National fiscal policy has played a vital role in mitigating the socio-economic fallout from the pandemic and the associated containment measures. In the European Union, more space for national fiscal policy was given by the March 2020 suspension of the bloc’s common public finance rules, the Stability and Growth Pact (SGP).
For 2021, there is a clear international consensus that the approach taken in 2020 should continue. While the health crisis continues to rage and uncertainty remains elevated, notwithstanding the roll-out of vaccines, fiscal policy should continue to support vulnerable sectors, assist in rebuilding the economy in a future-proof and inclusive manner, and prevent – as far as possible – the long-run scarring effects of the pandemic.
But beyond 2021, clarity at the political level is needed on how the EU and in particular the euro area wants to manage the next steps. Economic risks and needs might differ across countries and regions, but need to be managed in a common framework.
The fundamental economic and political issue confronting EU countries is how to manage support for the recovery and longer-term debt sustainability risks at the same time. The facts are clear: government debt-to-GDP ratios have jumped significantly since spring 2020, and the rebound of the GDP denominator, even in the short run, will only slightly improve the picture. Contingent liabilities for the government sector have also increased markedly. Adding to the macroeconomic woes, debt levels globally are high and rising for non-financial corporates and many private households, with ramifications for banks’ balance sheets. Governments might have to absorb part of the private sector debt.
This sets the scene for question number 1: Is there a debt sustainability problem?
Many macroeconomists take the view that there is no trade-off between fiscal support and longer-term sustainability risks at this stage. Interest rates will remain ultra-low for the foreseeable future and sovereigns should invest forcefully in the economy, notably in the green and digital economies. Debt servicing costs will remain low, and long maturities for low-interest rate debt add to the benign picture. Money spent wisely will lead to higher long-term growth, aiding debt sustainability.
An alternative view, however, is that risk management requires a more prudent approach to debt levels and dynamics: turning the corner only when interest rates rise and market sentiment reverses may be too late. So far, markets have remained calm. The European Central Bank has provided forward guidance that it will maintain its purchase programme for a longer period, but there is no long-term commitment to this and terms may change. With higher debt levels and less central-bank support, market volatility could return, driven by political events and fiscal developments. The more guidance markets have on the future fiscal path, the lower volatility should be.
Others point to the different fiscal starting points that EU countries had when they entered the crisis in early 2020. Low-debt countries such as Germany were able to roll out huge support programmes for their economies, while high-debt countries such as Italy were constrained by already high debt levels. From this perspective, the emphasis is on regaining fiscal buffers as a precaution against future crises.
A further factor in the discussion is the €750 billion Next Generation EU recovery plan that offset the budget constraints faced by a number of EU countries. Is this debt national or not? Is it a precursor for a larger EU budget and greater redistribution? If so, how should it be financed? Is it a blueprint for future crises or only a one-off?
Question number 1 is therefore: is there a problem with present debt levels or not? Are debt levels a challenge or easily manageable? Can euro-area governments agree politically on future fiscal needs and risks and how they should be managed? Which discussion should take precedence: debt sustainability or fiscal stimulus?
These questions raise another issue: the timing of the debate. Euro-area countries with their rules-based coordination of national fiscal policies require discussions soon on the 2022 fiscal strategy. These should lead to a common understanding about whether the suspension of the fiscal rules should continue in 2022 and the appropriate stance for next year. Clarity is needed before summer 2021 as countries need to prepare their draft budgetary plans for 2022 and submit them to the European Commission and the Eurogroup by mid-October 2021.
And then the question arises: if a supportive stance is adopted, how long will it continue and how much will it cost?
Because of the need to avoid cliff-edge effects stemming from premature withdrawal of fiscal support, it seems likely that a certain measure of budgetary flexibility will be required in 2022.
This raises the question of when to reinstate fiscal rules and how to manage their reintroduction. It seems reasonable to assume that once the European Commission considers that the conditions for the application of the SGP’s general escape clause no longer exist, it will seek the endorsement of finance ministers, as it did in March 2020 when this clause was activated.
Important questions will include whether a decision on the timing of the resumption of the rules should be taken before summer 2021 or later, and if the resumption should be across the board or country-by-country. The answers will foreshadow the direction of travel of fiscal policy over the next five years at least.
It is worth noting that even whilst the SGP rules remain in abeyance, EU countries can still be subjected to the excessive deficit procedure (EDP). Such countries could even be requested to adopt plans with corrective measures to be implemented when the SGP escape clause is de-activated. The Commission however took the clear view that this was not warranted in 2020. It remains to be seen if this will be the case for 2021 and, importantly, for 2022.
Such a course of action could be seen as a preparation for future consolidation. On the other hand it could send the wrong signals – that there will be premature tightening – about the future course of fiscal policy.
Even if the SGP’s escape clause were to remain activated in 2022, the Eurogroup will want to discuss the appropriate fiscal stance for 2022 within this flexibility. Budget preparations for 2022 will still take place under conditions of higher than usual uncertainty, but whether the fiscal stance should be supportive or strongly supportive needs to be agreed.
In the interest of signalling and possibly anchoring a medium-term orientation for fiscal policies, should a supportive stance of fiscal policy be agreed only for 2022, or possibly beyond? If so, what would the target variable be, and would it be country-specific or for the euro area as a whole?
