The discrepancy between technocratic rhetoric and economic facts is colossal.
Introduction and Summary
On February 10th, 2024, representatives of the European Council, the European Parliament (EP), and the European Commission (EC) reached an agreement on yet another reform of the fiscal rules.[1] The legislative package still has to be approved by both the European Council and the European Parliament by the end of April 2024. While the new rules have thus far received little attention, they will shape the fate of the European Union (EU) economy for years. After a decade of partial relaxations of its older super-restrictive rules that pushed the euro area into a prolonged recession in the years 2011-2013, and the activation of a general escape clause in the wake of multiple shocks (pandemic, energy crisis), the rules will abruptly turn restrictive again, though less so than the old ones. But if the new rules go into force, their effect on the socio-ecological transformation and the European welfare state will still be profoundly disastrous.
In announcing the agreement of the Trilogue negotiations, Vincent Van Peteghem, the finance minister of Belgium, which holds the EU presidency in the first half of 2024, claimed that the new framework “will safeguard balanced and sustainable public finances, strengthen the focus on structural reforms, and foster investments, growth and job creation throughout the EU.”[2]
This is not correct. The discrepancy between technocratic rhetoric and economic facts is just colossal. The new rules will impede, not foster growth and job creation, and they put the Euro area on track for another deadly cycle of austerity that sowed the seeds for the rise of the far-right in Europe. They admittedly build in some incentives to raise public investment, but this step implicitly comes with new pressures to restrain non-investment budgetary categories, such as social expenditures. Further, austerity programs threaten to curb economic performance, which will work against the reduction of the debt ratio which is a central objective of the new governance framework. Even though significant long-term investments in the socio-ecological transformation and in the strengthening of Europe as a business location more generally are desperately needed, the necessary investments are insufficiently protected and promoted in the agreement. In fact, the new fiscal framework will severely constrain an increase in public investment, in particular in high-debt EU countries.
Estimates of the additional public investments required to decarbonize the EU economy by 2050 vary widely.[3] The most recent study estimates the additional public investment requirement to be around 1,6% of the current EU GDP per year (Institut Rousseau 2024) which can be considered a lower bound. At 1,3% EU military spending in 2022 has been relatively stable as a percentage of GDP in the period 2013-2022 – fluctuating between 1,2 and 1,3% of GDP[4] - but this is expected to increase strongly in the upcoming years. The new rules are particularly worrisome at the back of the resistance to setting up a permanent EU investment facility – e.g. a Recovery and Resilience Fund 2.0. (RRF). A trilemma is clearly visible: An increase in public (capital) investment, fiscal consolidation, and reluctance to introduce or increase wealth tax revenues are incompatible. If the new rules are implemented the trilemma will most likely be resolved by substantially retrenching the welfare state.[5]
The methodology spelled out to assess the binding consolidation paths for countries in the new agreement is Baroque almost to a point of bizarreness and it bears a risk of procyclicality. Particularly worrisome is the use of a Debt Sustainability Analysis (DSA) to calibrate the consolidation path for each EU member state. A DSA can be considered useful to analyze fiscal risks under different scenarios with regard to growth, interest rates, or aging costs. But using this methodology – the details still have to be published - to calibrate a multiannual, binding net expenditure trajectory is an audacious undertaking. The DSA is highly judgemental, replete with self-fulfilling features, and hence is ill-suited for the operationalization of hard fiscal rules.
How Do the New Fiscal Rules Work?
Each member state is required to submit “Fiscal-Structural Plans” (FSPs) for the next four or five years to the EC. These FSPs set out strategies for sustainable public debt reduction - central to the FSPs will be the trajectory of the main operational target, the nominal growth rate of primary net expenditures – as well as strategies for inclusive growth, structural reforms, and investment. Reference is also made to the pillar of social rights, energy security, and possible defense spending as part of the FSPs. All these elements have, of course, to be compatible with the net expenditure path.
