Navigating the EU’s fiscal architecture: performance and the new economic reality (II).

In the second article of the series a more in-depth analysis of these EU fiscal rules is going to be presented. In addition and, in order to provide some hints to understand the current debate about the need of reform of the fiscal rules, a generic analysis about the new “post-Maastricht” reality is presented. 

In a general way, it can be said that the Stability and Growth Pact has helped to improve the overall euro area fiscal position. According to Eurostat, when comparing data from the period before and after the introduction of the SGP[1], it can be seen that the budget balances in the euro area have been reduced from -7.1% to -2.6%. Despite this positive outcome, the SGP has also led to the implementation of procyclical fiscal policies, limiting the fiscal shock absorption capacity of the Eurozone countries (Philip R. Lane, 2021; Vítor Constâncio, 2020). 

The SGP has been also characterised as a complex and, sometimes, incoherent set of rules. Concerning this last point in 2018, the European Fiscal Board argued that the assessments of the fiscal positions, due to its reliance on different indicators (some of them unobservable), has increased the scope for discretion and judgement.  In addition, they also argued that the two anchors guiding the medium-term fiscal policy “imply overlapping fiscal requirements [...], that occasionally offer conflicting signals”. Additionally, it has been highlighted that the SGP suffers from a time inconsistency problem as ex-post rules are relaxed to accommodate difficult cases and there is hesitancy to enforce sanctions. 

As (Kamps & Leiner-Killinger, 2019) point out, the 3% deficit rule has been a good and effective fiscal anchor that has contributed to contain budget imbalances, even for countries that did not comply with it. Although, the interpretation of the rule by the Member States has not allowed for the creation of buffers in good times, thus limiting the shock absorption capacity of the eurozone countries. Additionally, as (Francesca Caselli & Philippe Wingender, 2018) show, the deficit threshold has acted as a deficit “target” or “magnet” for MS. This is in clear contrasts with the initial goal of the rule, the creation of a deficit upper bound. 

Concerning the debt threshold, it has hardly affected the conduct of fiscal policies with a divergence among MS taking place. In this regard, it is possible to see a discrepancy between one of the fiscal targets stablished by the fiscal rules set-up[2] and the actual evolution of debt for the eurozone members. 

When it comes to the debt rule introduced with the “six pack” reforms, high indebted MS have not been compliant with it. As highlighted by (Kamps & Leiner-Killinger, 2019), “given the high requirements under the debt rule, the European Commission and the ECOFIN Council have de facto discontinued its application. They have instead argued that compliance (in some cases even projected future compliance) with the less demanding preventive arm […], is sufficient to avoid the opening of a debt-based EDP”. 

  

 The first reaction to the Great Financial Crisis in the Euro zone was articulated in 2008 through the European Economic Recovery Plan. The programme was a coordinated short-term budgetary impulse that mobilised €200 billion around 1.5% of the EU GDP at that time. €30 billion came from the EIB while the rest was provided by the MS.
 

When taking into account the fiscal impulse[3] of the Euro area during the period of 2008-2010 it can be seen that the fiscal stimulus was sizeable. According to the data reported by the EU Commission the fiscal impulse during the three years considered amounted a 6.3% of the GDP. When taking into consideration the components of the fiscal impulse, it can be seen that the fiscal response was mainly articulated by the use of discretionary measures and the use of automatic stabilisers (representing around a 0.52% and a 0.42% of the fiscal impulse respectively).  From a fiscal perspective, the results of the overall fiscal impulse lead to large increases in the government expenditure-to-GDP ratios as well as the deterioration of structural balances and the increase of debt-to-GDP ratios (Afonso et al., 2010). Around the year 2010, the sudden reaction of financial markets to the increased levels of debt in the periphery and the publication of the real data in regard to Greek deficits, influenced the fiscal stance of the Euro zone[4]. In order to restore confidence around the peripheric countries and, in a more general way, around the euro as a whole, European policy makers decided to reduce fiscal imbalances. At that time, in light of the expectations about the evolution of public debt, the estimations of fiscal multipliers[5] and the previous episodes of expansionary fiscal consolidation[6], fiscal moderation was seen as the best way to address the debt overhang and the sustainability concerns.

