Fiscal Governance in the Euro Area: Institutions vs. Rules

This contribution considers mechanisms for rule-based fiscal policy co-ordination to replace the failed Stability and Growth Pact in the euro area. It argues in favour of soft debt targets as a means of addressing problems caused by excessive debt. It is shown how such targets can be safely operated, supported by an effective excess debt protocol. A division of labour between fiscal and monetary policy is proposed, whereby fiscal policy is used for long-term targets and monetary policy for short-term stabilization. We then design a monitoring agency, in the form of a fiscal policy commission for Europe, to make the excess debt protocol operational. The contribution also addresses the issue of moral hazard, by proposing that governments be abandoned to financial markets at the upper debt limit, a commitment to be spelled out in advance. Finally, this framework is set within the idea of fiscal space. We show how structural reforms can expand that fiscal space.