Reforming the EU fiscal framework: Now is the time

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Niels Thygesen, Roel Beetsma, Massimo Bordignon, Xavier Debrun, Mateusz Szczurek, Martin Larch, Matthias Busse, Mateja Gabrijelcic, Eloïse Orseau, Stefano Santacroce 26 October 2020

On 20 October 2020, the European Fiscal Board published its new annual report. The report provides a careful assessment of 2019 and puts forward ideas on how to strengthen the EU fiscal framework. The year 2019 marked the end of a six-year long recovery from the financial and sovereign debt crises. Although slowing, economic growth settled at around 1.5%, in line with its estimated potential. Overall, last year still qualifies as good economic times, with the level of economic activity at or above potential in the vast majority of EU countries.  Despite sustained economic growth, the aggregate fiscal position of both the euro area and the EU weakened by around 0.25% of GDP as measured by the structural primary budget balance (Figure 1). The deterioration of public finances largely resulted from expenditure slippages, which more than offset savings on interest payments. 

Moreover, spending increases highlight failures to stick to budgetary plans. In the EU as a whole, public expenditure turned out 1.2 % of GDP higher than envisaged in governments’ medium-term budgetary plans, i.e. the Stability and Convergence Programmes presented in spring 2018. Sizeable slippages took place in countries with high or very high debt levels. Furthermore, in 2014-2019 the largest part of expenditure slippages went into current expenditure and only a very small fraction – less than one tenth – was allocated to government investment (Figure 3). 

Figure 1 Drivers of the change in the headline balance, euro area

Source: European Commission; own calculations

Figure 2 Euro area output gap and fiscal stance

Figure 3 Government expenditure slippages, EU (2016-2019)

a) By government debt level  

    

b) By type of government expenditure

             

Notes: (1) The figure shows the difference between government expenditure outturn and spending plans in the stability and convergence programmes over 2016-2019 as a share of GDP. (2) The classification of countries by debt level is based on the average debt-to-GDP ratio over 2016-2019. Very high-debt countries = above 90% of GDP (i.e. BE, ES, FR, IT, CY, PT); High-debt countries = between 60% and 90% (i.e. DE, IE, HR, HU, NL, AT, SI, UK); Low-debt countries = below 60% (i.e. BG, CZ, DK, EE, LV, LT, LU, MT, PL, RO, SK, FI, SE). Share in EU GDP: low-debt group (18%), high-debt group (44%), very high-debt group (38%).
Source: European Commission; own calculations

A record number of non-compliant cases with no follow up 

In its final assessment, the Commission found that ten countries fell short of the SGP’s required fiscal adjustments by a large margin (i.e. Belgium, Estonia, Spain, France, Hungary, Poland, Portugal, Slovenia, Slovakia, and the UK) while three failed to reduce their high debt levels at the required pace (Belgium, France, and Spain). In early 2020, an excessive deficit procedure (EDP) was opened only for Romania due to a planned breach of the 3% of GDP deficit reference value in 2019. The number of countries significantly deviating from the rules in 2019 was the highest since the six and two-pack legislative reforms of 2011-2013. Similarly, the size of the deviations was the highest since 2014 (Figure 4). Once again, many governments failed to take advantage of good economic conditions to build buffers.

Figure 4 Deviations from fiscal requirements (2014-2019)

Notes: (1) A country is considered to fall short of its requirement under the preventive arm of the SGP when both the established compliance indicators (i.e. the structural balance and the expenditure benchmark) show a deviation from the MTO or from the adjustment towards it. (2) The chart excludes countries in EDP.
Source: European Commission; own calculations

The spread of the COVID-19 pandemic in the spring of 2020 radically changed conditions. Triggered by the sanitary measures aimed at containing the spread of the virus, the deepest recession since the Great Depression was met by massive fiscal expansions in all countries. The economic and social impact of the pandemic fully justified the activation of the general escape clause of the SGP, allowing governments to respond to the crisis as they saw fit. Although the clause does not apply to 2019, the Commission and the Council agreed that the exceptional impact of the pandemic in 2020 did not warrant any action related to widespread non-compliance the year before. The conditions under which the clause would be de-activated should nevertheless be clarified soon enough to keep fiscal expectations well anchored.

Reforming the pact 

Before the COVID-19 pandemic wreaked havoc on public finances in the EU, the effectiveness of the fiscal rules had already been put into question. In the relatively favourable years up to and including 2019, deficiencies in the rules became evident: complications and ambiguities; pro-cyclical fiscal policies; and declining government investment. The EFB (2019) provided an extensive overview of these weaknesses. Our review of the most recent experience confirms this assessment, not least with respect to the inability to build fiscal buffers in good times. 

