The EU’s New Fiscal Rules

Valeria Álvarez

8 mins - 9 de Enero de 2024, 07:00

At the end of its six-month tenure at the helm of the rotating EU Presidency, the Spanish government scored two diplomatic successes: Romania and Bulgaria to join Schengen, and a political agreement on reform of the fiscal rules. The Schengen agreement is straightforward, at least as it impacts citizens: you’re either in or out of the border-free travel area. But the fiscal agreement is a lot more complex and nuanced. What is expected to change, and what can be expected to be the real impact of these changes?

How We Got Here
The EU fiscal rules were first adopted in 1997 as part of the Maastricht convergence criteria for Euro accession. These required prospective members of the European Monetary Union to keep, among others, government debt ratios under 60% of GDP and deficits under 3% of GDP. Those figures were largely arbitrary, and implied a nominal economic growth rate 5% higher than the interest rate on government debt, or commensurately lower government spending if economic growth faltered relative to that lofty goal. After Euro accession, the fiscal rules became known as the Stability and Growth Pact, but they were nothing of the sort.

In a recession, the Stability and Growth Pact was strongly contractionary. This became a huge problem during the Great Recession following the North Atlantic financial crisis which started in 2007. In 2010, things came to a head with the Eurozone fiscal crisis, but the EU reacted by doubling down on the fiscal rules. 

The European Council imposed austerity by introducing the Six Pack in 2011. This included a medium-term budgetary objective with a structural budget deficit no larger than 1% of GDP, a 20-year budget path to a 60% debt ratio, and economic sanctions of up to 0.5% of GDP for countries in breach of the rules.

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Shortly thereafter, in 2012, the Fiscal Compact followed. It required the structural budget deficit limit to be enshrined constitutionally, at a level of 0.5% of GDP if the debt ratio was above 60%. These stringent and arbitrary rules quickly ran up against economic and political reality again, which forced an increasing allowance of flexibility within the Stability and Growth Pact since 2015.

The lasting damage of the Fiscal Compact was done with the inclusion of the fiscal rules in the constitutions of Eurozone member states. This was an error originally made by Germany in 2009, and which recently even Germany itself has disavowed. But constitutional mistakes are easier made than unmade, as Germany is finding out.

Where We Stand
The concept of fiscal rules really met its death with Covid-19. This was a truly genuine external shock, of the kind economists like waving around to sweep under the rug the recurring failures of their macroeconomic forecasting. The lockdowns necessitated by the pandemic would have destroyed the European economy if the fiscal rules had been applied strictly. The EU was forced by circumstance both to suspend the Stability and Growth Pact using its General Escape Clause, and to introduce a large, multi-year Recovery and Resilience Facility taking necessary public investment outside of the fiscal rules. 

At the start of 2022, when Eurozone governments were hoping to come out of the pandemic slump, the European economy was hit by the consequences of the Russian invasion of Ukraine, another genuinely external shock which is still ongoing. In March 2023, the European Commission announced that the General Escape Clause would stop applying in 2024. This can be done because the higher inflation brought about by the Ukraine war is actually fiscally stabilising, even though the higher interest rates imposed reactively by the European Central Bank risk tipping the Eurozone economy into a cyclical recession.

In April 2023, the Commission proposed a reform of the fiscal governance framework to move towards a system emphasising expenditure targets within national medium-term fiscal-structural plans, rather than fiscal ratio targets over the short term. In December, the Council agreed a mandate along the same lines, allowing negotiations to begin with the European Parliament in order to approve a version of the Commission’s proposal.

The New Rules
The single most significant change to the quantitative rules is the desired pace of adjustment of the debt ratio. Previously, countries were forced to aim at reducing their debt ratios annually by one twentieth of the excess over the 60% reference level. This means for example that Italy, with a debt ratio of under 135%, would have been forced to reduce debt by 3,75 percentage points per year starting in 2024. Under the near-zero inflation and interest rate conditions prevailing prior to the Ukraine war, this requirement would have forced Italy to run a structural budget surplus of about that size. This is not only as nearly impossible to achieve as allowed by an inexact science such as economics, but it’s also almost 7 percentage points stricter than the 3% deficit limit and even farther away from the 5% deficit the country is running in 2023.

By contrast, the Council’s new mandate, according to the Spanish Presidency, foresees an annual reduction of the debt ratio by just one percentage point of GDP for countries with a debt ratio above 90%. This seems attainable, especially in the current conditions of higher inflation.

An important innovation introduced by the proposed new rules is a “resilience margin” requiring countries to reduce their structural deficit by 0.4% per year if their budget deficit exceeds 1.5% of GDP. This is to avoid countries treating the 3% deficit figure as a target rather than as a limit. While this is in principle more stringent than the current rules, it does cap the pace of deficit reduction at 0.4% annually. This pace of deficit reduction would be further capped at 0.25% annually in the event that a country requests an extension of the time horizon of its fiscal-structural plan from 4 to 7 years, which it can do to account for challenging economic circumstances.

Deviations from the expected path of government expenditure are to be tallied in a control account while an Escape Clause is not in force. An excessive deficit procedure would be triggered if the debt ratio exceeds 60%, the headline deficit is not “close to balance” and the control account records a deficit of 0.6% of GDP cumulatively, or 0.3% annually,

Politically, the agreement makes allowances for counter-cyclical policies as well as meeting the EU’s long-term policy goals: digital transformation, green transition, social protection, and defence spending. The inclusion of defence spending among the protected categories is an innovation likely brought about by the Ukraine war, and it adds to the existing goal of strategic autonomy motivated by competition with the US and China.

In addition to accommodating these policy goals, the real flexibility in the framework comes from the fact that the expenditure paths will be based on 4- to 7-year horizons, and presumably revised annually. Given the nature of economic forecasting and the vagaries of the business cycle, such a long-term and moving target really does provide a soft constraint on the path of government spending over the immediate next year or two, which is the horizon of budget planning. 
The Role of the Spanish Government
Of course a rotating EU Presidency cannot take full credit for the decisions of such a complex collegiate institution as the European Union, but the diplomatic priorities of the member state holding the Presidency play an important role in which dossiers make real progress at the Council each semester. 

Not enough emphasis is being placed on the effect that successive Spanish governments under Prime Minister Pedro Sánchez have had on European economic governance over the past few years. Perhaps reluctantly, because Sánchez didn’t set out to be an economic revolutionary. Nadia Calviño, the economy minister, was supposed to provide a safe budgetary pair of hands that would inspire confidence in European circles. In his second cabinet, Sánchez brought José Luis Escrivá from Spain’s independent fiscal authority AIReF to the social security ministry, further buttressing the impression of conventional fiscal responsibility. 

But then the Covid-19 pandemic struck and Spain was instrumental in providing political impetus for the adoption of the Recovery and Resilience Facility and the NextGenerationEU instrument. Later, Spain teamed up with the Netherlands with an informal “non-paper” on strategic autonomy. And, after the Russian invasion of Ukraine, Spain played a key role by driving the adoption of an emergency framework on energy prices and security of supply. Spanish economic priorities, which have long been aligned with the shift from fiscal ratios to expenditure targets, have undoubtedly helped bring the new agreement on fiscal rules over the line in the Council.    
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