Strict or flexible? Brussels kicks off debate to reform fiscal rules

As Europe’s economy recovers from the shock of the coronavirus pandemic, Brussels has decided to resume the politically sensitive process of reviewing the EU’s fiscal rules, which were suspended in March 2020 to allow greater spending to cushion the impact of the crisis.

The disciplinary rules, known as Stability and Growth Pact (SGP), require members states to implement financial policies that keep their deficit under 3% and debt under 60% of GDP, limits that many countries currently exceed by a considerable margin.

As of today, the government debt in the European Union represents 92.9% of total GDP, with the same rate rising to 100.5% inside the eurozone. Greece (209.3%), Italy (160.0%) and Portugal (137.2%) register the highest levels across the bloc – and even in the world – while Estonia (18.5%), Bulgaria (25.1%) and Luxembourg (28.1%) enjoy the lowest.

The SGP rules, which entered into force in the late 1990s and were reinforced during the Great Recession, have been often criticised for their stringency and intransigence, but also for their irregular compliance and biased enforcement. Southern countries have frequently complained of being unfairly targeted while bigger economies, like France and Germany, saw their excesses go unpunished.

The European Commission is well aware of the friction caused by the SGP in the past and is eager to open a new chapter with simpler rules agreed by consensus. The executive has set an ambitious yet tricky objective for the review: to reduce public debt and simultaneously increase investment to ensure sustainable economic growth.

The EU is in urgent need of cash: Brussels estimates that the parallel green and digital transitions will need almost €650 billion per year in public and private investments until 2030. The effort to cut greenhouse gas emissions by at least 55% before the end of the decade will demand €530 billion annually, with €390 billion just for the transport and energy sectors.

Despite appearing contradictory, the tasks of raising this colossal amount of money must go hand in hand with the imperative of gradually reducing budget deficits and public debt, which was already alarmingly high before the pandemic as a result of the prolonged eurozone crisis.

Cutting down public debt will determine the EU’s ability to respond to future economic shocks, said Valdis Dombrovskis, the Commission’s executive vice-president.

But new fiscal rules should not act as a burden that constrains growth, he noted. Instead they should promote a positive economic development so that countries have more resources to decrease their debt levels. The pace of this reduction will be one of the main key questions during the discussions.

“We need to go about this in a smart way: in a gradual, sustained and growth-friendly way,” he said.

The Commission officially opened the consultation process on Tuesday afternoon and set up an online platform where citizens, organisations and public authorities can submit their opinion until the end of the year. At the same time, a political debate will take place between Brussels and all the 27 capitals, some of which have already expressed their support – and opposition – for grater fiscal flexibility.

On the one side, countries like France, Spain, Italy, Greece and Portugal, all of which currently surpass the 100% debt-to-GDP ratio, are calling for a meaningful reform to reflect the post-pandemic reality and the financial obligations of the green transition.

On the other side of the room, the so-called Frugal Four – Austria, the Netherlands, Denmark and Sweden – together with Finland, Latvia, Slovakia and Czech Republic are demanding a return to healthier budgetary policies, arguing in a joint paper that “reducing excessive debt ratios has to remain a common goal”.

In between, Germany awaits a new government to succeed Chancellor Angela Merkel, which will be likely led by Olaf Scholz. Although a socialist on paper, Scholz is known for his moderate, centrist views, including financial management.

His potential government will be a three-party coalition with the Greens, who prefer greater room for spending on climate action, and the liberal FDP, who strongly advocates a frugal kind of governance. The reform of the Stability and Growth Pact is part of the negotiations between the three parties.

“My view is simple: a common currency needs common rules and our rules have been shown to provide the necessary flexibility,” Scholz said in summer, before winning the federal election.

Given the discrepancies between the two established camps, Germany is poised to act as main arbiter of the debate, possibly casting the tie-breaking vote.

‘Frank discussion with no taboos’

The European Commission is keen on building the new rules through consensus in the hopes that a wide and lasting agreement will improve compliance with the regulation.

“Fiscal rules will only work properly if everyone agrees and sticks to [them],” said Dombrovskis.

Every year, governments are asked to submit SGP reports presenting their financial plans, which are then analysed by the Commission and their fellow member states. In theory, Brussels can slap undisciplined countries with fines of up to 0.5% of their GDP.

The new rules should be approved well before 2023, when the exceptional suspension of the existing regulation is set to expire, so that governments can have sufficient time to design their new budgets.

Paolo Gentiloni, European Commissioner for the economy, said on Tuesday that slashing debt while boosting investment will force the EU to “square the circle” but that a balance must be found. The executive hasn’t taken an official position on the ongoing debate, although its flagship Green Deal and far-reaching climate policies can only be achieved if governments put money on the table.

“I am looking forward to an open and frank discussion with stakeholders and member states, with many contributions and no taboos,” said Gentiloni.

The enormity of the damage caused by the coronavirus pandemic is set to complicate the cause of the frugal group. Government deficit in the EU hit 7% in 2020, a stunning hike compared to the 0.5% rate recorded in 2019. Countries have been spending beyond their means to support furloughed workers, prevent bankruptcies and stimulate economic growth.

Although some of these temporary measures will be phased out in the coming months, the worst-hit member states intend to keep the tap open. Italian Prime Minister Mario Draghi has proposed a 5.9% deficit for 2022 and 3.9% for 2023, both above the current SGP limits. Meanwhile, Spain and France are aiming to have 5% and 4.8% deficit rates, respectively, next year.

The three countries are pushing for realistic rules to accommodate the Covid-era financial legacy and ensure the downward path is not trodden at the expense of their citizens. The 60% debt-to-GDP obligation might prove suffocating to fulfill for countries which more than double the rate.

“Southern European countries have high levels of debt. Some of them could be close to being in a risky situation, especially after the European Central Bank will end quantitative easing because, by that time, the interest rates might go up,” Zsolt Darvas, an economic analyst at the Brussels-based Bruegel think tank, told Euronews in a video interview.

“We made some calculations and found that some southern European countries would need to make an enormous fiscal adjustment in the order of 5-6% of GDP [to meet] that rule, which is simply, I think, inconceivable. It’s impossible that those countries would be able to make that. So, for this particular debt reduction rule, many, many countries will violate that.”

Rome, Madrid, Paris and their liked-minded allies hope the green transition and its crucial need for huge investments will help advance their campaign for greater flexibility.

In Belgium, State Secretary for Economic Recovery Thomas Dermine said this week the EU should invest €5 trillion in its climate plan over the next decade to “retain its credibility as a political project”. Italian and French officials had previously hinted that some parts of the EU’s €750-billion recovery fund should stay as a permanent tool to finance major environmental projects.

Both Dombrovskis and Gentiloni insisted on Tuesday the fund was agreed between heads of governments as a “one-off” tool that will disappear after 2026, when the Commission is expected to stop burrowing money on the financial markets to bankroll the national recovery plans.

Brussels wants the unique experience of the fund to serve as inspiration for the debate, which is poised to be fraught and politically explosive for member sates on both sides of the tables. The new updated rules will influence how governments tackle issues such as rising housing costs, social inequality, population ageing, weak productivity and long-term unemployment.

Darvas predicts that the majority of EU countries will have to undergo important fiscal adjustments, regardless of review’s final outcome.

“Now the main question is the speed of that adjustment,” he said. “I just hope the European Commission learnt the lesson from the previous crisis, the global financial crisis and the euro crisis, that a too rapid fiscal consolidation can undermine the recovery.”

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