Fiscal Rules Update

Last month the EU Commission released a communication on the fiscal rules that would, if implemented, have major implications for Europe. It would make it very difficult for EU member states to meet emissions targets while also signalling an end to the recent dalliance with fiscal expansionism.

Without recapping the ins and outs of the fiscal rules, some discussion of the November 2022 proposal is warranted, which I’ve discussed in a blog before. The November communication proposed to move away from rules based on quantitative indicators and targets such as the structural deficit, expenditure rule, and the minimum annual debt reduction requirement. While retaining the obligation that member states have debt below 60% of GDP and a deficit less than 3%, it was proposed that member states negotiate country-specific debt reduction paths for countries whose debt was considered to be high or medium risk.

The procedure went as follows: the Commission conducts an analysis and puts forward a ‘reference adjustment path’, which constitutes the initial position. Member states then respond by proposing medium-term fiscal adjustment plans. These set out country-specific fiscal trajectories and public investment and reform commitments. Once accepted, annual member-state budgets were then to commit to implementing the planned fiscal trajectory over four years to ensure the ten-year debt trajectory is sustainable. Member states can request adjustment periods longer than four years – a further three years – if underpinned by structural reforms and certain investments.

While far from perfect, adjustment paths were to be negotiated and tailored according to the member state’s specific situation. There was to be no requirement that countries reduce debt according to a one size fits all speed, such as 1/20^th of the difference between current debt level and 60%, which had been place before the fiscal rules were suspended due to Covid. While the main implementation or monitoring metric to achieve a negotiated path was to be net expenditure (spending net of tax changes and one-offs and temporary measures), there was to be no a priori restriction on what net expenditure should be. Preliminary simulations by the Commission found that compared to previous rules, the November proposals would have resulted in considerably less austerity.

The position last month, no doubt intended to placate Germany, rolled back many of these improvements. The basic framework of negotiated debt reduction paths remains in place. However, three new rules have been added, though additional clarity is needed about the precise details. First, countries in breach of the 60% and 3% limits will have to ensure that debt is on a downward path after four years, or remains at ‘prudent levels’. That is, debt will likely have to fall after four years. Second, net expenditure is also not to exceed the growth in potential output of the economy. Finally, for countries in breach of the 3% deficit rule, a fiscal adjustment of 0.5% of GDP per annum will be required, where fiscal adjustment is presumably in net expenditure terms (for countries with debt below 60% and deficits below 3% the Commission will issue guidance based on the structural deficit to ensure that remains the case).

These are significant and regressive developments. Regarding the requirement for debt to fall, a country that had a rapidly increasing debt will not only have to arrest that increase, but ensure that after four years it is below what it was when it started the process. The net expenditure rule will likely freeze public spending to GDP, absent tax increases. It also raises the vexed question of how to measure the unmeasurable, the growth in potential output of the economy. The 0.5% of GDP adjustment, regardless of where a country is in the economic cycle, may well end up being the most onerous of them all.

Ireland, for its part, won’t be in breach, so as long as the public finances are deemed to be in good nick. It will just have to make sure it remains that way. But many of the challenges Ireland faces are global, especially climate change. Here it is difficult to know what the precise amount of public investment is needed in each country. According to recent work by the NEF, under an optimistic scenario in which moderate amounts of public investment are needed to reach emissions targets, eight members would fall foul of the rules. If public investment needs prove more onerous, very few, just four, would be able to meet emissions targets. Importantly, the analysis does not account for last month’s tightening of the rules, so that targets will now be even more difficult to attain.

There may be further iterations before the final rules are agreed. The latest round of reforms means that Europe’s ambitions on climate and emissions, which many believe were insufficiently ambitious to begin with, look ever more unreachable. The Commission is talking a decent game on climate, and simultaneously pursuing policies to make that game unwinnable. Further loosening of the rules is required than has what has been proposed, and additional EU-level funds will be required. All of this is before anything is said about the damage that will be done to employment and living standards by a return to austerity, or austerity-light.   

Posted in: Economics • Environment • Investment

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.