2023-04-25 02:00:54
Do you remember the European fiscal rules? These are laid down in the Stability and Growth Pact, the collection of budgetary agreements that EU countries have made with each other. Since the outbreak of the corona pandemic in 2020, those fiscal rules have been suspended. But public finances in almost all European countries have taken a serious hit in recent years.
The fiscal rules are expected to come into force again in 2024. If they were to be followed to the letter, this would lead to major cutbacks or tax increases for most EU countries, with significant economic consequences. Northern European countries can also face Southern European countries again.
The fiscal rules state that the budget deficit cannot exceed 3 percent of gross domestic product (GDP) and that government debt cannot exceed 60 percent of GDP. According to the IMF, in 2022 14 of the 27 EU countries had higher budget deficits than 3 percent, including the Netherlands, France, Italy, Spain and Belgium. And 13 EU countries had debt levels above 60 percent of GDP by 2022, including Germany, France, Italy, Spain, Belgium, Austria and Finland.
In addition, countries that do meet the 3 and 60 percent norms must reduce their budget deficits by 0.5 percent of GDP per year until they reach their medium-term target for the structural budget deficit (which is a deficit for the state of the economy). cleaned) have reached. For most countries it is between +1 and -1 percent, roughly speaking budget balance. But the IMF estimates for 2022 that 22 of the 27 EU countries will have a structural deficit of more than 1 percent, except for Cyprus, Denmark, Ireland, Portugal and Luxembourg.
Moreover, in order to have even more discipline in public finances, government expenditure should not increase faster than the potential growth of GDP – the so-called expenditure rule. And if the national debt exceeds 60 percent of GDP, it must be reduced by at least 1/20e of the difference decrease each year.
The disadvantages of hard fiscal rules
The question of how to reform fiscal rules has been debated for years. How can the economy be supported in a crisis, how can structural space be created for government investments, can the budget remain sustainable in the long term and can EU countries be enforced to comply with the fiscal rules?
The fiscal rules were originally introduced to protect the European Central Bank (ECB) against pressure from Euro countries with high government debts. They want to ‘inflate away’ their government debts. In addition, investments could be crowded out if interest rates in the Euro area were to rise due to higher government debt.
These concerns have proved unfounded since the introduction of the euro.
At the same time, the disadvantages of hard fiscal rules became painfully clear during the Great Recession (2008-2015). Those rules have a blind focus on deficits and debts. As a result, Europe entered a double-dip recession as European governments began to cut massively and synchronously. During the corona pandemic and the energy crisis, European heads of government wisely decided to suspend fiscal rules via the so-called general escape clause. This prevented a repeat of history.
Fiscal rules mainly look backwards – how much deficit and debt have countries accumulated in the past?
Fiscal rules not only frustrate countercyclical fiscal policy, they also undermine public investment. EU countries have no extra budgetary room if they make socially profitable investments in, for example, education, innovation, infrastructure and climate. Therefore, public consumption spending often comes at the expense of public investment. Structural economic growth and the solution to the climate issue will then be delayed.
Moreover, fiscal rules mainly look backwards – how much deficit and debt have countries accumulated in the past? – and barely ahead: how much future expenditure are governments facing, for example for pensions and health care? And how much will government wealth increase with profitable government investments?
New budget rules
If countries respected the rules for the medium-term objective, public debt would disappear almost completely after a few decades. This is not only unwise because banks, insurers and pension funds need government bonds to function normally. The pursuit of structural budgetary balance or the reduction of government debt is also unnecessary for sustainable public finances.
IMF estimates show that government interest rates will remain low for the foreseeable future; they fall again when inflation has come under control. That is why countries can easily run somewhat higher deficits and debts than the current fiscal rules prescribe without this leading to a disruption of public finances in the long term.
What good are European fiscal rules if they are not observed at all by many EU Member States – including France, Germany and Italy?
No EU country has ever been fined for systematic violation of the rules. So what good is fiscal rules if they are not observed at all by many EU Member States – including the three largest countries: France, Germany and Italy?
In November 2022, the European Commission therefore made a proposal to renew the existing fiscal rules. Countries should commit themselves to long-term budget plans that should ultimately lead to sustainable public finances. Debt sustainability analyzes should demonstrate this. Moreover, these must be carried out by an independent institution, such as the CPB in the Netherlands. When government invests or spends on the climate transition, countries need to reduce their government debt to sustainable levels less quickly. However, the 3 percent rule remains in force as a hard limit on the budget deficit. The fines for violation of the rules will be abolished. Through the emphasis on the long term and bilateral negotiations, the European Commission hopes that countries will have a stronger political commitment to stick to their budget plans.
Draconian
In April of this year, the German Finance Minister threw a bomb under this proposal in a ‘non-paper’. Christian Lindner (FDP) does not want to hear about vague budget plans that follow from bilateral negotiations between EU countries and the European Commission. He wants rules set in stone to ensure that government debt actually falls. Germany recognizes that reducing debt by 1/20e of the difference from the maximum 60 percent of GDP could be draconian. Instead, Lindner wants government debt to fall by at least 0.5 to 1 percent of GDP per year when countries are medium to high in debt. Germany also wants to maintain many of the existing rules, such as the expenditure rule and the medium-term target for the structural deficit. The German proposal therefore mainly does not address the economic problems with the existing fiscal rules in all sorts of ways.
Back to start
Europe seems to be back at square one. The rules in the current Stability and Growth Pact have the high economic price that it is difficult to stabilize the economy or make government investments in times of crisis. The fiscal rules can hardly be substantiated economically. At the same time, high government deficits and debts can lead to economic problems in some EU countries.
Monitoring financial stability is the only real reason to still want fiscal rules in the EU. During the Euro crisis, the ECB supported countries through open market operations or loans to banks, because until Draghi’s ‘whatever it takes’ speech on July 26, 2012, there was no other way to defuse bond market panic.
Moreover, the Eurozone is financially fragile as long as it does not have clear rules for settling unsustainable government debts and debt restructuring by governments can cause shock waves in the financial system. The experiences with Greece have shown this.
In reforming the European financial sector, therefore, the solution to the stalemate lies in fiscal rules. The Eurozone must be able to withstand a government that derails its finances, without burdening other governments with the consequences. Financial parties that recklessly lend money to governments that behave financially recklessly must be presented with the bill by restructuring or downgrading their bonds.
Deadly embrace
To prevent disruption of the financial sector in the event of a government default, the ‘deadly embrace’ between banks and governments must be broken; failing banks lead to bankrupt governments and vice versa. This dynamic can only be stopped if banks are no longer too big to fail, a maximum is set for the number of government bonds that banks are allowed to hold, government bonds are given risk weights when determining capital ratios and those capital ratios become much higher. .
Does a country conduct good policy? Then the interest is low. Is the policy bad? Then the interest is high.
In a well-functioning Eurozone, countries are disciplined by financial markets rather than by EU bureaucrats. Does a country conduct good policy? Then the interest is low. Is the policy bad? Then the interest is high. The ECB prevents panic on bond markets for financially sound countries. And financially shaky countries must be able to restructure their government debts.
Each Euro country can then decide for itself whether it wishes to invest in the future or whether it wants to fight recessions. Those who want to make a mess of public finances bear the consequences themselves. The stalemate between Northern and Southern Europe is broken. Bureaucrats from the European Commission who deal with budget rules can look for other work.
Unfortunately, this solution will not get off the ground either, because Europe is actually still being held hostage by the financial sector. That is why finance ministers would rather argue with each other about budget rules than make those budget rules superfluous.
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