On Wednesday last week, the European Commission published a communication on the future trajectory of the Fiscal Rules, which have been suspended since Covid. The Fiscal Rules are probably the most important aspect of EU economic governance, and are of upmost consequence for the ability of member states to leverage public investment to meet emissions targets, and much else. The communication constituted a significant improvement – whereas before the Fiscal Rules were awful, in the future it looks like they’ll revert to being bad.
The current make-up of the rules is a monument to complexity, which few people fully understand. I certainly won’t claim mastery but will attempt to summarise key features. Originally, they were based on two simple metrics: member states’ public debt-to-GDP should not exceed 60% and the government balance/deficit-to-GDP should not exceed 3%. Layers of complexity were later added, especially after the financial crisis. In particular, the target concept of a ‘structural deficit’ was institutionalised. This is the deficit that is long-term, independent of short-term upswings and downturns of the business cycle. Targets of what the structural deficit should be below have shifted over time. Currently, there is a matrix of requirements ranging between 0 to 1% of GDP depending on cyclical conditions of the individual country and the debt level.
Other centrepieces of the rules include the speed of debt reduction and the so-called expenditure benchmark. As to the former, member states whose debt exceeds 60% are required to reduce debt by 1/20th the difference between their current debt and the 60% threshold annually on average. The expenditure benchmark mandates that countries’ net (after revenue-raising) expenditure should not exceed potential output growth. When in breach of structural deficit targets, an additional margin is required.
There is some limited variation in how these are implemented nationally. The expenditure rule in Ireland, implemented in July 2021, limited only exchequer spending to the potential growth rate of the economy, thus excusing local authority and other spending. Limited deviations from these rules are allowed for the purposes of public investment, provided the investment is co-funded by the EU and provided the 3% headline deficit rule is not breached. Limited deviations have also been allowed for ‘structural reforms’.
Technical criticisms of the rules are many and well-founded. Aside from complexity, they are based on a number of unobservable metrics, metrics that are poorly measured. Calculations may change with real-life implications due to new data becoming available and frequent methodological changes, which speaks to how unsatisfactory the rules have performed even in the eyes of their architects. The founding debt and deficit thresholds, moreover, have little basis in economic analysis. They were based on the average debt levels of the countries negotiating the treaty in the 80s. The rules have since instituted unnecessary spending cuts and tax increases, often when countries could least endure them.
Importantly, the world today is much changed. Interest rates are much lower and are expected to remain low in the medium term. Specifically, the arithmetic of debt implies that the debt-bearing capacity of countries is much higher today as economic growth exceeds real interest rates. For instance, in 2021 the burden of servicing debt was around 1.6% of national income in Ireland, which is close to historic lows, despite government debt being in excess of 100%, which is high historically. As debts across the EU have remained elevated since the crisis, the rules have required that countries reduce debt levels faster than ever. In other words, the greater strictness of the rules since the crisis has imposed even more unnecessary austerity in recent years than they did in the earlier ones.
So what has changed? It is proposed that member states negotiate country-specific debt reduction plans. The Commission would first do a debt-sustainability analysis which informs its ‘reference adjustment paths’. Member states then propose a medium-term fiscal plan over four years. These would include annual (net primary) expenditure ceilings. If member states commit to certain investments and structural reforms, the fiscal adjustment can be extended over an additional three years. The final plan is then assessed by the Commission and Council.
The original 60% debt and 3% deficit targets are very much retained and guide the fiscal strategy. Member states need to stay within these thresholds and adjustment plans are based on falling within them. The immediate lever to achieve these thresholds is now, primarily, a kind of expenditure rule. There is less reference to structural deficits, though they haven’t been abandoned – it seems that the structural balance will inform the Commission’s debt sustainability analysis. Its salience would certainly be diminished compared to its current place, however. The proposal has also removed any reference to the 1/20th debt reduction rule.
The removal of the debt reduction rule is positive, as is the demotion of the structural balance. Greater tailoring of fiscal policy to realities faced by an individual member state is also sensible. Allowances and extensions for public investment, particularly climate-related is an important step.
But the devil will be in the details and much will hinge on the Commission’s initial analysis. The structural balance, which is the most poorly-measured metric in the current rules, still looms there. It remains to be seen how much extra wiggle room will be afforded for climate investment. Importantly, the use of 60% and 3% as debt and deficit targets made little sense in the 80s and make even less sense today. Bargaining austerity for structural reforms will remain, but may play a greater role in a revised framework, which raises political legitimacy concerns. Structural reforms in the current ruleset have been used to pressure member states to, among other things, raise retirement ages which in an Irish context could make a 66 or 65 retirement age tricky.
The Commission is due to report again early next year. It is fair to say the recent communication suggests the rules will improve. However, the reforms are hardly radical, even by the standards of other EU institutions. For instance, the European Stability Mechanism proposed the debt threshold be raised to 100% of GDP. An even better proposal would be to abandon quantitative, metric-based rules altogether. Instead, the rules could use broader standards based primarily on the burden of servicing debt, as many prominent economists have advocated. For now, we’ll have to sit and wait.
Robert Sweeney @sweeneyr82
Robert Sweeney is a policy analyst at TASC and focuses on issues surrounding Irish political economy and distribution. He has a PhD in economics from University of Leeds, which concentrated on financial markets and investors, banking, international macroeconomics, and housing. He is also interested in debates on alternative schools and methodology in economics, and ownership.
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