Assessing the European Commission’s proposal for reforming the EU’s fiscal rules
image credit: wiiw/Philipp Heimberger
On November 30th, the ECON Committee of the European Parliament held an expert hearing on the upcoming reform of the EU’s fiscal rules with a focus on discussing the European Commission’s recent proposals.
My introductory statement focused on the following three issues:
- While the reformed fiscal rules should allow governments to meet the needs for additional public investment to facilitate the green transition, the Commission’s proposal leaves important questions unanswered with regard to the criteria according to which investment and reforms qualify for an extension of the fiscal adjustment path.
- The envisaged reforms of the fiscal rules fall short when it comes to improving the ability to coordinate national fiscal policies so that they make sense for the euro area as a whole.
- While debt sustainability analysis would become much more important, many of the most relevant underlying technical assumptions involve political judgement, so there should be an expanded role for democratic scrutiny in parliament.
The European Commission has published an orientations document on the EU’s economic governance framework including a proposal on how to reform the EU’s fiscal rules. The Commission’s proposal focuses fiscal surveillance on the reduction of public debt to GDP ratios in EU member countries. To ensure a stable or declining debt trajectory, the Commission would conduct a debt sustainability analysis (DSA) for each member country. For countries that are assessed as facing a substantial or moderate public debt challenge, the Commission would set a reference fiscal adjustment path covering at least four years based on the respective DSA. This adjustment path would be expressed in terms of net primary expenditures – expenditures net of discretionary revenue measures and excluding interest payments and cyclical unemployment expenditure – and should ensure that the public debt ratio is plausibly on a downward path for ten years after the adjustment period, while the fiscal deficit should not exceed 3% of GDP. Countries would be able to apply for a longer fiscal adjustment path by up to three years by presenting a plan for investment and reforms consistent with debt sustainability. Once the adjustment path is agreed with the European Commission, the respective country would have to translate this path into their annual budgets, which leads to expenditure ceilings. If there are no exceptional events, the fiscal adjustment path should remain unchanged for a period of at least four years. If a country with a substantial debt challenge failed to adhere to the expenditure path, an excessive deficit procedure (EDP) would automatically be opened. For all other countries that do not stick to the adjustment path, the European Commission would consider opening an EDP.
On November 30th, the ECON committee of the European Parliament held a public hearing on the upcoming reform of the EU’s fiscal rules in Brussels. This was my introductory statement:
Dear members of the ECON committee,
Thank you for inviting me. The reform of the EU’s fiscal rules is a crossroads for the economic and ecological development of the European Union. Today, I want to discuss three key issues that will turn out to be essential for reform outcomes in the context of the European Commission’s recently published orientations document.
1. Investment
The Commission’s orientations rest on the idea of protecting some public investment from fiscal adjustment pressures. Member States can commit to a set of investments and reforms to lengthen the fiscal adjustment path if the Commission agrees that they are consistent with debt sustainability. But will this be sufficient to meet the public investment challenges with regard to reforming the energy and transport systems across the EU and meeting the climate targets over the next decades?
It is widely acknowledged that more public investment is required to contain climate damages that would also worsen debt sustainability. The estimates used by the European Commission suggest that a significant expansion of investment in EU member countries is needed. Overall, tackling the challenges in energy and transport systems related to meeting the climate targets would require additional annual public investment amounting to about 1% of the EU’s economy.
If we cannot expect this additional investment to be financed by a permanent EU investment fund, national governments will need to undertake it, which needs to be accounted for in the upcoming reform of the EU’s fiscal rules.
The Commission is right to argue in its orientations document that “investment and reforms that enhance sustainable growth are both indispensable and mutually reinforcing in ensuring fiscal sustainability and in enabling the green and digital transition”. But the design of the “common assessment framework” is crucial when deciding which investments and reforms will be accepted in the adjustment plans of national governments. There are very tricky technical questions with regard to the quantitative analysis of both the medium-term budgetary impact and the potential growth impact of the set of investments underpinning the longer adjustment period.
The European Parliament should pay attention to this: in particular, there needs to be a proper assessment of investment multipliers. Some investments in the green transition may come with short-term fiscal costs but largely pay for themselves in the medium-run and long-run. Furthermore, green investment will help contain climate damages. This also needs to be considered in the context of debt sustainability analysis: to what extent could debt sustainability deteriorate in the long-run if investment turns out to be too low to meet the climate targets as climate disasters cause fiscal costs?
2. Coordination of national fiscal policies with a proper euro area fiscal stance
The Commission’s orientations emphasise that a reformed fiscal rules framework should prevent fiscal policy mistakes in some member countries that would cause negative spillovers for the euro area as a whole.
There is a risk of assuming that fiscal policy mistakes will only come in terms of a fiscal stance that is too expansionary. But what if the fiscal stance in some member countries turns out to be too restrictive, thereby creating deeper problems for the future – e.g. when public underinvestment leads to a slower transition in the energy and transport systems that makes the EU fall behind with regard to its climate targets, which eventually also undermines debt sustainability? What if fiscal policy-makers in some member countries do too little, and thereby contribute to macroeconomic imbalances in the euro area as a whole?
There are situations in which fiscal policy can have spillovers in the sense that a fiscal contraction in one country not only affects domestic output, but also output in other countries of the monetary union, which cannot be offset by using supranational monetary policy. This will lead governments to underuse fiscal policy. The Commission’s orientations do not address how this problem should be dealt with, as the Commission focuses on debt spillovers but not on demand spillovers.
While the Commission’s orientations rightly stress the importance of strengthening the euro area dimension with regard to the Macroeconomic Imbalances Procedure, the envisaged reforms of the fiscal rules fall short when it comes to improving the ability to steer the euro area fiscal stance.
To ensure symmetry, there should also be a possibility of sanctions when governments underuse fiscal policy with negative demand spillovers for other countries, thereby contributing to macroeconomic imbalances that hamper the functioning of the euro area as a whole. The European Parliament should ensure that the aggregated fiscal paths derived from the European Commission’s debt sustainability analysis for individual member countries make sense for the euro area and EU as a whole.
3. Critical assumptions in debt sustainability analysis
Finally, I want to make some brief comments on the envisaged increased importance of debt sustainability analysis in deriving fiscal policy paths in individual member countries that are consistent with stabilising or declining public debt ratios.
Debt sustainability analysis relies heavily on assumptions, especially with regard to growth and interest rates. Changes to these assumptions can easily lead to very different projected debt trajectories. Special attention should be given to the assumptions behind the European Commission’s reference adjustment paths, as debt sustainability analysis is not well suited to determining a specific debt path. It would be useful to have the European Parliament more heavily involved in the process of scrutinising the underlying assumptions of fiscal-structural plans than currently envisaged.
Making these assumptions in debt sustainability analysis is not merely a technical task, but also involves political choices. For example, the Commission’s debt sustainability analyses have projected interest rates on government bonds based on market expectations. However, market expectations are formed based on what the European Central Bank and other policy-makers are doing. European policy-makers’ choices with regard to the European institutional architecture have an impact on differences in financing costs for euro area member countries, thereby affecting debt sustainability trajectories. Growth expectations depend on a set of policy choices in which the European Commission and other policy-making institutions are involved.
Given that many of the most important technical assumptions involve political judgement, there should be democratic scrutiny in parliament.