The war on Ukraine has hit Europe hard and will test its resolve and unity alike. As European leaders still struggle to fully grasp the economic and financial consequences of the situation, the question of how to deal with inflation and aggravated supply shortages – which has translated into spiralling energy prices and food insecurity – is dominating the economic debate.

The covid-crisis has laid bare the debilitation of our supply chains, which have now further deteriorated. And as the EU is prepared to go ahead with a further sanctions package, it appears that the Union is willing to endure another longer-lasting economic downturn. These developments will require immediate and long-term spending, affecting the fiscal reform debate dramatically as EU leaders need to figure out how to finance the challenges ahead.

The fiscal reform debate revolves around the question whether the narrow fiscal provisions established 30 years ago in the Maastricht treaty, and which form the basis of the Stability and Growth Pact, should be considered inadequate for dealing with the challenges of our modern times. Recent developments have sharply accelerated this debate and calls for a fundamental reform of the EU’s fiscal framework are now louder than ever.

A new era of public finance

The fiscal response to the covid crisis has run the EU’s public balances deeper into debt, with most member states largely exceeding the debt and deficit limits foreseen in the stability and growth pact (SGP). Hence why the Commission had opted for a general escape clause at the onset of the pandemic, which freed member states from the SGP’s fiscal straitjacket to adequately respond to the covid crisis-induced recession.

chart public balance
Source: Eurostat

Now, as all seemed set for a short-term return to the SGP rules, the EU’s fiscal exit strategy has been dealt a tremendous blow by the war on Ukraine. The implications of this war for the future of the EU are still inconceivable at this point. They are set to change the tone of the fiscal reform debate, which had been previously conducted in a rather technocratic manner. Suddenly, we are witnessing new fiscal rhetoric spreading across the continent. After years of cutting back, member states are now dramatically ramping up their defence expenditures. Germany, for instance, has just produced a historic shift in its security and foreign policy in the blink of an eye.

In response to the energy crisis, the Commission set out ambitious plans to diversify and boost its energy mix to break with energy dependency on Russia. Short-term measures to offset the increase in energy prices being discussed in many EU member states include price controls or subsidies for fuel and/or living costs. And the situation is likely to be aggravated by looming gas and oil boycotts. Further public spending to curb the negative effects stemming from energy disruptions appears inevitable.

And on top of all that, the green transition is as relevant as ever. Achieving the climate targets will command great financial efforts. The Commission stipulates that to realize the green transition, the EU must disburse an additional 520Bn Euro annually over the course of the next decade. And the transition must now come at an even faster pace than originally predicted. In a recent publication, the Commission acknowledged the need to significantly boost the “Fit for 55” targets for renewables and energy efficiency.

A quick return to a narrative of sound public finance does now seem even less likely, as EU leaders have just tasked the Commission at last week’s council meeting at Versailles with a mandate to explore the possibility of filling investment gaps in issues concerning security and energy.

Reforming the rules or remaking the fundamentals?

The calls for sensible reform of the fiscal framework have always been there, and discontent over the complexity (the current rulebook consists of over 100 pages) and transparency of the SGP rules has only increased over the years. Consequently, in early 2020 the Commission launched an official review process seeking to significantly simplify the fiscal ruleset, as broad consensus had emerged over the staleness of technical criteria underlying the EU’s fiscal framework. The idea behind the review process was more or less to implement more efficient and streamlined rules without breaking with the fundamentals.

However, first, the covid crisis halted the process of soft review, and now the Ukraine war has given the debate a whole new spin. Economic disruptions and insecurities once considered temporary are now here to stay, as is the question of how to properly deal with (and finance) future economic crises appropriately.

In its recently published fiscal policy guidance, the Commission is clearly trying to balance the expectations of a return to fiscal stability while also encouraging much needed investment. Therefore, recommendations diverge for member states according to their level of debt to account for the heterogeneity of exposure across the EU. However, the guidelines remain vague, and the Commission delayed further decisions on fiscal rules until May, when the new economic forecasts become available.

As soon as the first dust settles, the EU will need to address elemental questions concerning its fiscal stance toward the current challenges. It remains to be seen if the upcoming weeks will shed some light on the way forward.

