The EU fiscal framework: A flanking reform is more preferable than quick fixes

Niels Thygesen, Roel Beetsma, Massimo Bordignon, Xavier Debrun, Mateusz Szczurek, Martin Larch, Matthias Busse, Mateja Gabrijelcic, Laszlo Jankovics, Janis Malzubris 10 November 2021

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On 10 November 2021, the European Fiscal Board (EFB) published its new annual report (EFB 2021). The report provides an assessment of the immediate fiscal policy response to the Covid-19 crisis and further updates the EFB’s reform proposal for the EU fiscal framework to account for post-pandemic realities. The deep contraction of over 6% – unprecedented in its severity since WWII – invalidated earlier policy plans, which in many cases contained unambitious fiscal targets, in particular for high-debt countries. 

The Covid-19 impact on public finances in the EU

An explicit provision was introduced in the Stability and Growth Pact (SGP) in 2011 to cater for Covid-like symmetric calamities, the ‘severe economic downturn clause’ (in the public debate commonly known as the ‘general escape clause’). Its swift, and very first, activation, in conjunction with the equally swift reaction of the ECB via the pandemic emercency purchase programme (PEPP), provided the necessary room for policy manoeuvre. Starting from March 2020, Member States have virtually all enacted massive crisis-relief packages, so the budgetary impact was more pronounced than after past major economic shocks, with the deficits exceeding 9% of GDP in several Member States (see Figure 1). This robust fiscal response coupled with the sharp drop in economic activity led to an equally unprecedented increase in government debt-to-GDP ratios by over 13 percentage points on average. Member States with the highest debt before the crisis recorded the biggest jumps in debt ratios, also linked to the fact that they happened to be particularly hard hit by the pandemic.

Figure 1 Government balances in 2020 by country

Note: Estimates of the structural budget balance are surrounded by uncertainty as they involve forecasts of real GDP. They are likely to be revised when new data become available. 
Source: European Commission’s spring 2021 economic forecast.

Overall, the swift and forceful reaction of both fiscal and monetary authorities was warranted. It stands in sharp contrast to what happened in the wake of the global financial and economic crisis and was, without doubt, instrumental in softening the economic and social fallout of the pandemic, at least for the short term. At the same time, the policy response underscored at least two important and interlinked issues in the EU fiscal surveillance framework: the notorious failure or difficulty on the part of some Member States to build fiscal buffers in good economic times, followed by the tendency to find new often improvised forms of flexibility in the implementation of the EU fiscal rules or through new elements of risk sharing when times turn bad.   

As was explained in previous EFB reports (e.g. Thygesen et al. 2020), not all Member States had taken advantage of the protracted recovery from the global economic and financial crisis to improve public finances. A significant number of euro area Member States entered the pandemic with a debt-to-GDP ratio well above pre-2007 levels and had more limited or no budgetary leeway for responding to another major economic shock. In light of the truly exogenous nature of the pandemic, common EU initiatives created room for manoeuvre for this latter group of countries as well. In particular, following difficult negotiations in the Council the EU started the Next Generation EU (NGEU) initiative, which involves substantial cross-country transfers. In addition, the ECB’s PEPP programme very much helped mitigate early signs of stress on certain euro area sovereigns and stabilise yields at low levels. Nevertheless, as Figure 2 demonstrates, countries with less fiscal headroom mobilised a comparatively smaller increase in government expenditure in 2020; it remains true when one takes into account the impact of the various liquidity support schemes, such as the government-guaranteed lending programmes.

Figure 2 Net expenditure growth in 2020 (country groups by fiscal positions)

Notes: (1) The medium-term rate of potential GDP growth is in nominal terms. It is calculated as the 10-year average of real potential output growth rates plus the GDP deflator, taken as an average over the same 10-year period. (2) Fiscal space reflects the difference between the estimated structural budget balance and the medium-term objective (MTO).  The fiscal space for Greece is set to zero due to fiscal commitments taken at the end of the economic programme. (3) Net expenditure growth refers to the growth rate of government expenditure in 2020 excluding some items (interest expenditure, expenditure on EU programmes fully matched by EU funds revenue, and the cyclical part of unemployment benefit expenditure) and is net of discretionary revenue measures and one-offs. Investment expenditures are averaged over four years. (4) Low debt countries = EE, LU, BG, CZ, SE, DK, RO, LT, LV, MT, PL; High debt countries = NL, IE, SK, FI, DE, HU, SI, AT, HR; Very high debt countries = CY, FR, BE, ES, PT, IT, EL.
Source: European Commission’s spring 2021 economic forecasts, EFB calculations.

To accommodate the fiscal response within the EU fiscal rules, the Commission and the Council started early on to discuss various flexibility options. They quickly agreed to resort to the severe economic downturn clause. Although extra flexiblity was needed, the way decisions were taken highlights issues in the implemenation of a rules-based system. In particular, although designed to grant some flexibility on a country-by-country basis around the requiremens of the SGP, the severe economic downturn clause was communicated and applied like a general waiver without real differentiation across countries. Second, the timing or conditions for its deactivation were not addressed until spring 2021, which in turn had been singled out by a number of independent fiscal institutions as complicating factors to provide guidance to national bugdetary authorities. Furthermore, official Commission documents rightly insisted that the activation of the clause did not mean the suspension of the SGP. However, the Commission and the Council decided, citing the high degree of uncertainty surrounding the economic outlook, not to launch any procedural follow-up when they assessed clear cases of non-compliance, notably excessive deficits. This approach was based on political considerations rather than established practice or precedents. Excessive deficit procedures (EDPs) were customarily opened for straightforward breaches of the deficit criterion. At the current juncture, EDPs are clearly not to be used as an instrument of frontloaded and abrupt fiscal adjustment, but could still offer policy guidance and credibility for the medium term. The extensive interpretation of the severe economic downturn clause, which as described above gave rise to diverging interpretations as to the procedural follow-up and the modalities of deactivation, is a particularly visible symptom of the underlying challenge in the current arrangements of EU fiscal surveillance: within the limits imposed by the Treaty, discretion (when backed by the necessary majority in the Council) trumps rules. A more organic review of the current set of flexibilty clauses, taking into account the lessons learnt, is needed. 

