FINANCIAL WORLD  |  WORKING PAPERS

The Prudence Principle – A New Framework for Eurozone Fiscal Policy

by Marc Blyth & Eric Lonergan

PUBLISHED

13. DECEMBER 2021

Abstract

This working paper is an intervention into the on-going debate over the future of fiscal rules in the European Union. It argues that rather than writing down rules and expecting the world to conform to them, a better approach is to make the concept of ‘fiscal space’ operational by tying it explicitly to rates of interest on government debt. This permits huge flexibility in the size of the deficit, in the debt/GDP ratio, leaves inflation targeting to the central bank, and guarantees debt sustainability. It would also provide clarity to the public that the government is honoring its word.

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More than a decade after the financial crisis there still seems to be something seriously wrong with the financial system. Financial markets still tend to periodically misprice risk and contribute to boom and bust cycles. A better financial system needs to discourage short-termism and speculative activity, curtail systemic risk and distribute wealth more broadly.

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