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Changes to the EU’s fiscal policies – paving the way for a Sovereign Debt Crisis 2.0?

It goes without saying that the Covid-19 pandemic has been the topic of the last two years. However, the negative indirect impact on the relative health of economies will certainly persist for many years to come, with the burden of substantial government debt created likely to affect future budgetary policies. The latest discussion about the proposed changes to the common fiscal framework clearly depicts the importance of this topic for the European project.

The pandemic can be labelled as a typical supply-side shock, with the distortion emerging in the real economy. As a response to health-protective arrangements aimed to tame the rapidly spreading virus, combinations of expansionary fiscal and monetary policies are used to mitigate economic losses created as a result of these pandemic restrictions. The purpose of this approach is to limit the contamination of financial markets and the transformation of the shock to a more common demand-type crisis. Put simply, governments and central banks flood economies with money to protect employees and businesses, with the costs of these actions materialised in the mounting of the nation’s public debt. But what prevents governments from regularly going on such uncontrollable spending sprees? Fiscal rules. Nevertheless, it is precisely the current EU fiscal scheme that is allegedly ready for a correction.

The Stability and Growth Pack (SGP) represents an agreement of the EU27 aimed to ensure financial stability of the Economic and Monetary Union. Its goal is to prevent overspending of national states to such an extent that would endanger their public debt sustainability and threaten the overall soundness of the whole economic community. Its latest 2012 version commits the member states to the following points. The main principle states that general national budgets should be balanced or in surplus. However, this rule is also considered to be respected if the balance meets the country-specific medium-term objective and if the structural deficit (actual deficit cleared of the estimated cyclical components) does not exceed 0.5% of the GDP. In addition, if a country’s debt-to-GDP ratio stands significantly below the notorious 60% threshold and if a risk to long-term sustainability is low, a structural deficit as low as 1% of the GDP is allowed. Naturally, this set of fiscal rules includes instructions on convergence policies, reduction of the excessive debt, as well as the enforcement of the above points by the European institutions.

However, it is clearly impossible to obey these rules in unprecedented times, such as caused by the latest pandemic. In order to create fiscal space to stimulate the economies during this time of global unrest, EU leaders have agreed on a temporary deactivation of the SGP principles until the end of 2022. Thus, consolidation of public finances will follow from 2023 onwards to repay the debt, implicating the need for possible austerity measures for some countries. This has been precisely the topic of a recent round of meetings between the EU finance ministers and the European Commission, discussing the review of budgetary rules with respect to several proposals. The Commission’s Vice President Valdis Dombrovskis emphasised that the debt reduction path should not only deliver fiscal sustainability but also be realistic for national states in the context of the persistent need for economic recovery. A consensus seems to be forming, especially regarding the impact of such restrictions on government investment. For example, Economic Commissioner Paolo Gentiloni commented on why certain alteration of the rules is necessary by: “We need to avoid what happened in the previous crisis when public investments year by year reached level zero.” With the commitment to meet environmental goals in the CO2 reduction, green investment is discussed to be fully exempt from the deficit estimations. Moreover, further extension of the temporary halt beyond the year 2022 as well as a less strict overall approach will certainly also be on the table.

It is clear that some changes have to be made, since a sharp return to the sustainable debt path this shortly after the pandemic seems unrealistic for many nations. This holds especially when considering the requirements of massive government investment expenditures to fulfil highly important environmental commitments. Secondly, given the character of the economic shock, some sectors require longer-lasting financial assistance than others. If the stimuli are cut prematurely, a full revival for the most-severely-hit businesses will be disabled, with such K-shaped recovery resulting in an even greater inequality within the society. Moreover, if the current arrangements are kept in place, fiscal rules are going to pressure debt reduction, leaving very little space for the overall government investment due to the budgetary constraint. Therefore, for the sake of ensuring a complete recovery while also reaching other important targets (such as emission reduction goals), relaxation of restriction sounds reasonable. However, the EU has been historically divided in this matter, with fiscally frugal countries often criticising the southern members for their irresponsible budgetary behaviour, repeatedly breaking the rules in the past. Fearing that some nations will misuse these exemptions, financial ministers of 8 members (including the Netherlands, Finland, Sweden, Slovakia, Czech Republic, Austria, Denmark, and Latvia) openly declared the willingness to improve the current arrangement while strictly respecting the core principles of the responsible rules-based fiscal governance, bringing the apple of discord back to life yet again. Despite these difficult negotiations likely to continue well until the end of the following year, the tone has been clearly set, with both camps aware of the current framework’s design being unfit for the post-pandemic reality.