Joint common borrowing or NextGenerationEU 2.0?

Some EU leaders, led by French President Emanuel Macron, favour a crisis response mechanism that would allow the Commission to procure loans on the capital market and distribute the money to member states in the form of grants and transfers.

Similar to the NextGenerationEU funds developed during the covid-crisis, these investments should be strategically targeted, in this case, directed to the areas of green infrastructure, energy, and defence. Macron envisages a joint borrowing fund of around 200bn Euro to solve these urgent needs.

The French president is confident that now is the time to push for his idea of a more coordinated and expansionary European fiscal policy, which he has been advocating for a while now. And he certainly feels that the success of Europe’s expansionary fiscal stance during the covid-crisis is proving him right, given that it was largely successful in stimulating employment, combating the recession, and lifting confidence.

There is, still, significant opposition to further large-scale joint financing approaches. Neither the traditionally frugal member states nor the Commission are fully convinced. Whilst not shutting the door completely, the Commission would prefer to see member states first tap their remaining RRF (Recovery and Resilience Facility) budgets rather than opening a new round of common borrowing just yet.

Germany, in particular, is treading lightly on the path to such fiscal policy. After displaying an exceptionally progressive stance in the immediate response to the covid-crisis, Germany has now reverted to its traditional position of curbing more ambitious fiscal efforts. Now, the country is leading the opposition to joint borrowing schemes over fears that such undertaking could render the RRF emergency fund strategy – called by the German finance ministry an “exceptional response to temporary but extreme circumstances” – into a rather permanent instrument.

History has shown that crisis measures often later become a recurrent tool. This is an outlook the German government is eager to avoid. Permanent large-scale debt-financed transfers and joint liability are a nightmarish thought for many fiscal conservatives in the largest net-contributor of the Union.

The case for more flexibility

Currently, in countries like Germany and the Netherlands, the concern about unsustainable debt levels is still prevailing over the willingness to make further budgetary concessions. Nevertheless, the unforeseen urgency for elevating defence and energy spending along with the ever-present question of how to finance the green transition is overshadowing the fiscal debate. The inadequacy of current SGP rules for accommodating those needs is glaring.

In this context, many, especially leaders like Emmanuel Macron, Mario Draghi or Pedro Sánchez, are pushing for a permanent relaxation of fiscal rules and have been championing the movement for more flexibility. Many proponents of this approach would like to take advantage of the currently low-interest-rate environment to conduct targeted spending and let public budgets absorb the deficits, sparking fears in frugal European countries over ballooning debt levels.

A similar approach would call for a less general relaxation to promote investment in the right areas and prevent debt-induced spendthrift. A so-called “golden rule” could exclude necessary spending, such as green investment or defence and energy spending, from SGP deficit calculations.

At any rate, it appears clear-cut that inflexible consolidation cannot be the long-term answer to the challenges ahead. The EU’s fiscal framework will need to become more technically sensible but also designed in a way that it can account for the new reality of today. Mere modifications are unlikely to fit this purpose. Streamlined rules and technical improvements continue a necessity in the reform process. Still, there is widespread belief that the fiscal framework must also accommodate the need for increased spending to be functional in the long-term, be it through the creation of common borrowing funds, the relaxation of debt and deficit limits, or a golden rule for targeted spending exemptions.

As for now, any final decisions on the fiscal framework are being delayed, but the reform debate is already gaining momentum. The time will come when the EU needs to address the issues of how to deal with the short-term impacts of yet another global crisis and the pressing needs of the green and digital transition.

About the Author

Lucas Resende Carvalho is an intern at the Bertelsmann Stiftung in the Europe’s Future Program. 

Read more about the geopolitical and economic impact of Russia’s invasion of Ukraine:

Agricultural Production in Ukraine and Russia: Economic Implications for Europe

Europe’s divided security

What are the economic implications for the Russian and European economies? The Russian war against Ukraine

SWIFT exclusion is fine, sanctioning the Russian Central Bank is better

Caught between Russia and the West? China’s Struggle for a Position on Ukraine

Russian Sanctions Highlight Need for Green Transition for European Energy Independence