Years of economic underperformance, ill-advised austerity and a lack of resilience against economic shocks have led to the realization by decision-makers that fiscal discipline for the sake of it threatens to incapacitate the Eurozone countries. However, challenging the system of fiscal rules has proven a tedious task in the past. Instead, these inadequate rules have mostly been ignored or suspended as a way of muddling through. The last time the general escape clause was triggered was in the wake of the COVID crisis. Now, the imminent return to fiscal rules in 2024 has galvanised a critical mass of proponents for a reform of the current dysfunctional framework.  

Following the Commission’s proposal earlier this year, member states in the Council and the European Parliament are in a heated debate over how to achieve a new set of rules. However, the ongoing debates in the Council and Parliament are posing a risk of further tightening the commission’s proposal. Without fiscal instruments at the EU level, these developments could not only threaten long-term economic growth prospects but also limit the national fiscal space required for sustainable investments. This, in turn, could jeopardise the attainment of climate and transformation objectives. As the EU stands at a crossroads, the decisions made during the coming months are more than mere adjustments; they are essential steps to equip the Union with the tools necessary to face upcoming challenges and build a fiscal framework that enhances economic resilience.  

A needed push for change 

The key objective of the introduction of fiscal rules was to ensure fiscal and macroeconomic stability in the Eurozone by preventing excessive debt and deficits levels and restore confidence in financial markets to stabilise the Eurozone. The current set of fiscal rules was established within the Stability and Growth Pact (SGP) but has since suffered various tightening rounds in response to the financial and Euro crises between 2008 and 2015. However, their rigidity became especially apparent during the COVID pandemic, necessitating the temporary suspension of these rules through a general escape clause to accommodate much-needed, crisis-related stabilisation spending.

Additionally, the current framework lacks a credible enforcement mechanism. Although member states generally managed to decrease their deficits upon entering the Excessive Deficit Procedure (EDP), public debt levels frequently remained unchanged or even increased by the conclusion of an EDP. Notably, no member state has never been fined under this procedure. 

Not only have the fiscal rules proven to be too constraining and not enforceable, but they are also widely regarded as pro-cyclical and austerity enhancing, leading to chronic economic under-performance in the EU. In fact, since the euro crisis, Eurozone growth rates have been negatively diverging from those of the US which can be partly attributed to the lack of growth-enhancing investment caused by the austerity effect of fiscal rules. 

This austerity effect has also led to under-funding of infrastructure and social spending, especially in disadvantaged member states. This created, for instance, negative trade-off effects between public investment and cohesion funds, as shown by the recent 8th Cohesion Report by the EU Commission, which finds that “a large part of public investment stems from EU cohesion funds rather than from member states themselves whose own investments are constrained by EU fiscal rules“. But the negative effects of austerity-induced fiscal restrictions apply to the EU as a whole. Findings show that fiscal reforms since the euro crisis have left each European on average €3,000 a year worse-off. Looking ahead, the ever-increasing frequency of crises and global challenges requires a revamp to the current fiscal architecture. The economic shock of the COVID crisis, exacerbated by the energy crisis following Russia’s war against Ukraine, has highlighted the urgent need for a robust and forward-looking debate on fiscal reform. 

Against this backdrop, it appears that a critical mass has formed to push ahead fiscal rules reform. Member states, the European Parliament and the Commission are now striving for a reform agreement.  

The European Commission’s proposal 

The Commission presented its legislative proposals for new fiscal rules in April 2023. The main objective of this new set of rules is to reduce complexity and strengthen enforcement, while striking the right balance between ensuring debt sustainability and creating enough flexibility for much needed investment. Its main elements are: 

  • Focus on net primary expenditure 

The proposal pivots away from the multi-indicator system of the previous rules and towards a single operational indicator of net primary expenditure. This marks a large improvement compared to the old rules that would take into consideration factors that are hardly under the control of a government, such as interest rate payments and structural deficit estimations. Net primary expenditure is also considered a more reliable indicator because it directly measures government spending, avoiding the complexities and inaccuracies of adjusting for economic cycles. 

  • Country-specific debt reduction pathways 

The Commission aims to tailor debt reduction plans to country specific circumstances. Therefore, putting an emphasis on national ownership in the crafting of those plans, drawing from experience with the Recovery and Resilience Plans. Member states that exceed the deficit and debt limits should present individual plans that set out their fiscal objectives and how they intend to achieve reform and investment. The Commission will assess these plans and provide a “technical trajectory” for the respective member state based on a number of factors including debt levels, debt trajectory, economic growth, interest rates and other country specific factors.  

  • Medium-term approach 

The individual debt-reduction plans should be structured over the medium-term to enhance flexibility. Governments will have four years to reduce public debt, which can be extended to seven years depending on certain investments and reforms.  

This should better balance debt sustainability with much-needed investment into sustainable growth and EU macro-goals such as digitisation and the green transition. With the proposal, the Commission wants to create incentives by extending the adjustment period for such reforms and investments. However, it is unclear under which conditions member states are allowed to deviate from their fiscal adjustment paths. This leaves the Commission with a lot of discretionary power in the process to the detriment of transparency. 

The Commission’s proposal also features safeguards to ensure that the public debt-to-GDP ratio will be lower at the end of the reduction plan. Therefore, it includes a numerical benchmark of a mandatory annual reduction of 0.5% of GDP until the deficit falls under the 3% limit. 

