat Europe would be best served by focusing on the fundamentalcauses of unsustainable debts — public enterprises thatare too big to fail, unfunded public pension schemes that aretoo big to ignore, inefficient and costly labor market and socialwelfare problems, and budget making institutions that createcommon pool and free-rider problems — rather than on arbitrarynumerical indicators like whether the budget deficit is aboveor below 3 percent of GDP. It proposes defining an index ofinstitutional reform with, say, a point each for reform of budgetmaking arrangements, reform of public pension schemes, and reformof labor markets and unemployment insurance. Countries receivingthree points would be exempt from the Pact's numerical guidelines,since there is no reason to think that they will be prone tochronic deficits. The others, whose weak institutions renderthem susceptible to chronic deficits, would in contrast stillbe subject to its warnings, sanctions and fines.(JEL E0, F4)