The European Commission has an essential role to play, as it examines these plans when they are submitted and subsequently monitors the annual progress. Formally, the European Council continues to decide on the basis of the Commission’s analysis to approve the plans or impose sanctions in the event of deviations.[6] Member states may also ask for an extension of the SFPs from four up to seven years which allows them to consolidate less per year and fulfil fiscal targets later. But the extension requires an increase in nationally financed public investments. The direction taken therefore depends on how the EC – and subsequently the European Council – assess the envisaged structural reforms and investments. In any case, the discretionary scope of the EC with regard to national fiscal policy strategies is considerable.
At the heart of the FSPs will be the trajectory of the main operational target, the nominal growth rate of net expenditures. The primary net expenditure path for the adjustment period will be provided by the EC and will be – after technical consultation with the member states - incorporated in the FSPs. The European Council then decides on a multi-year net expenditure path for the respective country – on the basis of a recommendation from the EC.
The definition of net expenditure is crucial for the assessment of the new fiscal rules.[7] It is defined to avoid procyclicality as it should not be affected by the operation of automatic stabilizers and other expenditure fluctuations outside government control. Further, it allows for the financing of additional expenditures with additional discretionary revenues (e.g. wealth taxes). However, public investments are not deducted from net expenditure, as the “golden rule” of public finances would have stipulated. The idea behind the golden rule is that effective public investment can both benefit future generations and, via its growth-enhancing effects, increase debt sustainability. Hence, exempting these expenditures from the calculation of expenditures may be economically justified. On a positive note, the national co-financing share within the framework of EU programs, for example, is excluded from the definition of net expenditures. Hence, national co-financing is not restricted by the expenditure rule. However, national co-financing only plays a negligible role up to now.
The net expenditure path for each country is derived in such a way that minimum adjustments have to apply so-called “safeguards” that should ensure sustainable fiscal positions at the end of the adjustment period. The latter is defined as a (structural) budget deficit ratio of no more than 1,5% and a debt ratio that is on a plausibly downward trajectory or stays at prudent levels. Hence, the net expenditure indicator is in fact the operational target, but it is endogenous to safeguards that are defined as follows:
- DSA (Debt Sustainability Analysis) safeguard: The EC conducts a DSA for each member state with the goal of deriving a reference fiscal adjustment path consistent with declining or stabilizing public debt ratio by the end of the adjustment period (see European Commission 2022 for the current EC methodology). Further, the debt ratio at the end of the adjustment period must exceed the debt ratio five years after the adjustment period with sufficiently high probability, as assessed by the Commission’s stochastic analysis. The DSA is used, so the argument goes, to preserve the country-specific nature of fiscal adjustment requirements.
- Debt sustainability safeguard: Members states with a debt level of over 90% of GDP must reduce it by an average of at least 1 percentage point each year. Members states with a debt level between 60% and 90% of GDP must reduce it by 0.5 percentage points each year.
- Deficit resilience safeguard: For countries with more than 60% of GDP public debt or more than 3% of GDP budget deficit the overall budget deficit should not be higher than 1.5% of GDP. When it is higher, the annual improvement in the structural primary balance should be 0.4% of GDP when the adjustment lasts for four years; With an extended adjustment period of seven years, the annual minimum adjustment of the structural primary balance ratio is 0.25 percentage points.
Each safeguard provides an adjustment requirement for the structural primary balance; the respective strictest safeguard is the binding constraint that is ultimately converted into the multiannual net primary expenditure path (reference path). The adjustment has to be linear to avoid backloading of fiscal consolidation; the no-backloading requirement could be considered as another important safeguard which, however, can be relaxed in particular circumstances.[8]
In general, escape clauses apply to individual member states as well as to all member states if particular circumstances outside of the control of the member state(s) have a major impact on public finances, provided it does not endanger fiscal sustainability in the medium term.
An overall assessment
On average, the consolidation requirements in the proposed framework are less stringent than those under the current fiscal rules (Darvas et al. 2023). However, with the new fiscal framework, the consolidation efforts in some countries will still be significant. Based on estimates provided by the think tank Bruegel[9] the Table below shows the annual minimum consolidation efforts for the EU-27 under the new EU fiscal framework, measured by the annual change in the structural primary balance (SPB) in percent of GDP.
