Time to ditch the EU’s long-neglected fiscal rules

On Monday, Brussels gave EU countries another year during which they may spend more than the rules of the bloc allow. That decision was widely expected. What is more of a surprise is that Europe has never been brave enough to cut loose its complex tangle of severely outdated budget rules.

Each year, the European Commission issues recommendations for countries not to overspend and keep public debt in check, a process known as the European Semester, which dates back to the days that the euro was set up. 

The system was meant to allay – mainly German – fears that southern European profligacy would sap Europe’s economy, and was described in the 1997 Stability and Growth Pact (SGP).

The idea was that countries could face substantial fines if they exceeded the debt and deficit limits laid down in the euro’s founding Maastricht Treaty. While the threat was barely ever used, peer pressure at first was enough for governments to keep their public debt under control to a degree.

That is, until the sovereign debt crisis hit in 2010 – and then Covid-19. It was the pandemic that triggered the activation of the “general escape clause” in March 2020, which effectively suspended the SGP. With the economy virtually frozen as a result of lockdowns, this seemed the right thing to do.

But just as the global economy cranked back into action as the virus retreated, Russia invaded Ukraine, sending energy and food prices soaring. And it is a bad idea to clamp down on public budgets across Europe at a moment that voters could not pay their household bills. And so, the rules stayed in limbo.

And there are those who argue it should stay that way. The SGP has been reworked several times up to a point where even experts working in Brussels’ inner sanctum admit they find it hard to understand.

Even before the war, French president Emmanuel Macron and Italy Prime Minister - and former European Central Bank President - Mario Draghi, argued that the current fiscal rules were “excessively complex”, “failed to provide incentives for prioritising key public spending” and constrained governments’ ability to act in case of a crisis. 

The Eurocrat would like to express her support for that view.

Europe conceived its fiscal rules thirty years ago, in a different economy, with only twelve countries in the EU. Crucially, interest rates were much higher, which explains why the debt-to-GDP ratio was chosen as a central benchmark . If the ratio was too high, debt would become unsustainable. 

But more recently, Europe’s crisis fund – the ESM – brought Greece back from the brink of bankruptcy with ratios that were more than three times as high as what Europe prescribes. And the ESM, run by Germany's Klaus Regling, is nothing if not an austerity champion.

By extending the escape clause, Brussels is effectively acknowledging the SGP no longer works. The Pact just did not offer enough flexibility for countries to keep investing at a time of duress. The war has made clear that the EU cannot ignore spending on defence. Europe is also seeking strategic autonomy for its industry and in the digital economy, which will require major investments. 

Last but not least, the energy transition and fight against the climate crisis will require large amounts of cash. Obviously, such spending cannot fall exclusively on the shoulders of taxpayers. Private investment should accompany it. But governments will need to be a catalyst because the strategic interests are so important for Europe. The SGP should not stand in the way of that.

The plans countries had to submit to apply for money out of Europe’s corona recovery fund could show what a new fiscal pact looks like. The fund is financed by jointly issued debt, and this allows countries to continue to invest in the future without racking up higher debt costs. 

One candidate to replace the SGP is to turn the Recovery and Resilience Fund – the official name of the corona fund – into a permanent fiscal capacity to ensure investments in strategically important sectors. Of course, this would not mean that countries can take on unlimited debt levels – ratios above 100% of GDP are especially tricky – but any new rules need to become more realistic, allowing countries to adapt gradually and sustainably. 

The debate dates back from before the crisis. The pandemic, and later the war, just made it more relevant. If fiscal hawks do not ease their grip, the EU might not be able to weather the next storm.

What the Eurocrat will be also watching:

Klaus Regling, managing director at the ESM, already appeared in this story. On Monday, finance ministers of the 19 countries using the euro – the Eurogroup - will decide who his successor will be. Former Luxembourg Finance Minister Pierre Gramegna is one candidate. The pro-business liberal tried to become the head of the Eurogroup, to no avail. Heading the ESM would be a nice consolation price. And it's already based in Luxembourg anyway...

The Luxembourg Times has a new mobile app, download here! Get the Luxembourg Times delivered to your inbox twice a day. Sign up for your free newsletters here.