Importantly, the principle of a cautious approach to public expenditures has also been reflected in the largest stimulus package ever financed by the European Union – the NextGenerationEU (NGEU) recovery plan. The aim of this recent €800 billion temporary instrument, financed through a joint loan of all the member states, is to boost the EU’s economies and repair the immediate damages caused by the coronavirus pandemic. It was sold under an ambitious promise of a “greener, more digital, and more resilient Europe”. However, most of the finances coming from this monstrous loan are not a blank cheque, with the conditionality on reforms as one of the newest and arguably smart features. The EU has certainly learnt its lesson of the hazard created by cheap loans, irresponsible politicians, and unwise investments. The Greek path must have been on the mind of the policymakers when a requirement for a country to follow specific steps was introduced as a condition for financial transfers. The central as well as the largest part of the NGEU, the €700 billion Recovery and Resilience Facility (RRF), requires supportive legislative and structural reforms from member states. National Recovery and Resilience Plans, assessed and approved by the European Commission and other joint institutions, represent reform packages countries have to successfully implement to obtain money for their recovery, with specific points tailor-made based on their domestic needs and shortcomings. As touched upon prior, the two flagship topics are green and digital transitions, ensuring a well-prepared European Union for future challenges.

Understandably, the Union wants to prevent another European Debt Crisis from emerging as a consequence of reckless investment, spent to cover, for example, immediate social aid packages and populistic promises, but lacking the creation of a real added value. Additionally, such an approach equips the EU with tools to successfully challenge any national leader vigorously fighting its values with one hand while gladly receiving its financial support with another.

The verdict

Admittedly, the title of this article is a bit of an exaggeration. However, several important notions in the latest developments can be highlighted. There is clearly some rationale behind voices calling for less strict budgetary policies as the economies are heading out of the pandemic, with the threat to investment and environmental goals being very real. With the substantial amounts of debt created in recent months, some countries would find it extremely difficult to obey the current rules in place. Subsequently, budget cuts and other austerity measures will have to be implemented, having a severely negative impact on the lives of ordinary citizens still financially recovering from the pandemic experience. From that perspective, given that deficit-exception categories are clearly and correctly defined, adjustment to the current framework should cause more good than harm. On the contrary, the motivation to tame the spending desires of some EU members is fairly logical given the relatively recent Sovereign Debt Crisis, with the current talks seen as a mistake that can backfire painfully. Without strict oversight and control mechanisms allowing for enforcement of the common agreements, history can repeat itself quite easily. For that reason, regardless of the outcome of these negotiations, one thing is clear: stricter compliance with the jointly-determined fiscal rules seems to be the sine qua non for the successful future of the European project. When discussing the effectiveness of stimulus packages, the conditional-based approach of the NGEU package is an additional improvement, ensuring both the best value-for-money investments and the economic development needed to repay the dues in the future. Additionally, national states have extra incentives to push through changes often unpopular among the general public but absolutely crucial for the overall development, limiting temptations of governments to postpone reforms while still receiving EU funding. All of the recent proposals and changes come certainly as consequences of good intentions. However, promises are easy to make but hard to keep. Unfortunately, mankind has learnt the hard way that this holds even more for short-sighted politicians countless times throughout history.


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