The temporary suspension of the European fiscal rules to enable member states to take emergency measures against the Covid crisis offers an opportunity for an ambitious reform of a now clearly outdated fiscal framework.
This column, part of the Vox debate on euro area reform, argues that the reactivation of the rules, nowforeseen in 2023, should be made contingent on a political agreement on
reforming the fiscal framework, and proposes a comprehensive reform in
which the new European fiscal framework would prioritise externalities
arising from debt sustainability risks and demand spillovers. Fiscal
targets should be differentiated depending on country vulnerabilities
and implemented in a more decentralised way.
The European fiscal rules have been temporarily suspended since March
2020 to enable member states to take emergency measures against the
Covid crisis. This should be taken as an opportunity for an ambitious
reform of a now clearly outdated fiscal framework. The reactivation of
the rules, now foreseen in 2023, should be made contingent on a
political agreement on reforming the fiscal framework.
We propose a comprehensive reform in which the new European fiscal
framework would prioritise externalities arising from debt
sustainability risks and demand spillovers. Fiscal targets should be
differentiated depending on country vulnerabilities and implemented in a
more decentralised way. We provide a detailed economic and
institutional roadmap for this reform.
We are no longer in the world of Maastricht
Since the Maastricht Treaty, the European fiscal rules have been
constantly revised (without significant Treaty changes) but overall, the
underlying framework has remained the same. Even before the Covid-19
crisis, many economists and officials were calling for its reform (e.g.
Bénassy-Quéré et al. 2018, Darvas et al. 2018, Feld et al. 2018,
Thygesen et al. 2018).
The post-Covid context results in a disconnect between these rules
and four new facts: higher public debts, very low or even negative
interest rates, limited effectiveness of monetary policy in the vicinity
of the effective lower bound, and common debt issuance with
the adoption of the European recovery plan in 2020. In this context, the
role of fiscal policy in reducing both temporary and persistent demand
deficits must be reassessed.
This has strong implications for the euro area, where this role has
been codified on a premise that now appears to be obsolete. Echoing
Mario Draghi’s 2014 call for a “greater role” for fiscal policy
alongside monetary policy (Draghi 2014), ECB Executive Board member
Isabel Schnabel recently advocated rethinking the relationship between
monetary and fiscal policy when interest rates can no longer be reduced,
saying that “effective macroeconomic stabilisation in the vicinity of
the lower bound requires both unconventional monetary and fiscal
policies” (Schnabel 2021).
The case for a comprehensive overhaul of the fiscal rules
In a recent French Council of Economic Analysis paper (Martin et al.
2021), we argue that to be effective, an overhaul of the rules should
address two main fiscal externalities.
The first, which was at the heart of the euro area crisis, is the
risk to the area’s financial and monetary stability posed by sovereign
insolvency and, even more so, by the possible exit that could follow.
The rules should tackle the insolvency risk resulting from excessive
debt, not the threats resulting from self-fulfilling expectations, which
are and should remained addressed by the ECB (Farhi and Martin 2018).
The second externality, which was largely neglected in the design of
the EMU, pertains to aggregate demand. As long as fiscal support to
aggregate demand is called for and no central budget exists to take on
this role, the impact of national fiscal policies on partner countries
must be considered. This externality was long considered secondary
because of opposite spillover effects through the goods and capital
markets, yet it is significant when the central bank's policy rate can
no longer be reduced due to the effective lower bound.
While the need for reform is increasingly recognised, its nature
remains fiercely debated. Blanchard et al. (2021) call for replacing
budgetary rules by qualitative standards. They propose to get rid of all
numerical criteria, to replace them with the sole principle that member
states "ensure that their public debts remain sustainable with a high
probability" and (in the most streamlined version of their proposal) to
replace the mechanism of gradual sanctions by the standard EU procedure
of action by the Commission before the Court of Justice.
We agree on the focus on sustainability and on removing the multiple
numerical criteria that have accumulated in the European fiscal
framework. However, we consider a complete break with the Pact as
Country-specific debt targets
We do not propose to rewrite the central provisions of the Treaty on
the Functioning of the European Union (TFEU). This applies first of all
to Article 126 (“Member States shall avoid excessive government
deficits”), including the gradual pressure its procedures entail and the
possibility – never used – of financial penalties. We regard a gradual
peer pressure mechanism as appropriate in a context where excessive
public debt may have adverse effects on partner countries.