According to the EU Commission the fiscal impulse during the period was around -3.2% of the EMU’s GDP. According to (Baldwin & Giavazzi, 2015), the exercise of fiscal consolidation, if required for some members, affected to all the eurozone countries. The tightening of fiscal policy in the GIIPS[7] amounted for the 48% while the one taking place in Germany and France accounted for the 32% and 13% respectively. Despite the expectations around the positive effects of the fiscal consolidation in the eurozone, it is argued that the simultaneous consolidation initiated in 2011 exacerbated the economic slowdown and contributed to the European double dip recession[8]. In a general way, as shown by (Fatás & Summers, 2015), fiscal consolidations can be self-defeating in terms of economic activity and debt as a result of the permanent effects via hysteresis. In the context of the Euro zone, the QUEST model of the EU Commission points out that the fiscal consolidation, if needed, was too fast[9] and, as a consequence, there were cumulative deviations from the GDP baseline scenarios[10]. (Rannenberg et al., 2015) find similar results. Concerning the fiscal rules, the deterioration in the fiscal positions in conjunction with the debt and deficit caps may have also contributed to the change in the EU fiscal stance. In this regard, it is important to highlight that the inexistence of countercyclical fiscal policies during the decade before the financial crisis did not allow for the creation of buffers in good times, thus restricting the use of countercyclical fiscal policies during bad times[11]. 

 The unusual nature of the Covid recession created a consensus among economists around fiscal policy. It is considered that fiscal policy was the most suitable instruments to address the problems that the Covid induced lockdowns arose. This vision was supported by the degree of exposure of the different economic sectors to the negative effects of Covid. In this light, the fiscal policy measures were able to provide liquidity to the most affected firms[12] and households. When it comes to households, the targeted measures can consider the degree of heterogeneity of this group and as a consequence, the fiscal may be more adequate than monetary policy as it can be tailored to households with higher propensity to consume and lower capacity to borrow. In this sense, fiscal policy acted as a social insurance mechanism complemented by a central bank providing monetary support (Debrun et al., 2021). The support of the MS has been provided through a combination of discretionary stimulus, automatic stabilisers and liquidity support measures. For 2020 the data provided by the Commission[13] shows that these were around the 4%, the 2,5% and the 18% of the euro area GDP, respectively. When it comes to 2021, based on the Autumn forecast of the Commission, the fiscal policy stance will still be expansionary with a fiscal impulse of 7.1% of the euro area GDP. The discretionary stimulus and the automatic stabilisers[14] amount 2.1% of the GDP each. In contrast to what happened during the past recession, the fiscal authorities have empathised the importance to preserve the levels of government investment as a way to counteract the effects of the recession, increase the level of potential output and strengthening the debt sustainability. Another important difference with respect to the double dip recession has been the unprecedented EU fiscal response. The main lines of action have been articulate taking into account the different phases of the crisis. In the first place, drawing on previous lessons, the General Escape Clause of the SGP was used in March 2020. This clause allows for a coordinated and temporary deviation from the usual fiscal requirements of the SGP for all MS, as long as the deviation does not endanger fiscal sustainability in the medium term. This measure gave government the necessary flexibility to contain the first impact of the pandemic through the use of discretional measures. In the second place, new measures, including the direct use of EU resources, were approved during the month of April. This set of measures was articulated around three main programmes: the Temporary Support to Mitigate Unemployment Risks in an Emergency (SURE), the European Stability Mechanism Pandemic Crisis Support and the European Guarantee Fund provided by the European Investment Bank. The SURE consisted in support credits directed to the financing expenditures directly related with unemployment[15]. The €100 billion needed for the implementation of the programme were obtained by the EU Commission in the capital markets. Concerning the ESM credit lines, the €240 billion obtained by the institution in the capital markets will be directed to the financing of Covid-related health expenditures. Unlike in previous occasions, the ESM support is not attached strict conditionality. In respect to the EGF provided by the EIB, it consists in the provision of €200 billion in investment guarantees and upfront payments to firms based on the MS contributing to the fund financing. Finally, the Commission also approved the Next Generation EU, a €806.9 billion[16] temporary instrument targeted to the post Covid recovery. An important difference with respect to the other programmes is that the NGEU will be more directed towards to the less performing MS and it will be articulated through grants and loans. The resources will be obtained by the Commission in the capital markets and its use will be oversight through the European Semester. In a general way, the reforms implemented using the NGEU resources will have to be aligned with the green and digital transition. Apart from the funds per se, the NGUE has shown that the idea of creating a supranational macro stabilisations tool is feasible, at least under periods of economic stress. As argued by (Claeys, 2017), a supranational macro stabilisation tool is one of the necessary requirements to complete the EMU’s architecture[17]. Despite the amount mobilised by the NGEU programme, it is also important to mention that the effectivity of these may decrease as a consequence of problems related with the slow absorption of funds in some euro countries and the slow disbursement[18](Darvas, 2020a, 2020b). 