Simultaneity in fiscal contraction potentially increases fiscal multipliers and bears the risk of self-defeating, i.e. contractionary fiscal consolidation: Strikingly, the six largest EU countries without Germany (Italy, France, Spain, the Netherlands, Poland, and Belgium) that together account for around half of EU GDP, have – with the exception of some smaller countries – the highest consolidation requirements, measured by the average annual change of structural primary balances in percent of GDP (see Table below). Italy, for example, has to consolidate by around 1% of GDP annually, France and Spain by around 0,8% of GDP if the shorter adjustment period is chosen. This implies possible simultaneous fiscal contractions which – via cross-border spillovers – will most likely aggravate the negative growth effects of fiscal consolidation.
The envisaged ‘counter-cyclicality’ of the net expenditure rule is at risk of becoming pro-cyclical: The single, operational binding indicator, the net primary expenditures, is defined in such a way as to avoid pro-cyclicality. However, the calibration of the net expenditure path is constrained by the strictest applicable safeguard – which is, in many of the cases, the DSA. In an economic downturn that is not considered exceptional, countries are obliged to stick to the consolidation path. This may undermine the operation of automatic stabilizers and inhibit discretionary countercyclical fiscal policy reactions to the economic downturn.
The fiscal framework is overly complex and obstructs democratic legitimacy; the controversial and opaque “structural balance” remains an important variable: The fundamental objective of reducing the complexity of the new fiscal rules was clearly missed. Although net primary expenditure growth is, at first sight, the single, binding operational fiscal target, in fact, structural budget ratios remain as imperative calculation, target, and control variables (Fiskalrat 2024). The derivation of the consolidation requirements thus becomes even more of a “black box” which impedes accountability and democratic legitimacy. Moreover, the calibration of the primary net expenditure path is based on medium-term forecasts (four or five years for the FSPs plus ten years for the DSA – thereof five years for the stochastic probability projections) and will be affected by forecasting errors. This applies, among other things, in particular to variables that are susceptible to notable revisions, such as the unobservable output gap and the interest rate, which are used to estimate the primary structural balances.
The DSA which becomes an important element in designing the fiscal trajectories of individual member states has problematic and – to some extent – self-fulfilling features. The new fiscal framework is often called “risk-based” because the EC uses a DSA as the basis for one of the safeguards to calibrate the net primary expenditure trajectory. The precise DSA methodology used for the implementation of the fiscal rules is not yet known.[10] The DSA toolkit of the EC currently in place consists of a range of projection scenarios for government debt over the next ten years: first, a baseline scenario in which compliance with the consolidation path is assumed, second, six deterministic scenarios - three deterministic stress tests (e.g. adverse ‘r-g’ differential) and three alternative fiscal policy scenarios – plus, finally, stochastic probability projections.
If this sounds implausibly complicated, it is. The methodology itself has some features that can be judged farcical at best. For example, one of the alternative fiscal policy scenarios (‘lower structural primary balances’) assumes that after a short period following the end of the adjustment period fiscal consolidation efforts stall permanently – which in some cases would result in unsustainable debt paths in the long term. To avoid this the required fiscal adjustment path then becomes more restrictive. To simplify this absurdity: The new rules implicitly assume that they will be breached later and, in anticipating this, the consolidation path is tightened. This seems to be the main reason why according to estimates based on the current EC methodology for the DSA,[11] in most of the countries that have a debt ratio that is higher than 60%, the DSA safeguard is the strictest among the safeguards.
By definition, any DSA is subjective and judgemental as it relies on assumptions and/or market expectations, in particular with regard to fiscal (e.g. fiscal costs of aging), financial (borrowing rates), and macroeconomic variables (e.g. potential output growth). Hence, the chosen methodology strongly affects the outcome. Moreover, significant forecast errors for projections for such a long period are unavoidable. If for instance potential output is projected to be too low in the DSA this will imply higher fiscal adjustment needs which, via the fiscal multiplier, will become self-fulfilling. Lower growth will then potentially bring about a result the governance framework wants to avoid: higher debt (and deficit) ratios.