Similarly, we do not propose to eliminate the central provision of
Article 121 (“Member States shall regard their economic policies as a
matter of common concern and shall coordinate them within the Council”)
on which the preventive arm of the Stability Pact was built. Neither the
spirit nor the letter of this article prejudges the nature of
externalities or the desirable direction of national policies.
However, we believe it is essential to at least de facto (and in time de jure)
remove the uniform numerical thresholds for the debt (60% of GDP) and
the deficit (3% of GDP) indicated in the Protocol 12 annexed to the
TFEU. The debt threshold sets a target that is too far removed from
reality and lacks analytical foundations.
Uniform numerical criteria are misplaced because debt sustainability
depends fundamentally on the differential between the interest rate and
the growth rate and on a state’s capacity to maintain a sufficient
primary surplus. These determinants of debt sustainability are all very
We therefore propose that each government sets a medium-term debt
target, the appropriateness of which would be first assessed by the
domestic independent fiscal institution (IFI) on the basis of a common
methodology, monitored by the EFB, and second endorsed (or rejected) by
the EU. This target should be explicitly based on estimates of the
maximum primary balance and the risks to the interest rate–growth rate
Once debt targets have been set, they should serve as anchors for
expenditure rules. The path for primary nominal expenditure net of new
discretionary tax measures (and excluding automatic stabilisers on the
expenditure side) would be determined accordingly.
Our proposal would change the hierarchy of objectives. So far, the
deficit criterion has in most cases been given priority over the debt
criterion. We would instead give priority to a country-specific debt
target and de-emphasise the primacy of the deficit criterion.
Legally speaking, the reference value for public debt mentioned in
Article 126 would need to be interpreted as country-specific rather than
uniform. Ultimately, this would require amending Protocol 12, which can
be done by unanimous agreement.
We do not favour introducing a golden rule that would treat
investment expenditures differently from other public expenditures, as
the distinction between investment expenditures and other
growth-enhancing expenditures would raise endless discussions.
Nevertheless, it will be the role of the IFIs and of the EU to take into
account the impact on potential output of public investment in a broad
sense. The assessment of public finance sustainability should also
consider the time profile of climate investments in order to ensure they
are not postponed.
Space for discretionary policy
Because discretionary fiscal policy has an important role to play in a
regime of low interest rates and as long as the sustainability
objective is not at risk, the fiscal framework should leave room for
active demand management. A possibility would be to apply a common
flexibility factor to national expenditure rules. However, this would
not prevent member states from running excessively tight fiscal policies
in a slump.
The Recovery and Resilience Facility (RRF), introduced in 2021 to
respond to the pandemic shock, could serve as a template for a new
European fiscal instrument. It would not be a budget, and the
stabilisation of business cycles would continue to rely on monetary
policy and on the member states’ fiscal policies. Nevertheless, the
experience with the RRF could serve as a basis for taking joint fiscal
initiatives in response to crises leading to prolonged demand shortfalls
or to a structural lack in public investment. This could take the form
of a European instrument to finance specific public investment
programmes by means of mutualised debt.
A new institutional framework
We propose a redefinition of responsibilities of both the IFIs and of
the European Fiscal Board (EFB). We recommend strengthening the
resources, independence and surveillance capacities of the national
IFIs, in order to further anchor the culture of fiscal responsibility in
domestic institutions. We propose that:
- the EFB defines a common methodology to assess national fiscal sustainability, and controls its implementation by the IFIs;
- each government sets a debt target and expenditure rule over a five-year horizon;
- the IFI assesses whether the government's debt target is compatible
with the EU sustainability standards, and its detailed assessment is
- the Commission recommends to the Council whether or not to endorse the national debt target and expenditure rule;
- the Council (in euro format) endorses or rejects the member state’s fiscal targets; and
- the Commission monitors the implementation of the country-specific fiscal rule.
A detailed map of the institutional geography is given in Figure 1.....
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