EU fiscal rule reform has become a defensive fight

The new EU fiscal rules proposed by the Commission will not slam public investment or exacerbate recessions in the immediate future, but they might haunt the eurozone in the long-term, Centre for European Reform’s (CER) Sander Tordoir writes for EURACTIV.

For the first time since the eurocrisis ten years ago, the European Commission tabled a package of legislative proposals to upgrade EU fiscal rules, which guide and constrain member-states budget policies.

After months of debates with EU capitals, the Commission’s rightful crusade to ditch rules that take little account of macroeconomic conditions or political realities has borne some fruit.

The proposed system will do away with rigid debt reduction targets that apply to all countries above a 60% debt threshold. Instead, it will require countries to negotiate a multi-year fiscal-structural plan with the Commission, rooted in an analysis of long-term debt sustainability.

The plan will be defined by a single operational target that, unlike the current system, eurozone finance ministers can track: a net expenditure path – basically the growth rate of government spending, netted out for factors like interest rate payments and cyclical unemployment spending.

But to placate frugal countries led by Berlin, the Commission included safeguards to curb its discretion in giving high debt member-states room for maneuver.

First, the new framework would oblige member-states to already reduce debt-to-GDP ratios over the course of the four-year plan and, second, to let government expenses grow slower than the economy potentially can.

Albeit in weakened form, these tweaks fulfill German requests.

Third, countries that have surpassed the 3% deficit limit will have to make a minimum fiscal adjustment of 0.5% of GDP a year. This safeguard was not a German idea, but added by Brussels at the eleventh hour, because it narrows the gap between the novel long-term debt plans and the deficit logic of the ancient regime. This may help to avoid lengthy ‘excessive deficit procedures’.

For example France, whose deficit will not fall below 3% until 2027, would not emerge from such a procedure for years.

Short-run v. long-term logic

The legislation and its concessions to frugal member states (the ‘frugals’) have given rise to a flurry of critiques. The main concerns – new fiscal rules stymy investment, exacerbate recessions, or lack teeth – are overblown in the short-run but they might haunt the eurozone in the long-term.

Take investment. After being depressed for a decade, the public investment ratio of the eurozone is finally returning to 4% of GDP, thanks to the pandemic ‘recovery and resilience fund’ (RRF). But the EU is struggling to get the RRF money out the door, let alone into projects on the ground, because of bottlenecks in absorption and administrative capacity in member-states.

So far, only an average 17% of the national recovery plans have been paid out. Back in 2020, the expectation was it would be roughly 10 percentage points further along by now.

Proponents of faster climate action are right that the EU needs to prime the budget pump in this area, but we may have simply reached the effective speed limit for public investment for now.

But the RRF will reach its end in 2026 and the post-recovery fund era looks more concerning. Governments come and go, and insofar as they slack on the commitments enshrined in their multi-year fiscal plans, they will face tough budget consolidation choices just as the recovery fund’s spigot dries up.

Finance ministers would then be tempted to cut investment first because voters notice spending cuts and tax rises more than cuts to investment. That could devastate the EU’s plans for more ambitious investments in public goods such as energy infrastructure, more resilient healthcare, and defense.

Thankfully, the emerging fiscal framework is a far-cry from the stringency of the old rules. If inflation and nominal growth remain relatively high, meeting nominal debt reduction targets seems doable. And as long as the net expenditure path clearly overrides any safeguards during recessions, fiscal policy can play its stabilising role, avoiding the self-defeating austerity that German finance minister Christian Lindner advocates.

In the medium-term however, the eurozone may very well be cast back into a low inflation and low growth equilibrium, as the IMF believes. The factors underpinning the pre-pandemic secular stagnation, such as the global savings glut, might reassert themselves. Achieving the framework’s nominal debt reduction targets could then imply budget cuts even as a country tries to recover from a recession.

Further common fiscal action to provide EU public goods like green energy infrastructure or military defense would make all these problems easier to solve. The recovery fund has helped the EU shake off a recession. Extending this type of joint fiscal instrument would help the EU keep investment up in budget-constrained countries.

Enforcement issues

Finally, enforcing the new rules will remain a challenge. The only carrot the Commission will have to nudge member-states is a three-year extension of fiscal plans. That will help persuade current governments to get serious about reform and investment to smear out debt reduction requirements over more years. But the extension can be given only once: the Commission will have nothing to offer subsequent governments after elections.

A way to give the Commission more enforcement carrots would be to extend the conditionality mechanism of the recovery fund to other future EU funds.

The Commission has avoided a discussion on what will happen after the RRF. Cleaving the rules from a side-stepped debate on central fiscal tools is the original sin of the reform effort.

As a result, it has inevitably become a defensive fight. The maximum the reform can now achieve is to retain EU fiscal credibility, help member-states save up to weather the next crisis and bring political peace for further joint fiscal action when the recovery fund runs dry. Trading less strict safeguards in the rules for stronger enforcement mechanisms is the best way to reconcile fiscal policy’s ability to pursue EU objectives with debt sustainability in the meantime.

Wrangling over the legislative text of the fiscal reform is starting now. Because two of the three pieces of legislation are subject to unanimity, both ‘team frugal’ and ‘camp high debt’ have vetoes. Any landing zone will have to balance their interests.

The alternative – letting the reform collapse – is economically reckless amidst increasing government financing costs, and politically toxic with climate change accelerating and war raging in Europe.

Sander Tordoir is a senior economist at the CER, working on eurozone monetary and fiscal policy, the institutional architecture of EMU, European integration and Germany’s role in the EU.