Another limitation of the DSA is that cross-border spillovers are not taken into account (Heimberger 2023), which, however, might be substantial (Eller et al. 2017). The EC assumes a fiscal multiplier of 0.75, meaning that a fiscal consolidation of 1 percentage point reduces GDP growth by 0.75 percentage points in the same year compared to the baseline. In’t Veld (2013) finds that the negative growth effects of fiscal consolidation can be notably higher when countries consolidate simultaneously (see also Heimberger 2017).
While in principle a DSA can be a useful tool for analyzing the fiscal risks under different scenarios with regard to growth, interest rates, aging costs, etc., financial markets can be very sensitive to their details. their results. Given this sensitivity, the use of DSA is very delicate. Using this tool to calibrate a multiannual, binding net expenditure trajectory is a fairly bold endeavor. Why have members of the Economic and Financial Affairs Council (ECFIN)[12] and the Committee on Economic and Monetary Affairs (ECON) of the European Parliament,[13] without knowing the precise, still-to-be-published details, voted in favor of this Rube Goldberg framework is a separate research question.
The new fiscal rules allow the EC a wide scope for decision-making while neglecting the need for appropriate democratic accountability: This holds particularly for the decision on requested extensions of the multiannual FSPs which allows for lower fiscal adjustments of the member states. A member state can extend the required adjustment path from four up to seven years if it credibly assures that it intends to make growth-promoting investments, among other things, but also if it implements EC recommendations for structural reforms as part of the European Semester. Hence, the EU Council may – at the recommendation of the EC – press member states to implement particular structural reforms. This would be a dramatic shift from the usual practice where the EC can only issue recommendations that are non-binding. To give the DSA an enhanced role in the fiscal governance framework moreover strongly limits democratic legitimacy as this tool is opaque and difficult to comprehend for policymakers. Regrettably, the same holds true for the overall fiscal governance framework.
The regulation of the new fiscal framework contains numerous references to the involvement of the social partners and to the European pillar of social rights. For example, the countries should set out in their FSPs which measures they are planning to implement in order to accomplish the European pillar of social rights. But at the same time, they should also explain how they are implementing the EC’s recommendations as part of the “European Semester” which is often aimed at deregulating economies. While references to social issues can be considered as “soft law”, where the EC has a high degree of discretion in their interpretation, the net expenditure path needs to be implemented as “hard law” - otherwise sanctions may be imposed.
The opportunity to foster temporary (green) public investments, e.g. by excluding public investment expenditures from the safeguards and/or implementing a ‘golden rule’, was largely missed: With the new fiscal rules public investments can only be increased if discretionary revenues rise in parallel, e.g. via a wealth tax, and/or if member states undertake more fiscal consolidation in non-investment components (e.g. social expenditures). The new rules also raise questions about the Recovery and Resilience Fund (RRF) 2.0 which is supposed to become a permanent EU investment fund. The RRF currently in place expires at the end of 2026. Calls for the extension of the EU fiscal capacity were dismissed. Given the need for rising public investments and the requested rising defense expenditures a significant retrenchment of the European welfare state is the likely outcome should the new fiscal rules materialize, with vast consequences for Europe’s social and political system.
References
Darvas, Z., L. Welslau and J. Zettelmeyer. A quantitative evaluation of the European Commission’s Fiscal governance proposal. Bruegel Working Paper 16/2023. https://www.bruegel.org/sites/default/files/2023-09/WP%2016_3.pdf
Eller, M; Feldkircher, M and F. Huber. How would a fiscal shock in Germany affect other European countries? Evidence from a Bayesian GVAR model with sign restrictions. Focus on European Economic Integration 1/2017.
European Commission (2022), Debt Sustainability Monitor. Institutional Paper 199, April 2023. https://economy-finance.ec.europa.eu/publications/debt-sustainability-monitor-2022_en
Fiskalrat (2024). Neuer Fiskalrahmen der EU – neue Komplexität. Kursanalyse des Büros des Fiskalrats Austria, https://www.fiskalrat.at/publikationen/studien-des-bueros/kurzanalysen-informationen-uebersicht.html
Heimberger P. Did Fiscal Consolidation Cause the Double-Dip Recession in the Euro Area?’, Review of Keynesian Economics, Vol. 5, No. 3, 2017, pp. 539-558 .
