Last November, the European Commission proposed a radical reform of the European Union’s Stability and Growth Pact. The debate that followed – and the updated proposal that the Commission released in April – revealed that, despite the progress the EU has made in designing common policies over the last few years, mistrust still prevails.
As originally formulated, the Commission’s proposed legislation would replace rigid limits on public debt and fiscal deficits with country-specific debt-reduction targets (determined by a debt-sustainability analysis) and national medium-term fiscal plans. Monitoring would be based on a simple “expenditure path” – binding annual net-expenditure limits, excluding interest payments and adjusted for business-cycle variations – and enforcement would be strengthened.
Neither Germany nor Italy was convinced. Germany feared that the new system would give the Commission too much discretion over debt-reduction targets, making them susceptible to political pressures. Italy worried that the debt-sustainability analyses would generate volatility in the sovereign-debt market, and preferred to stick to a system that had been so rigid in principle that it ended up being flexible in reality.
Germany then advanced a counterproposal, which the European Commission seems to have embraced. The new iteration of the Commission’s reform plan, released in April, includes several additional “safeguards” against excessive debt. Most significant, it requires countries with deficits larger than 3% of GDP to reduce their debt by at least 0.5% per year, regardless of the results of their debt-sustainability analysis.
The new proposal would also require that the debt ratio be lowered within an adjustment period of 4-7 years – again, regardless of what the debt-sustainability analysis says. This is a tough requirement to meet, not only for Italy and Greece, but also for France and Spain.
The addition of these requirements defeats the entire purpose of devising a new framework. The Commission’s November proposal was based on the recognition that achieving debt sustainability is complicated and that devising an effective debt-reduction plan requires a dialogue with national officials.
Neither pillar of the fiscal framework that the Commission envisioned last November is built on hard science. Debt-sustainability analyses, while imperfect, are an important tool for determining what fiscal-adjustment path is realistic. And medium-term fiscal plans provide a basis for constructive discussions between national governments and the EU.
Together, these components help policymakers organize all relevant information regarding economic growth, financial conditions, inflation, and so forth, and establish feasible strategies that can be adjusted in response to changing circumstances. It is the difference between making explicit forecasts, which are unlikely to be accurate in an uncertain environment, and devising plausible scenarios, like those that guide central banks’ decisions about interest rates.
Ultimately, the Commission’s original plan established a framework in which a common language and approach would enable a national government to defend its policies, and the European Commission could then challenge the government’s arguments. This is infinitely better than setting arbitrary targets, which become meaningless when countries cannot meet them.
In fact, as we have learned over the last two decades, rigid rules that fail to adapt to changing circumstances either harm the countries attempting to follow them or are violated systematically, undermining the credibility of the rule-setting body. The last thing Europe needs is to revive the “blame Brussels” game that once threatened the EU’s survival.
This is not to say that there should be no EU-level rules governing member countries’ public finances. Yes, removing such rules would give governments full ownership over their fiscal plans, eliminating the need for complex ex ante negotiations among the EU and its member states. But it would also leave the market as the sole enforcer of fiscal discipline – a recipe for instability. The EU would no longer have the power to prevent crises; it could only manage them after they erupt – a process that would require complex political negotiations.
The European Commission’s original proposal carries some risks, rooted in its lack of transparency and consistency. But when it comes to reconciling the imperatives of respecting national sovereignty over public finances and ensuring stability in an integrated economic area, there is no silver bullet. The solution the Commission proposed in November is more promising than the version it proposed in April.
Europe is not alone in struggling to adhere to its own fiscal rules. In the United States, after much political jockeying, White House officials and lawmakers managed to reach a last-minute deal to raise the debt limit for two years. But the sources of the crisis are far from resolved. On the contrary, debt-ceiling showdowns have become a kind of political ritual in the US, highlighting both the destabilizing effects of deep polarization and the unsustainability of a fiscal framework that fails to adapt to changing circumstances.
There is a lesson here for the EU: rules are no substitute for trust. Unless the EU builds confidence among its members, disagreement over fiscal rules will continue, undermining their credibility. As a result, any reform of the Stability and Growth Pact is likely to be deemed unsatisfactory within a few years.
Nonetheless, a new framework for a dialogue between national governments and the EU would do far more to bolster trust than yet more inflexible, unrealistic rules, and it would have implications extending far beyond fiscal stability. In a changing geopolitical landscape, Europe must articulate a shared vision of the role it wants to play and build a common governance system to support it. The foundation must be a broadly accepted, credible approach to public finances.
Lucrezia Reichlin, a former director of research at the European Central Bank, is Professor of Economics at the London Business School and a trustee of the International Financial Reporting Standards Foundation.
Copyright: Project Syndicate, 2023.
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