Member states debate in the Council 

Earlier this month, EU finance ministers  were unable to finalise an agreement on the fiscal rules. Still, there is hope that a final agreement in the Council will be reached by the end of year. The Council will meet December 19th for an extraordinary meeting, with the Spanish Council presidency determined to iron out a compromise.  

As it stands, the Council will add some amendments to the Commission’s proposal which will likely increase the focus on fiscal discipline and rigidness of rules. Notably, while the Commission’s proposal regards the 60% debt-to-GDP and 3% deficit-to-GDP limits as long-term debt anchors in the debt-reduction plans, the Council is debating to extend these limits by further additional numerical safeguards. Interestingly, Spain and the Netherlands had proposed a „deficit resilience safeguard“, which would force highly indebted countries to reduce their deficit to 1.5% instead of 3% of GDP to create margin for unexpected spending. It was somewhat remarkable that Spain, a southern member state and net recipient, advocated for additional safeguards. This nod towards the more frugal member reflects the Spanish council presidency’s eagerness to broker a compromise and finalise a deal. However, this proposal did not sit well with France and some other southern member states. 

While the differences between member states have narrowed, questions remain also on how to measure the required deficit calculations in the corrective arm of the excessive deficit procedure.  

France, advocating for flexibility, wants to scrap green investment and interest payments altogether from calculations, while the eastern member states are particularly keen on exemptions for defense spending. Germany on the other hand is frustrated with these attempts to dilute the EDP, with finance minister Lindner planting his foot down to ensure a nominal debt reduction and strict, uniform criteria. He recently underscored this by stating that “excessive deficits have to be reduced, not excused”, with some feeling bit of irony in light of this, considering this statement is coming from a man who relied on large scale shadow budgets to circumvent German fiscal deficit limits.  

The European Parliament will vote in January 

Meanwhile, the  Committee on Economic and Monetary Affairs of the European Parliament has last week approved its draft opinion on the fiscal rules reform which clears the way for the Parliament vote that will be held in January. Essentially, the draft position will add the “debt-reduction safeguard” – put forward by Germany – requiring member states with debt ratios over 60% and 90% of GDP to annual reductions of 0.5% and 1% of GDP respectively. Only 8 Member States would be currently unaffected by this. 

 

The Social Democrats (S&D) have brokered this draft position together with liberals and conservatives of the EPP against the will of the left and the greens – ultimately giving in to a stricter rule set than originally desired by the Social Democrats. Clearly the S&D values reaching an early compromise more than further stalling discussions by insisting on more flexibility. Possibly to ensure that the parliamentary vote goes through before the Parliament dissolves in April and then likely returns leaning more to the right after the elections in June. This would reduce the leeway of progressives even further in the reform process. 

Ultimately, if the parliamentary vote in January follows the ECON committee’s draft position it can be expected that the Council and Parliament will find consensus on a tighter approach regarding the revision of the Commission’s original proposal. 

A lot is at stake 

With the general escape clause running out, fiscal rules will return one way or another. It will be crucial to reach a deal for a sensible reform because of the pressing need for a stable fiscal framework. The Eurozone is currently in the paradoxical situation of much lower debt and deficit levels than the US, while simultaneously experiencing higher bond yields, indicating a lack of credibility of the current framework that is putting financial stability at risk.  

At the same time, investment gaps are widening and public spending on the green transition is required to significantly increase. New fiscal rules must ensure that member states can muster the fiscal space to invest in the sustainable transition and are given the possibility to implement a counter-cyclical fiscal policy in the context of economic shocks or else risk triggering the general escape clause repeatedly.

The ongoing failure of the EU to establish common instruments, such as a successor of NextGenerationEU, makes it all the more important that fiscal rules do not constrain necessary future investment. While the proposals under discussion offer improvements over the previous regulations of the SGP, the adherence to strict numerical benchmarks will necessitate considerable fiscal adjustments. Such types of consolidation have seldom resulted in a decrease in public debt levels.

Moreover, they pose a threat to the success of the green transition, as fiscal consolidation often leads to cuts in investments rather than a reduction in structural spending. This issue has been recently highlighted by the fiscal turmoil in Germany, where the government had to slash billions in allocated climate funding to meet consolidation requirements. If the European Union is genuinely committed to rectifying the shortcomings of the past, it must learn from these experiences and find a more balanced approach to support targeted investments, while maintaining a credible mechanism for stability. 

As things stand, the EU will soon reach an agreement on a new fiscal architecture. It remains to be seen if this framework will deliver an improvement against the old rules. A halfhearted compromise could spell trouble for economic resilience and hinder effective action when it is needed most. 

 About the author 

Lucas Resende Carvalho is a Project Manager at the Bertelsmann Stiftung in the Europe’s Future Program. 

Read more about fiscal rules in the EU 

The Impact of the War Against Ukraine on the European Fiscal Reform Debate (globaleurope.eu) 

Europe.Decisions Compact Digital Conference – Discussion on EU Fiscal Policy (globaleurope.eu) 

“Cautious but Justified Optimism” – Eurogroup President Paschal Donohoe Confident about Economy of the European Union (globaleurope.eu) 

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