Heimberger P. (2023). Debt sustainability analysis as an anchor in EU fiscal rules. An assessment of the European Commission’s reform orientations. In depth analysis requested by the ECON committee of the European Parliament. March 2023. https://www.europarl.europa.eu/RegData/etudes/IDAN/2023/741504/IPOL_IDA(2023)741504_EN.pdf
Heimberger P and Andreas Lichtenberger, 2023. “RRF 2.0: A Permanent EU Investment Fund in the Context of the Energy Crisis, Climate Change and EU Fiscal Rules,” wiiw Policy Notes 63, The Vienna Institute for International Economic Studies, wiiw. https://wiiw.ac.at/rrf-2-0-a-permanent-eu-investment-fund-in-the-context-of-the-energy-crisis-climate-change-and-eu-fiscal-rules-dlp-6425.pdf
In ’t Veld, J. (2013): Fiscal consolidations and spillovers in the Euro area periphery and core. European Economy – Economic Papers 506.
Institut Rousseau, Road to Net Zero. Bridging the Green Investment Gap. https://institut-rousseau.fr/road-2-net-zero/
Notes
[1] The legislative package consists of a regulation on the preventive arm (Regulation on the effective coordination of economic policies and multilateral budgetary surveillance – final compromise text following the trilogue agreement) as well as a directive (Directive on requirements for budgetary frameworks of the Member States - Agreement in principle with a view to consulting the EP) and a regulation on the corrective arm (Regulation on speeding up and clarifying the implementation of the excessive deficit procedure - Agreement in principle with a view to consulting the EP).
[2] https://www.consilium.europa.eu/en/press/press-releases/2024/02/10/economic-governance-review-council-and-parliament-strike-deal-on-reform-of-fiscal-rules/
[3] For an overview see Heimberger and Lichtenberger 2022.
[4] See https://ec.europa.eu/eurostat/statistics-explained/index.php?title=Government_expenditure_on_defence#Expenditure_on_.27defence.27
[5] Christian Lindner, German Finance minister, has recently provided insights into what might be awaiting us. He has urged a moratorium on social expenditures and subsidies to finance public military expenditures. This view was supported by Clemens Fuest, President of the IFO Institute. https://www.faz.net/aktuell/wirtschaft/lindner-fordert-moratorium-bei-sozialausgaben-19540142.html.
[6] An excessive deficit procedure (EDP) can be opened a) if the 3% deficit ratio threshold is breached or b) if there is a significant deviation from the specified net primary expenditure path. Deviations from the expenditure path are noted in a control account and an EDP procedure is triggered if thresholds are exceeded (0.3% of GDP in one year or cumulatively by 0.6% of GDP). In this case, however, an EDP is only opened if the public debt ratio is higher than 60% and the deficit ratio is higher than 0,5%.
If an EDP is opened, member states have to adjust their primary structural balance ratio by 0.5 percentage points. While they may initially exclude interest payments, after 2027 exclusion of interest payments is no longer possible which makes little sense.
[7] ‘Net expenditure’ means government expenditure net of interest expenditure, discretionary revenue measures, expenditure on programs of the Union fully matched by Union funds revenue, national expenditure on co-financing of programs funded by the Union, cyclical elements of unemployment benefit expenditure, and one-offs and other temporary measures.
[8] A member state may request an exemption to the no-backloading safeguard. This has to be taken into account if the respective country has projects related to the Recovery and Resilience Facility loans as well as national co-financing of EU funds in 2025 and 2026.
[9] See https://www.jvi.org/fileadmin/jvi_files/News/2024/24WR02_Feb21/2024-02-21_Greening_EU_fiscal_rules.pdf
[10] The methodology will be described in the Debt Sustainability Monitor 2023 that will be published in April 2024.
[11] See for example, https://www.jvi.org/fileadmin/jvi_files/News/2024/24WR02_Feb21/2024-02-21_Greening_EU_fiscal_rules.pdf
[12] The new fiscal rules were approved by the members of the EU Economic and Financial Affairs Council (ECFIN) by 8th December 2023.
[13] The new fiscal rules were approved by the members of the Committee on Economic and Monetary Affairs (ECON) of the European Parliament by 5th of March 2024.
