One of the many things summarily halted when coronavirus hit Europe was the EU’s debate on the future of its fiscal rules. In February the European Commission had invited a debate on the “economic governance” of the bloc, intended to create the political space for tweaking the unloved and unwieldy rules for its member states’ budgets.
The European Fiscal Board, made up of independent economists, had already published a series of reports assessing how well the existing rules, which require member states to “pursue sound public finances”, had worked (not very) and proposing improvements. All of it was put on hold as the pandemic intensified.
With economies opening, the debate is beginning to come back to life. The fallout from the crisis will force leaders to take a hard look at their fiscal framework and ask whether it is fit for today’s situation. Every member state in the Union will run huge budget deficits this year, and exit the acute phase of the crisis with more public debt than previously expected.
“Covid debt effects . . . will leave countries in very different positions,” says Silvia Merler, head of research at the think-tank unit of Algebris, an investment fund. “The risk there is high-debt countries will have less space to expand and ensure a steady recovery.” Some of the countries whose public finances are suffering the worst hit — such as Italy and Spain — owed disproportionately more debt to begin with.
Roel Beetsma, professor at the Amsterdam School of Economics and an EFB member, agrees that “one should acknowledge that debt to GDP ratios will be very different after the current crisis and for some countries extremely high”.
Nobody disagrees that governments need to spend what it takes to combat the crisis and get their economies back on track. The EU activated a general escape clause in its stability and growth pact without controversy when the magnitude of the Covid-19 crisis became clear.
But the commission has not given an expiry date, nor spelt out under what conditions the escape clause will be deactivated. Mr Beetsma says “our concern is that some sunset provision is absent. At the least, a review date should have been set.”
The open-ended nature of the escape clause has ruffled feathers among some of the more fiscally hawkish member states. Calls for clarity about which rules will apply when are likely to intensify as leaders have to agree both on the EU’s pandemic recovery fund and its ordinary seven-year budget, needed for the start of 2021.
When the escape clause is deactivated, “by default the existing rules would apply in the way they did before”, says Mr Beetsma. “The question is whether deactivation is also the moment or opportunity for a much-needed revision of the rules.” The EFB is likely to weigh in on this in its next report, expected on July 1.
Some economists warn against restoring the existing rules unchanged. Ms Merler says “it will need to be recognised that [the fiscal framework] needs reform and simplification — including at this point dropping the debt reduction rule.” This rule requires a country to reduce its debt burden every year by one-twentieth of its excess above 60 per cent of gross domestic product. For a country like Italy, this could mean cutting the debt-to-GDP ratio by 5 percentage points a year while trying to coax the economy into recovery.
The EFB’s Mr Beetsma says “we still stand by our proposal” for a simplification of the rules to a single long-term debt target and a simple rule for net spending growth to reach it. But he says “realistic paths for debt reduction need to be set”. One way to do this, he argues, “is to differentiate adjustment rates for public debt reduction” between countries.
A battle over fiscal rules seems to be looming, even if it is the last thing leaders want with recovery and budget spending still unresolved.
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