EU Fiscal rules: Fit for the future?

Few questions have been as polarizing, in Europe, as that of whether and how the overly complex EU fiscal framework should be reformed. This question, closely connected to a decade-long discussion on the reform of Eurozone macroeconomic governance, has been made ever more salient by the unprecedented economic shock the world went through with COVID-19.

The existing EU fiscal framework is grounded in two requirements – enshrined in the Treaty on the Functioning of the European Union (TFEU) – prescribing that budget deficits should stay below 3% of GDP and public debt should not climb above 60% of GDP. The Stability and Growth Pact (SGP) sets out in secondary legislation how the rules in the TFEU should be interpreted – by establishing the ‘preventive’ and ‘corrective’ arms of EU fiscal discipline, which include a requirement for debt in excess of 60% of GDP to decrease by 1/20^th of the difference every year. The SGP’s focus on fiscal discipline was further strengthened in 2011 with the ‘Six Pack’ and ‘Two Pack’ legislation. In 2012, the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union (TSCG) added a new focus on the structural balanced budget, which has more recently become object of criticism due to its over-reliance on uncertain potential output estimates. These successive additions resulted in a multi-layered setting, the application of which has become increasingly complex and reliant on discretionary flexibility clauses.

The existing framework is no longer fit for the post-pandemic world. It was envisioned at a time – the early Nineties, in the run-up to Maastricht – when the major economic risks based on historical experience appeared to be inflation and fiscal laxity. The ‘Brussels-Frankfurt consensus’ that emerged back then was grounded in the theoretical remit of monetarism and the conviction that the flexibility in the SGP rules framework and the ECB’s policy of inflation targeting would make a system-wide budgetary policy to stabilize the business cycle unnecessary. The Euro crisis clearly showed that such framework, while sufficient to guarantee exchange rate stability, was inadequate to guarantee financial stability in the event of asymmetric shocks. COVID-19, on the other hand, clearly shows that a centralized stabilization function may be needed even in case of a major symmetric one.

As Europe navigated through the biggest economic shock in post-war history – the pandemic – the rules have been suspended through the first-ever activation of the General Escape Clause (GEC) embedded in the SGP. This has allowed Member States to spend massively and fund emergency measures and an unprecedented fiscal stimulus. The reactivation of the SGP, which is now foreseen in 2023, should be made contingent on reaching a contemporaneous agreement on how the whole EU fiscal framework needs to be reformed for the post-COVID world. This agreement should rest on three pillars.

First, the debt reduction rule set out in the fiscal compact is untenable in the post-COVID economic environment and it should be dropped. In April 2020, the IMF expected global growth to dip to -3% in 2020 due to COVID-19, compared to a mere -0.1% during the Global Financial Crisis. The budgetary impact of measures that government implemented in response to this shock is unprecedented: on average, Eurozone countries undertook a discretionary stimulus of 4% of GDP, versus just 1.5% during Global Financial Crisis. This was possible thanks to the suspension of the SGP and the scrapping of large swaths of the EU State Aid framework, which allowed for an unprecedented degree of government intervention in the economy. Because some countries already had a high legacy debt from the Euro crisis, the massive fiscal stimulus has resulted into a worsening of the asymmetry in public debt loads across Europe. The European Commission forecasts the debt to GDP ratio of Northern euro members such as Germany, Austria, Finland, or the Netherlands to remain comfortably below 80%, while Spain would hit 115%, France 120% and Italy a staggering 155%. In these conditions, reinstating the debt reduction rule towards a hard 60% threshold from 2023 would generate a sizeable contractionary shock right after the largest recession in post-war history. Assuming a return to trend of public finances from 2023, fiscal dynamics are in fact at risk of being markedly asymmetric within the Eurozone. Countries in what we have become used to call the Eurozone ‘North’ would be over-compliant with the debt reduction rule if they returned to their pre-pandemic fiscal stance, but economies like France and Italy would have a hard time keeping the pace of consolidation currently required by the EU fiscal rules. Calculations suggest an adjustment in the order of 1.5-2.5% of GDP in France and Italy for several years (Figure 1), which risks working against the positive demand effect from the Next Generation EU investment initiative. In the current interest rate and inflation environment, a more moderate and politically feasible pace of adjustment would still deliver consolidation. European integration has (unexpectedly to many) survived the apocalypse: it should not be killed off a fiscal cliff of our own making.

Second, it is time to talk seriously about closer fiscal policy coordination for Eurozone member states. As fiscal policy remains decentralized, there is a risk that lack of coordination exerts undue pressure on the one policy that is centralized at the Eurozone level – namely, monetary policy. After an initial misstep (“we are not here to close spreads”), the pandemic has seen the ECB evolve and embrace a response function that is decidedly more need-based and sensitive to deviations in individual countries’ funding costs. This is evident in the large and persistent deviations from the capital key throughout the first phase of the Pandemic Emergency Purchase Programme (PEPP) implementation. In spring 2020, the ECB’s sovereign purchases were ~30% overweight on Italian debt compared to the theoretical share that would have been consistent with a strict application of the capital key rule.