Before 2008, the mainstream economic consensus was based around the idea that monetary policy was the best tool to stabilise aggregate demand and achieve low inflation. In this regard, fiscal policy was confined to the passive role of pursuing debt sustainability and debt reduction, relying mainly on automatic stabilizers and the use of discretionary policies in periods of major distress. This consensus started to be abandoned during the aftermath of the GFC mainly as a consequence of the Zero Lower Bound[19] and the effectiveness of fiscal policy in environments characterised by lower interest rates and higher than one fiscal multipliers. As argued by (Blanchard, 2019), the economic environment that characterised the last decade was propitious to mitigate (or even eliminate) the negative welfare consequences of deficits. To support this argument, he shows that the international budget constraint and, more specifically, the solvency condition was not as binding as in the past due to the fact that the difference between the interest rate on public debt and the GDP growth rate has been steadily decreasing. In this situation the debt ratio tends to decline because the borrowing “pays for itself”. Apart from the results, it is also empathised that in the long term the negative differential between the interest rate and the GDP growth should not be assumed[20]. Another of the characteristics of the post-GFC economies has been the higher levels of public debt. This trend has been exacerbated by the sluggish recovery following the Euro zone debt crisis and, more recently, by the Covid induced recession. 

As depicted in the graph, the level of debt-to-GDP has increased in the majority of Euro zone countries during the periods including the double dip recession and, more recently, the coronavirus induced recession[21]. In presence of these high levels of debt, some concerns around the sustainability effects of fiscal expansions during downturns have arisen. Despite this, some authors have pointed that fiscal stimulus in weak economies may help improving fiscal sustainability (Auerbach & Gorodnichenko, 2017; Delong & Summers, 2012). Apart from this, some authors have claimed that considering the current economic conditions we should understand deficit sustainability in a different manner. (Furman & Summers, 2020) show that the debt-to-GDP measure is an uninformative measure because of the way in which it is calculated (comparing a stock with a flow measure), the low levels of interest rates and the backward-looking nature of it. As a way to overcome the problems related with the debt-to-GDP they propose to complement the analysis with the fiscal gap[22] and a projected debt service ratio. In addition to this, and in the case of the EMU, (Nielsen, 2021; Ubide, 2021) point out that longer maturities of government debt, the improvement in the crisis prevention mechanisms and the high market demand of government debt have contributed to the increased sustainability of public debt. It is also important to mention that, at least during the last decade, monetary policy on its own was unable to achieve the required levels of inflation. In this situation, a right policy mix, taking advantage of the monetary and fiscal complementarities, is required. Apart from this, when it comes to balance sheet policies, the political constraints affecting the ECB and the end of the Pandemic Emergency Purchase Programme[23] will likely decrease the flexibility of the ECB acting on the sovereign bonds market. It is also important to note that if some countries were to return to the pre-pandemic fiscal stance, it would be difficult for the ECB to rollover expiring public debt without crowding-out private investors from the market for certain countries. When it comes to public investment, the need of resources to finance the green and digital transition as well as the development of strategic autonomy for the EU, will require an active use of fiscal policy. 

