A new fiscal approach in Europe

Life after Covid could transform old budget rules.

In late March 2020, the EU member states agreed to suspend the Union's rigid fiscal rules. Every country was facing a new deadly virus and unprecedented rules, such as mobility restrictions and lockdowns, were being imposed to reduce the spread of coronavirus among citizens. A different spending approach was necessary to contrast the situation and the European Commission took action quickly, activating the “general escape clause”, which relaxes the 1997 Stability and Growth Pact budgetary rules. “European national governments can pump money into the economy as much as they need”, explained European Commission President Ursula von der Leyen during a press conference.

The decision surprised many experts and politicians because in the previous two decades the EU fiscal rule book had been interpreted, especially by northern countries, as something that could only be tightened up rather than loosened. But the economic shock, which affected all European countries, facilitated the decision.

Economic and budget cohabitation in the European Union, originally established by the Maastricht Treaty in 1992, is based mainly on two pillars: each government may not run budget deficits in excess of 3% of GDP and its public debt may not exceed 60% of GDP. However, some events damaged the credibility of the norms. The latter rule was immediately modified for those countries (such as Italy and Belgium) which at the time could not respect the limits on public debt. In 2003, France and Germany exceeded the deficit ceiling and persuaded the member states not to take action. Furthermore, neither of the aforementioned numerical limits rested on a proven scientific or economic ground. They were simply the average level of deficit and debt in several countries when the Eurozone launched.

Fiscal policy is the main aspect dividing the Union along geographical lines, often causing southern and northern states to take a defensive stance against each other. Similar dynamics play a key role with another divisive topic, that of migration policies. However, the Covid outbreak made it clear that the EU fiscal rules had to be adjusted.

During the pandemic the European institutions have intervened twice with an innovative approach to tackle the member states’ budget problems. Firstly, the Stability and Growth Pact was suspended. Secondly, a €750bn recovery plan was devised. Next Generation EU allows the European Commission to borrow money on the financial markets and to subsidize member states. They will use the resources to reconstruct their pandemic-stricken economies through investments and reforms, previously validated also by the Commission.

Closing the deal was neither easy nor free for members with high debt levels. Countries who initially opposed the plan, like the Netherlands, managed to institute a surveillance mechanism that could potentially block financial transfers to a country should its commitments not be respected. In addition , it obtained a reduction on the rebates, which will reduce its financial contribution to the long-term EU Budget.

Therefore, the Next Generation EU represents a new instrument for the Commission to monitor spending and investments in all member states while ensuring their debts are sustainable. Reintroducing the Stability and Growth Pact, with its present distortions and stiffness, would have been too tight a constraint for many EU members. Almost all countries exceeded the 3% deficit in 2020 (see chart) and in the first quarter of 2021 the public deficit to GDP ratio stood at 6.8% in the EU. Many member states plan to exceed the 3% level in the next few years as only a slow reduction of the deficit will foster the recovery without narrowing it. For these reasons, Mario Draghi, Italian Prime Minister and long-time European Central Bank President, described EU fiscal rules as “obsolete”.

A discussion on how to change the Stability and Growth Pact was already on the table in Brussels but the pandemic paused it. Now that almost 75% of European citizens are fully vaccinated and daily activities are returning to normality it is time to reopen the dossier. Within the European community, rules are essential to guarantee stability. Nevertheless, the implementation of old and rigid rules would be detrimental to the Union, regardless of the future German and French governments.