The European elections held in June, shortly followed by the French general elections gave us a transformed political landscape. France and Germany’s political leadership is weakened by adverse electoral outcome. Negotiations are now in progress to form a new European Commission with on the one hand the winning centre-right parties trying to move the needle towards the right, away from highly unpopular green-transition policies and on the other hand other forces trying to maintain the political status quo reiterating the path of the first Ursula von der Leyen mandate.
Also in June 2024, the outgoing European Commission triggered the “Excessive Deficit Procedure” (EDP) for seven countries, including France and Italy, as their 2023 deficit was above the 3% threshold. Italy’s figure was particularly egregious at it reached 7.4% of GDP, also thanks to the long-lasting effect of green building subsidies (“superbonus”).
These two seemingly unrelated event come must be observed in conjunction with the new framework of fiscal rules that is coming into force in 2024, generating a highly unstable scenario from both the political and budgetary points of view.
Old and New Fiscal Rules
In 2020 the COVID pandemics triggered a blanket stop to the enforcement of European fiscal rules, but it was far longer that these rules had been subject to intense scrutiny and criticism. These rules had been deemed to be too “pro-cyclical”, i.e. constraining countries’ spending especially in times of need, i.e. during recessions, contributing to a decrease in public investments in countries with higher level of debt, to sluggish growth.
The latest stint of these rules were set up in the aftermath of the financial and sovereign debt crises and have been depicted many times as too strict, exacerbating the crisis effect on economies and population. Some went as far as saying that the populist flares in many European countries political landscapes can be attributed also to government being incapacitated in compensating the “loosers” of both the financial crisis and globalization (the so-called “China shock”).
Some of the rules in force until 2019 were so strict that they had hardly ever been implemented: the debt rule included in the so-called “Fiscal Compact” would have imposed high-indebted countries (further) budget corrections in the order 3-4% of GDP per year, in times where fiscal consolidation was already ongoing.
The second aspect that triggered the reform was that the continues sedimentation of different waves of rules set up had created a very opaque and cumbersome infrastructure. Since the early Nineties, the Maastricht Treaty imposed a simple deficit rule: deficits should not be larger than 3% of GDP. The financial crisis taught European governments that in presence of a financial bubble, governments with very bad public accounts may still be compliant with this rule, as a low nominal deficit could be coherent with a large structural deficit, covered by the large tax receipts generated by the bubble. Ireland could be the obvious example in this, with all account in order, but a huge reliance on stamp-duty real estate-related taxes, whose revenues burst as quickly as the real estate bubble, bring together with them the whole Irish banking system and economy.
For these reasons, the rules in force up to the pandemic were heavily reliant on measures such as the “cyclically-adjusted budget balance” (CABB) or the output gap, which are not directly observable.
At the same time compliance had been very low, conferring very little credibility to the enforcement. The 2019 annual report of the European Fiscal Board analysed compliance with these fiscal rules in details. We report here Figure 1, which shows how compliance with fiscal rules was strongly linked with the business cycle, with very little compliance during recessions. Tables 1 shows in more details how average compliance in the 1998-2018 period was strongly correlated with specific country characteristics. Compliance was also higher for smaller non-founding countries, implicitly showing how more influential member states were able to force their way through strict rules more easily.
To further undermine the rules credibility, often countries would draft the required medium-term objectives putting most of the fiscal effort in the more distant part of the plans, “kicking the bucket” towards the future hoping to bargain for further fiscal space in the years to come (or to transfer the “hot potato” to the country’s next government, were national elections looming).
The new framework that is coming into force this year was implemented with the aim to simplify and to increase compliance, but probably will succeed only in the latter. Rather than relying on simplistic numerical rules (like the original 3% rule of the Maastricht Treaty) or rules based on unobservable figures such as the output gap (as the rules in force until now), the new rules will rely on highly complicated stochastic modelling of the debt path under the name of Debt Sustainability Analysis. These are mathematical models that will indicate the expenditure path to achieve a given level of debt at the end of a 4- or 7-year period.
Countries whose debt level is above the (Maastricht Treaty) 60% level should submit in coordination with the Commission a 4-year plan detailing the primary expenditure growth path such that is reduced. Countries could also choose to implement a (less restrictive) 7-year plan in exchange for a closer control by the Commission in terms of reforms and investment in growth-enhancing areas.
To ensure that the fiscal effort is not pushed forward in the distant future, countries such as Germany and the Netherlands managed to introduce a further constraint on the way the fiscal effort is distributed within the 7-year period.
According to calculations by various economists these rules will imply a necessity of a very strong fiscal adjustment for highly indebted countries, with average adjustments with respect to the status quo of around 1% of GDP for 4-year adjustments for Italy and France. These two countries are in the most dramatic predicament as they are currently running a large primary deficit and will need to run a primary surplus.
The new rules state that the fiscal trajectory is to be “proposed” by the European Commission in a “structured dialog” with each member state’s treasury, as the the “Debt Sustainability Analysis” model is managed directly by the Commission. This of course introduces potential conflict between the Commission and member states, widening the opacity of the process and potentially widening the discretionary power of the Commission in the implementation of the plans.
To conclude
So is this any better or worse? The new fiscal rules surely have left behind the strong pro-cyclical elements of the rules emerged from the global financial crisis. The initial aim to make rules simpler and more transparent has fallen victim to a number of specific requests by the various parties involved in the negotiations, making the overall construction cumbersome. All in all though we expect these rules also to be more realistic, increasing their expected compliance and therefore their credibility.
The European Commission will remain strongly at the center of the implementation of these rules, but the outcome of political developments in France and Brussels will affect in unpredictable ways the manner in which these new rules will be interpreted both technically and politically.
The article is based on the author’s opinions based on research and analysis.
Prof. Emanuele Bracco
Associate Professor of Economics
Dipartimento di Scienze Economiche
Università di Verona, Italy