A look at the current rules – Eurasia Review

By Janos Allenbach-Ammann

(EurActiv) — With the European Commission set to present its ideas for reforming much-criticised fiscal rules for EU member states on Wednesday (9 November), EURACTIV takes a look at the current rules and explains why they are being criticized.

Initially, common EU fiscal rules became necessary with the introduction of the single currency as it streamlined the monetary policy of the monetary union. This meant that member state governments could not unilaterally devalue their currencies to reduce their debt burden.

But fiscal policy remained primarily the responsibility of member states. which means that national governments alone decide on budget deficits and public borrowing.

Many economists have argued that only a fiscal union can solve the problem of the inadequacy of a European monetary policy coexisting with a national fiscal policy, but there was not enough political will to give up much of the national sovereignty over fiscal policy.

In this tension between national sovereignty and economic requirements and doctrine, a web of rules has developed to govern the finances of member states.

The rules

Since 1994, the EU treaties have set an upper limit on member states’ debts and deficits relative to their economic output. Their debt-to-GDP ratio must not exceed 60% and their annual budget deficit must not exceed 3% of GDP.

Three years later, the ‘Stability and Growth Pact’ (SGP) introduced a process to enforce fiscal rules by creating the ‘excessive deficit procedure’, under which EU member states with a deficit too high will have to follow a path of fiscal adjustment, with possible fines for non-compliance.

In the wake of the global financial crisis and the euro crisis, the EU further tightened fiscal rules by introducing the 1/20 rule and the expenditure benchmark, among other measures.

The 1/20 rule, applying to countries with debt levels above the 60% target, determines that these countries must reduce their debt-to-GDP ratio by at least 1/20e the difference between their current debt-to-GDP ratio and the target of 60% each year.

The expenditure benchmark should limit the net growth of public expenditure by obliging governments to offset all expenditure increases that go beyond a country’s medium-term potential economic growth with additional public revenue, for example increases of taxes.

However, the EU also introduced the “general safeguard clause”, which allowed the deactivation of fiscal rules in times of economic turbulence. This safeguard clause was triggered following the COVID-19 pandemic and will remain active at least until 2023.

Criticism

The rules have long been the subject of criticism, which has intensified in recent years. In a Survey 2021 out of 41 leading macroeconomists, 40 academics agreed or strongly agreed that the existing fiscal rules needed to be revised.

On the one hand, proponents of low public spending and low debt levels have complained that the rules are not enforced strictly enough and that EU member states are always finding ways to shore up their budgets less than is necessary to reduce debt levels.

On the other hand, proponents of greater fiscal flexibility argue that fiscal rules restrict public investment needed to promote economic growth. They argue that if the goal is to reduce the debt-to-GDP ratio, countries should focus on increasing GDP instead of reducing debt levels, in other words, getting out of debt.

Whatever political opinion one has on the fiscal rules, they seem to have brought neither stability nor growth. Southern EU countries in particular, such as Greece and Italy, have recorded dismal growth figures over the past decade and their debt levels have increased further.

The average debt-to-GDP ratio in the EU was 87.9% at the end of 2021, well above the 60% target enshrined in the Treaties.

The high debt levels of some countries also make compliance with the 1/20 rule almost impossible. With a debt-to-GDP ratio of 194.5%, Greece would have to reduce the ratio by 6.7 percentage points each year to comply with the rule.

Another point of criticism is addressed to the expenditure criterion because it is based on the concept of potential economic output. Potential economic output is a theoretical construct that is difficult to verify.

Moreover, it is calculated on the basis of past data, with the risk of perpetuating its own errors. If potential output is calculated too low, government spending is also constrained too low, making it difficult for the government to stimulate the economy and growth.

Many of these problems were recognized by the Commission when it relaunched the review of the macroeconomic governance framework in October 2021. On November 9, it is expected to present how the fiscal rules should be changed in response to these criticisms.

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