The Commission’s economic governance review of 5 February 2020 launched a debate on how to improve the SGP. With the aggregate euro area and EU deficit now expected to surge from just 0.6% of GDP in 2019 to around 8.5% in 2020 and debt ratios at historic highs, the Commission’s review and consultation will take place in a completely new context with potentially far-reaching implications. From the current perspective, the long-standing deficiencies seem even more obvious: non-observable short-term policy indicators such as the structural balance are surrounded by even higher uncertainty; the responsibility for sustaining investment has temporarily been assumed by the NGEU, but will require national follow-up; fiscal stabilisation subject to sustainability constraints must be reassessed to leave more room to support demand in the low interest-rate environment.

Figure 5

While the pandemic has postponed the review of the EU fiscal rules, the EFB (2020) emphasises three major gaps in the current EMU architecture.

  • First, EMU needs a permanent fiscal capacity to address large shocks. While it essential for countries to take advantage of economic good times to build buffers, the COVID-19 crisis also showed the costs of not having a permanent and genuine central fiscal capacity that can be deployed in a timely manner to deal with a very large, exogenous shock. The capacity should ultimately take the form of a larger EU budget financed by own tax resources, with a meaningful size, the capacity to borrow in the event of large shocks, and a focus on EU investment priorities. Disbursements could be based on a combination of indicator-based automaticity and independent assessment. 
  • Second, the EU fiscal framework needs to be simplified and more effective. The surge in public debt stresses the need for realistic and country-specific adjustment paths to ensure debt sustainability in each country. The EU fiscal framework should be rebuilt on three principles: (i) a debt anchor, (ii) an expenditure rule laying down credible, country-specific adjustment speeds to reach the debt anchor, and (iii) a general escape clause, to be activated on the basis of independent analysis and advice. To strengthen governments’ incentives to abide by the rules, compliance with them should be a precondition to have access to the proposed central fiscal capacity. 
  • Third, growth-enhancing expenditure needs to be protected. The crisis underlined how certain items of government expenditure that are essential to support growth, such as investment, have declined over time, especially during periods of fiscal consolidation. This expenditure therefore needs an effective shield in the future, notably by allowing certain increases in investment when assessing compliance with the expenditure rule.

A central fiscal capacity

In a little more than ten years, the EU has been hit by three extreme crises, dangerously testing the limits of the current architecture. As in the previous two cases – the Global Crisis and the European sovereign debt crisis – the current pandemic has triggered a lively debate about the necessary common fiscal response by presenting ideas for instruments tailored to address primarily the current emergency.

In our view, Europe needs a larger EU budget. While abiding by the principle of subsidiarity, a larger EU budget would help stabilise the euro area and the EU, foster economic convergence and efficiently supply EU public goods (Figure 6). To address all three policy objectives effectively a central fiscal capacity should entail the following characteristics: (1) it would be permanent, (2) ideally, the EU budget would be financed by genuine own tax resources and have the capacity to borrow to face large shocks, (3) its size should be meaningful, (4) the spending focus would support the EU investment priorities and (5) the criteria for disbursement should be governed by clear rules, based on indicators of economic activity combined with independent assessment.

Figure 6 EFB proposal for a central fiscal capacity

Differentiating debt reduction

As many member states will come out of this crisis with historically high debt levels, it is urgent to preserve a credible medium-term anchor for fiscal policies and, thus, to reactivate and possibly conclude the SGP reform process before the de-activation of the general escape clause. 

In particular, the operationalisation of the ‘satisfactory pace’ of debt adjustment defined in the six-pack reform has become a less realistic guidepost with the major worsening of public finances, especially in the low-for long interest rate environment.1 Further differentiation of the pace of debt reduction would allow better tailoring to countries’ needs and capacities for those far above the Treaty reference value, while easing the monitoring of those well below it. At the same time, countries would be required to demonstrate stronger commitment to the new debt reduction paths.

In our latest annual report, we illustrate how that might be done under different assumptions regarding the level of debt and the difference between the interest cost of debt servicing and the nominal growth rate of the economy. Building on the EFB original proposal for a simplification of the SGP,2 Figure 7 provides simulations of how the expenditure rule would operate in one of the EU member states most affected by the COVID-19 health crisis, namely Italy. The top panel compares the debt reduction paths and the implied structural balances, net of interest payments, under the current 1/20th SGP rule (the red line and bars) with the our baseline expenditure rule (the dark blue line and bars).3 Although the expenditure rule provides for some relief compared to the SGP debt rule in the first years of adjustment, the consolidation efforts implied by the expenditure benchmark rule show a sharp steepening as soon as cyclical conditions improve.4  

In order to better distribute the adjustment efforts along the debt reduction path and to overcome the very demanding fiscal corrections in the latter years of the adjustment, the bottom panel of Figure 7 shows an alternative debt trajectory (i.e. the yellow line and bars). Compared to the baseline, the debt trajectory starts in 2021 with a speed of adjustment of 0.05 (i.e. 1/20) and in 2027, at the second revision of the expenditure ceiling, a slower adjustment speed of 0.04 (i.e. 1/25). While the debt ratio remains on a steady downward trajectory, the required primary surplus profile appears more evenly distributed along the adjustment path.