Should the rules be reformed now, later or much later?
In February 2020 – on the eve of the pandemic – the European Commission started a public consultation on reviewing EU economic governance. The pandemic interrupted the debate but it is expected to resume in the coming months.
The present rules are generally considered unclear, hard to implement, and neither politically sensible nor economically meaningful. Fiscal policy prescriptions given to member states that are based on cyclically adjusted economic developments, on potential output, have always been contentious and will be economically meaningless as Europe emerges from a crisis that makes estimating potential output developments little more than guess work.
It is relatively clear what the alternatives are to the current rules, but minds need to be made up.
One approach would be to strengthen the no-bail out clause in the EU Treaty. The policy changes and reforms of the last decade, from changes to the monetary policy framework to the setting up of the European Stability Mechanism, have however made the no-bail out clause somewhat meaningless.
More realistic alternatives would be to focus on expenditure-based rules, and/or rules that concentrate on adjustment paths for different debt levels. The European Fiscal Board has made a number of eminently sensible contributions to this debate, balancing good economics, practical applicability and the question of political acceptance.
There will of course be some who want simply to return to the old rules, even if it is not quite clear what that would mean given the numerous escape clauses, exceptional circumstances and other wrinkles that have made the SGP the bureaucratic exercise it has become.
Finally, as a fourth alternative, some EU countries might choose to stick largely with the current set of rules but agree to apply them somewhat differently. One obvious candidate for change would be the rule that requires member states with debt levels beyond 60% of GDP to bring them down by 1/20th of that excess value per year. For Italy currently, that would imply bringing debt levels down by an unrealistic and hard-to-enforce three percentage points of GDP per year.
On timing of the various alternatives: Should a possible revision of the rules be settled and agreed well before normalisation – by and large – sets in? Alternatively, this question could be put to one side, increasing the pressure on those member states that might be reluctant to agree to a common interpretation or strategy.
Tackling debt levels
There will be vigorous debate on whether debt levels should be brought down, stabilised or ignored. This debate needs also to be seen against the background of climate-related financing needs, which even with a well-functioning European capital market (which is not in sight) will place significant additional demands on public budgets.
In this debate, low costs of debt servicing and the option of locking in ultra-long maturities contrast with arguments of non-linear reactions of markets, risk management aspects and regaining room for manoeuvre for future crises.
Even among those who see a need to reduce debt levels, there are at least three different schools of thought: start soon; wait until interest rates start ticking up; make it state-specific. None of these approaches are likely to have a huge impact on today’s debt sustainability calculations. However, these approaches would bring about very different fiscal policy frameworks for the euro, meaning very different market perceptions.
Recent episodes show that market participants are more sensitive to redenomination or fragmentation risks than to debt sustainability risks, but it remains to be seen how long this would hold after a ‘normalisation’ of monetary policy.
Lastly, agreement on debt reduction will need agreement on a common debt-reduction approach
The easy path to debt reduction is to model higher growth rates for the medium term: as long as growth rates are significantly higher than interest rates the problem is solved. Given the highly uncertain rates of potential output growth in Europe this is politically attractive for those who wish to delay and do less.
Increasing revenues will remain a weapon of choice at the margin given tax levels in most member states. Even making headway on desirable new taxes, from digital levies to carbon tariffs, will quantitatively not change the picture hugely. Changes in EU countries’ tax structures will anyway be necessary if environmental footprints are to be reduced, and potential growth rates should be supported by growth-friendly tax reforms.
Given these constraints, across-the-board expenditure restraint or cuts will be at the front of many policymakers’ minds. This tends to be an economically questionable choice as cuts usually impact asymmetrically on investment and expenditure categories that support long-term growth, such as research and education. Protecting ‘good’ investment in a framework of responsible fiscal policy is not easy.
Finally, doing more and better with less – known among insiders as the quality of public finance – will be a necessary element. While highly attractive in policy discussions, this is an issue which involves politically difficult and very determined action to overcome entrenched interests. Increasing the efficiency of public-sector operations while spending less is vital if one wants to ‘build back better’ and lift potential output growth.
However, it requires politicians to invest a large part of their political capital, and requires stable parliamentary majorities – ideally over a number of electoral cycles – and cross-party agreement on national strategies. Examples in practice are few and far between, though where programmes on quality of public finance have been implemented, they appear to have generated benefits for both growth and fiscal sustainability.
A call to action
For a euro-area fiscal policy framework that works economically and is well received by markets, member states need to know what they really want, and make up their minds fairly rapidly, even if only internally for now. The Commission will be divided on the questions summarised in this blog post, which does not bode well for clear and concise processes. The Eurogroup must therefore have a very clear and focused debate on these issues, which will take time to resolve.
Even if Brussels-level discussions work out well, success must be achieved on the ground, and for that to work, all member states, especially the high indebted, must have national pacts on policies and timelines in order to convince partners and markets. It worked between 1995 and 2000 in many countries, in preparation for the launch of the euro. Today there is no similar strong incentive but a common approach to national public debt reduction, underpinned by strong national ownership, could be facilitated by progress on risk sharing, or by building on the NGEU Recovery and Resilience Facility.
Wieser, T. (2021) ‘The post-coronavirus fiscal policy questions Europe must answer’, Bruegel Blog, 3 February