While these imbalances have been re-absorbed later in the year, it would be ideal if the flexibility inaugurated with PEPP could remain a tool in the box of the ECB well beyond the pandemic. Yet, not only does the ECB face legal challenges on its sovereign-focused asset purchase programmes, but it its ability to stabilise funding costs also risks being curtailed by a more ‘mechanical’ coordination problem. If the self-labelled ‘frugal countries’ were to return to their pre-pandemic spending trends, it would become increasingly difficult for the ECB to rollover expiring public debt on its balance sheet without crowding out almost completely the market for some euro countries’ government bonds (Figure 2). As a result, fiscal consolidation in some countries would have a magnified cross-border negative spillover effect through the simultaneous constraint it would impose on monetary policy.

To mitigate this risk, the reform of the EU fiscal framework should include a much stronger and formalised focus on the Eurozone fiscal stance and account for the fact that a too rapid fiscal consolidation in the Euro ‘North’ may make fiscal adjustment in the Euro ‘South’ more difficult (as discussed some time ago here). A simple, state-contingent fiscal policy rule – along the lines of the one recently proposed by Angel Ubide – could be a good solution to achieve balance between the objective of supporting growth and inflation while ensuring debt sustainability across the Union in both good and bad times. This should be accompanied with an increase and explicit attention to the quality of public expenditure – something that currently finds little space in the application of the SGP, most likely because of political opposition to the increase in the Commission’s discretion and power that this would entail. Additionally, the new framework should include the set-up of a dedicated countercyclical stabilization function for the EMU – a building block that was debated lengthily and unfruitfully in 2018 on the back of the Franco-German Meseberg declaration. While the EU Cohesion Policy has played an indirect and implicit stabilization role during the Eurozone crisis (as discussed here), it does not have an explicit countercyclical mandate and it is by construction ill-equipped to perform that function, which is however critical to the long-run sustainability of the EMU.

Third, Next Generation EU should be made permanent and turned into a federal fiscal capacity for strategic investment. Theinitiative has been born with the underlying idea to stabilise public investment at a time of exceptional stress on public accounts, but it should not be retained for its countercyclical properties – which would be better served by the changes discussed in previous paragraphs. Next Generation EU should instead be turned into a fully-fledged federal spending programme dedicated to finance EU-level investment on strategic priorities (including but not limited to climate change).

The rationale for having an EU-level and EU-funded strategic investment facility could not be clearer, after the pandemic. The world is growing more complex, the geopolitics of trade and economic power is shifting, and despite a lot of emphasis on the ambition of reaching strategic autonomy, the EU remains ill-equipped to face these epochal changes. In its update of the EU Industrial Strategy, the European Commission has recently reviewed the list of Important Projects of Common European Interest (IPCEI), which constitute the backbone of what should become a more organic EU Industrial Policy. Coordinated investment in IPCEIs will be key for EU resilience in a more complex geopolitical environment, where globalization and international cooperation may become less of a given. Yet, spending earmarked for IPCEIs in the Next Generation EU National Recovery and Resilience Plans (NRRPs) is quite limited. This is unsurprising, given that the cross-border dimension was never really a focus of this initiative, yet worrisome. Next Generation EU could be used to permanently fund more investment in these strategic priorities, but for this to happen the facility should be brought back to the spirit of the original Commission proposal – which envisioned using it to finance not only projects at the national level but also EU-level public goods. A new permanent Next Generation EU focused specifically on EU-level investment in EU-wide strategic priorities should un-controversially be funded through EU common issuance underpinned by agreement on new Own Resources to service the resulting debt. Lastly, it would make logical sense for this debt – issued by the EU, services with EU own resources, and incurred in the pursuit of EU-level strategic priorities such as fighting climate change or a resilient industrial policy – to be considered to all effects and purposes EU (federal) debt. That would be a European Hamiltonian moment worthy of the name.

Today, widespread agreement exists on the fact that the EU fiscal framework needs reforming, but agreement on how it should be changed has so far been elusive. At the core of the disagreement lies a different perception of the need for, and the modalities of, European solidarity. The countries that had been hit hard by the Euro crisis and have gone through a decade of painful and politically challenging macroeconomic adjustment, have been calling for a reform of macroeconomic governance and the EU fiscal framework predicated on more risk sharing. The ‘frugal’ countries whose economic models emerged unscathed from the Euro crisis but whose political goodwill was eroded by domestic sentiments of ‘bailout fatigue’, have instead been in favor of a reform predicated on risk reduction and disengagement.

COVID-19 has turned the table on all these political calculations. As a symmetric shock completely exogenous to domestic economic policy choices, the pandemic was an obvious case for European solidarity to tackle the risk of a renewed macroeconomic divergence due to countries’ different pre-existing macroeconomic conditions. Unexpectedly to many, Europe rose to the challenge and agreed that the response to a common catastrophe needed to include solidarity for the purpose of saving integration. It is now time to build on this act of courage to ensure European integration can thrive sustainably in the increasingly complex future that awaits us.

Silvia MERLER* – Head of ESG and Policy Research, Algebris Investments

*I am thankful to Antonio Focella for excellent assistance in the research underlying this piece.

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