Figure 7 Italy’s debt-to-GDP paths under different debt reduction strategies

a) Expenditure rule versus the SGP’s debt rule  

             

Notes: (1) The adjustment path under the baseline expenditure rule is computed assuming that the economy is growing at its potential rate, inflation is at 2% and the debt-to-GDP ratio converges to 60% in 15 years. The adjustment path under the debt rule is computed based on actual projections for GDP and inflation. (2) Implicit interest rates are computed assuming that long-term nominal rates converge to 3.1%, i.e. the observed 10-years average, and interest expenditures increase in line with the expected rollover schedule of debt.  (3) Net expenditure growth refers to the growth rate of primary expenditures at current prices, net of discretionary revenue measures and cyclical unemployment benefits. 
Source: European Fiscal Board      
   

b) Expenditure rule with a revised adjustment speeds  

Notes: (1) The alternative scenario assumes debt-to-GDP converging to 60% in 20 years and, starting from 2027, in 25 years. (2) The adjustment path is computed assuming that the economy is growing at its potential rate and that inflation is at 2%. (3) Implicit interest rates are computed assuming that long-term nominal rates converge to 3.1%, i.e. the observed 10 year average, and interest expenditures increase in line with the expected rollover schedule of debt. (4) Net expenditure growth refers to the growth rate of primary expenditures at current prices, net of discretionary revenue measures and cyclical unemployment benefits.
Source: European Fiscal Board

These elements for a possible reform of the pact should go hand in hand with improved governance. In particular, the reformed framework would benefit from enhanced transparency and a clearer role for independent economic assessment and institutions. The debate on updating the framework is in our view urgent and the agenda clear: make the rules simpler, more readily accepted, and hopefully more enforceable, while still implementing them flexibly, but in an economically more meaningful way than in the past. Future implementation should end the frequent practice of accommodating for the political expediencies of national governments who find it hard to take more structural measures to reduce their country’s deficit and contain the rise of debt. This is especially pertinent now, as the EU relies increasingly on common fiscal and monetary stabilisation instruments

References

Beetsma, O, N Thygesen, A Cugnasca, E Orseau, P Eliofotou and S Santacroce (2018), “Reforming the EU fiscal framework: A proposal by the European Fiscal Board”, VoxEU.org, 26 October. 

Blanchard, O, A Leandro and A Zettelmeyer (2020) Revisiting the EU fiscal framework in an era of low interest rates. 

European Fiscal Board (2017), Annual report. 

European Fiscal Board (2018), “Assessment of the fiscal stance appropriate for the euro area in 2019”. 

European Fiscal Board (2019), “Assessment of EU fiscal rules with a focus on the six and two-pack legislation”. 

European Fiscal Board (2020), Annual Report.

Endnotes

1 See Blanchard et al. (2000).

2 The 2018 EFB proposal for a simplification of the SGP envisaged: i) a single fiscal anchor (i.e. a debt-to-GDP ratio objective and a declining path towards it); (ii) a single operational rule (i.e. a ceiling on the growth rate of net primary expenditures for countries with debt in excess of the objective); and (iii) one general escape clause, triggered on the basis of independent economic analysis. See Beetsma et al. (2018) for more details.

3 This is consistent with the ceiling on net expenditure growth being computed as to ensure that the debt-to-GDP ratio reaches 60% in 15 years based on the underlying macroeconomic scenario. In turn, the speed of adjustment under the baseline expenditure rule is 0.07 (i.e. 1/15). The ceiling is then fixed for three years and recalculated in year t+3, on the basis of the realised stock of debt and an updated macroeconomic scenario, so as to ensure that the 60% debt-to-GDP ratio is reached again in 15 years’ time. Thus, as for the SGP debt rule, debt ratios are allowed to decline asymptotically to the target level.

4 In turn, the expenditure rule may allow for a short-term debt increase during adverse economic circumstances – as long as this is offset by a faster debt reduction in the subsequent years – while the current debt rule imposes a reduction in the debt ratio already in the short-term.



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