Countries with Weak Fiscal Reputation Benefit from Strict Budgetary Rules

Strict budgetary rules increase the credibility of countries with a low fiscal reputation. According to a study conducted by the Centre for European Economic Research (ZEW) in Mannheim, the establishment of stringent budget rules reduces government bond interest rates in these countries. The European Fiscal Compact will likely have the same effect. In this treaty, 25 states of the European Union (EU) agreed to implement new rules in their national legal systems allowing a maximum structural deficit of 0.5 per cent of GDP. A convincing new regulation to limit structural deficits will send an important signal for the future budgetary policy: If the regulation is credible, it will be an incentive for potential investors on bond markets to have confidence in the country’s efforts to perform a sustainable budgetary policy.

Assessing the success of stricter budgetary rules requires a verifiable correlation between the new fiscal rules and the development of government bond interest rates. Providing this empirical evidence, however, is difficult. Former studies have shown that countries with strict budgetary rules do have moderate bond interest rates, but they have not provided evidence that the same effect might also apply for embattled countries. If stringent rules had so far only been established in countries which already have a consensus for stability, strict rules would have to be considered a mere symptom of a deeply rooted preference for stability.

In order to achieve convincing results, particularly regarding crisis-stricken countries, ZEW researchers expanded the estimation approaches of former scientific studies to include indicators for the stability consensus in EU member states. Since there are no internationally comparable values on the debt preferences of voters, ZEW economists used proxy variables, including for example a nation’s average inflation rate, because the stability performance relates to stability preferences. Another indicator included in the assessment addresses the rigidity of fiscal rules. This indicator is being calculated by the EU Commission and aggregates qualitative and quantitative elements of fiscal rules.

Countries employing strict budgetary rules have established an image of stability. The ZEW studies show that the main reason for low bond interest rates in these countries has indeed been their image of stability, not rigid budgetary rules themselves. Countries which have had lower stability preferences still benefit from the newly established rules, because they bring about a significant reduction of interest rates. A similar effect could not be observed in countries with high stability preferences. It can be concluded that fiscal rules hardly impact nations with a long record of sustainable budgetary policy. For countries with substantial stability problems, on the other hand, stringent rules constitute a significant change. So there is reasonable hope that the Fiscal Compact will help to increase the credibility on bond markets of countries with a low fiscal reputation in particular.

For more information please contact

PD Dr. Friedrich Heinemann, Phone +49 621/1235-149, E-mail heinemann@zew.de