  The deficiencies of the EMU’s fiscal architecture have been known for several years and various proposals regarding the overhaul of the fiscal rules have been proposed. Despite this, the years prior to the emergence of Covid-19, quiet in economic terms, made politicians to become complacent about the necessity of reform. The irruption of the covid-induced recession and, more specifically, the worsening of fiscal positions across member states, has changed this completely.  Some of the main overhaul suggestions include the European Fiscal Board’s proposal, articulated around differentiated debt targets and country specific debt adjustment paths, as well as the European Stability Mechanism proposal, arguing for a 100% debt-to-GDP ratio and a cap on expenditure growth based on the output trend growth. Apart from the supranational institutions, (Blanchard et al., 2021) have suggested the creation of standards instead of numerical rules, taking into account the probability of debt being sustainable as a consequence of the debt-stabilising primary balance exceeding the actual primary balance. (D’Amico et al., 2022) argue about the increase in the debt-to-GDP 60% limit, the introduction of a golden rule and the different speeds of adjustment when it comes to different types of debt. They also propose the creation of a European Debt Management Agency to intermediate member state’s debt, taking advantage of the market’s appetite for EU’s supranational debt. If it is true that there is an academic consensus around the necessity to reform the fiscal rules, the outcome of the reform, if any, will be determined by politicians. When it comes to the Eurozone core countries, France and Italy, in a recent joint declaration, argued for the necessity of softer fiscal rules. Concerning Germany, Christian Lindner, the new Finance Minister declared that Germany is to reform the EU’s fiscal rules. In clear contrast with this, some northern and eastern countries have less appetite for reform. In a common document signed by their finance ministers, they declared that they were opened to debate about the improvement of the fiscal and economic governance, drawing some red lines in regards to the reduction of government debt. Without a doubt, the development of the negotiations concerning the overhaul of the fiscal rules will be one of the hot topics of the European politics in the year 2022. Right now, the outcome of the negotiations is difficult to anticipate as a consequence of the deep divisions among MS. Despite this division, I believe that policymakers, drawing on past experiences, will at least introduce some changes allowing for a more gradual and pro-growth fiscal adjustment.
   


[1] The periods taken into account in the sample go from 1980 to 1997 and from 1998 to 2019.

[2] Understanding this as contained levels of debt over the medium to long term.

[3] The fiscal impulse takes into account the automatic fiscal stabilisers, the fiscal stance and the interest payments. Concerning the fiscal stance, it includes the discretionary measures as well as other components not directly influenced by policy (such as revenue windfalls /shortfalls, built-in momentum of public expenditure and factors related with output gap estimators).

[4] For a more detailed explanation about how the Euro zone crisis unfolded, see (Baldwin & Giavazzi, 2015).

[5] According to the 2011 World Economic Outlook, the fiscal multipliers of the eurozone were around 0.5. In this context, the effects of fiscal consolidations on the level of GDP are lower than the fiscal gains obtained. In contrast with these results, (Blanchard & Leigh, 2013) pointed out that the fiscal multipliers of the eurozone around that time were 1.3.

[6] See (Ardagna, 2004; Giudice et al., 2004).

[7] GIIPS stands for Greece, Italy, Ireland, Portugal and Spain.

[8] More specifically, as argued by (Debrun et al., 2021) the reductions in public investment may be behind these severe effects of the crisis.

[9] In line with (Alesina et al., 2017), the Commission also highlighted that the fiscal adjustments based on spending costs appeared to be less costly than the ones based on tax increases.

[10] See (Veld, 2013).

[11] According to the fiscal rules, the contribution of fiscal policy to macro stabilisation was mainly possible as a consequence of the free operation of automatic stabilisers over the business cycle. Discretionary measures, if allowed, must be within the limits stablished by the SGP.

[12] This targeted fiscal policy was able to minimise the possible hysteresis effects through the preservation of the productive fabric.

[13] See (European Commission, 2021).

[14] Concerning the automatic stabilisers, the Commission acknowledges that due to the uncertainties surrounding the estimation of potential growth, the impact of these could be subject to larger revisions than normally.

[15] The implementation of the SURE resembles some of the proposals related with the creation of a European unemployment reinsurance scheme.

[16] The amount takes into consideration current prices.

[17] In addition to this, it is important to mention that the size of the NGEU will also contribute to the development of the EU capital markets, thus enhancing the financial architecture of the euro. (Christie et al., 2021).

[18] According to the regulation proposal of the EU Commission, around one quarter of the NGUE will be disbursed between 2021 and 2022.

[19] For a more in-depth analysis of the constraints faced by monetary policy see (Vítor Constâncio, 2020).

[20] In the paper Blanchard also highlights that his analysis is subject to some other caveats and, therefore, the results should not be interpreted as a direct political recommendation. In (Charles Wyplosz, 2019), an analysis of some of the problems of Blanchard’s analysis is exposed.

[21] It should be noted than in the period between 2014-2019 a slow reduction of debt-to-GDP was taking place among the countries considered.

[22] The fiscal gap gives information about the immediate and permanent change of the primary balance that is required to stabilise the debt as a percentage of GDP at its current value for a specific period of time.

[23] The PEPP is exempt from the limits regulating the maximum amount of public debt that the ECB can purchase in the secondary market. These limits are set around the capital key and the 33% of the total debt in circulation.