The case for a swift and comprehensive reform

The pandemic understandably froze the economic governance review process initiated in early 2020; its recent relaunch by the Commission was timely and more than welcome. Regardless of divergent perceptions among Member States as to how to return to a rules-based fiscal framework, the EFB believes in the significance of wide-ranging changes. Our reform proposal organised around three central elements: i) a medium-term debt anchor; ii) an expenditure rule as the main policy instrument; and iii) a single escape clause applied on the basis of independent analysis. It was basically laid out in detail before the outburst of the pandemic (Beetsma et al. 2018, EFB 2019), and it gained more relevance post-Covid. In fact, there is an emerging generation of reform blueprints that are similar to the EFB’s.

The EFB is a strong advocate of maintaining reference values, as clear and recognisable numerical goalposts play an important role in any solid fiscal framework. They provide tangible focal points for public debates and a basis for decision-makers’ accountability in the fiscal domain. Concretely, the 3% of GDP deficit threshold remains a useful backstop against unsustainable debt dynamics. The headline deficit is observable, easy to interpret, and uniformly applicable to all EU countries. It should remain the main triggering point for assessing the opportunity to initiate corrective actions in a revised framework.

A revised EU fiscal framework should preferably be complemented by additional policy levers enhancing its resilience and robustness. Beyond the update of EU fiscal rules, there are other long-overdue governance reforms in the EU, most notably the creation of a central fiscal capacity and schemes to promote public investments, such as augmenting the EU budget by dedicated national envelopes for providing EU common goods. The availability of a joint fiscal capacity is all the more important when monetary policy is constrained by the effective lower bound and some Member States struggle with keeping public finances on a sustainable path. Conditioning the access to the common instrument to compliance with the fiscal framework may further encourage fiscal responsibility across the EU. The recently established NGEU facility consists partly of budgetary transfers, with strings attached as to how they can be spent and to what reforms should be pursued, also with a view to reverse the trend of declining government investment and to improve the quality of public finances. The jury is still out whether this initiative remains a one-off or it will lead to permanent institutional changes.

In a scenario of no major changes to the SGP, EU institutions should spell out transparently how the necessary flexibility and constrained discretion vis-à-vis the ‘Maastricht numbers’ will be applied in the coming period. Most importantly, the boundaries of flexibility should be clarified. In this vein, routine channelling of the outcome of bilateral negotiations between the Commission and national governments through the Council should be abandoned. 

Ideally, independent fiscal institutions should play a greater role in the EU surveillance process, in particular outside the corrective arm. While greater reliance on country-specific guidance by national IFIs can have its clear benefits, the EFB sees limits to the reform avenue of significant decentralisation. In a broad sense, national fiscal institutions remain too heterogeneous in the EU to consistently shape the conduct of fiscal policy. This insight is corroborated by our annual report’s analysis of the early experiences with the national correction mechanisms. Absent a conscious effort to harmonise the role and functions of these entities, the Commission’s and the Council’s role in monitoring performance and formulating recommendations will remain essential. 

Reforming the framework in time would serve the interests of both groups of Member States: those keen to avoid a further erosion of the rules-based system, and those willing to exploit flexibility in a productive manner. By contrast, less predictable fiscal policy only makes sudden risk repricing by financial markets more likely. Given the two decades history of discretionary and hard-to-predict tweaks in the implementation of the existing SGP rule book, reforming genuinely the fiscal framework seems to be a far better approach.

References

Beetsma, R, 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.

Bénassy-Quéré, A, M Brunnermeier, H Enderlein, E Farhi, M Fratzscher, C Fuest, P-O Gourinchas, P Martin, J Pisani-Ferry, H Rey, I Schnabel, N Veron, B Weder di Mauro and J Zettelmeyer (2018), “Reconciling risk sharing with market discipline: A constructive approach to euro area reform”, CEPR Policy Insight No 91.

Darvas, Zs, P Martin, and X Ragot (2018), “European fiscal rules require a major overhaul”, Bruegel Policy Contribution No. 18.

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

EFB (2021), Annual Report 2021.

Martin, P, J Pisani-Ferry and X Ragot (2021), “Reforming the European Fiscal Framework”, Les notes du conseil d’analyse économique No 63., Conseil d'Analyse Économique

Thygesen, N, R Beetsma, M Bordignon, X Debrun, M Szczurek, M Larch, M Busse, M Gabrijelcic, E Orseau and S Santacroce (2020), “Reforming the EU fiscal framework: Now is the time” , VoxEU.org, 26 October.

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Topics:  EU institutions EU policies Europe's nations and regions

Tags:  EU fiscal rules, EU fiscal framework, European Fiscal Board, Stability and Growth Pact

Chairman, European Fiscal Board; Professor Emeritus of International Economics, University of Copenhagen

MN Professor of Pension Economics and Vice-Dean of the Faculty of Economics and Business, University of Amsterdam, Member of the European Fiscal Board

Professor of Public Economics, Catholic University of Milan

Advisor, Research Department, National Bank of Belgium

Member of the European Fiscal Board; former Minister of Finance, Republic of Poland

Head of Secretariat, European Fiscal Board

Economic Analyst, European Fiscal Board Secretariat

Economist, European Fiscal Board Secretariat

Economist, European Fiscal Board Secretariat

Economic Analyst, Secretariat of the European Fiscal Board

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