It's Groundhog Day for EU fiscal rule reform

A desperately needed reform of the EU’s fiscal rules is finally underway.

The current rules are too complicated — they impose unrealistic demands on some countries, and they lead to overspending in economic booms and austerity in recessions. Unsurprisingly, member countries barely adhere to them, and they just mandated the European Commission table legislation to address these flaws.

For a long time, the European Union pretended that enforcing fiscal rules was a technocratic exercise, hiding political questions behind technical details. But the Commission’s original proposal, tabled in November, opened the door for more workable rules and better enforcement. It did away with rules that took little account of macroeconomic conditions or political realities, and it replaced them with multi-year debt-reduction plans individually negotiated with member countries, enabling them to take ownership of their own plans.

However, hawkish member countries, led by Germany, are now seeking to water down the Commission’s attempts to make the rules more sensible. Worried about a larger role for the Commission, these frugal members want to go back to inflexible numerical debt-reduction targets that apply to everyone. But much like Groundhog Day, the EU will only go around in circles, ending up with the same dysfunctional technical exercise.

Hard-wired numerical rules that lead to strict automatic enforcement don’t take unforeseen crises — like Russia’s invasion of Ukraine or COVID-19 — into account. In the past 20 years, the eurozone has lurched from recession in the early 2000s to stable growth, to disinflation with low-trend growth, then to a recent phase of high inflation. Codified rules cannot keep pace. And tensions between such economic realities and closely following the rules have increasingly given rise to a flexible but opaque interpretation of the fiscal framework.

The enforcement of European fiscal rules is ultimately a political process.

Technocratic institutions like independent fiscal councils, which advise governments on fiscal sustainability, can play an important role in forecasting the effects of policy, but they cannot be the enforcers. They lack the legitimacy and power to press a democratically elected government to adjust its budget. Only the Commission, with sufficient backing from the Council — which can apply “peer pressure” — has the potential to do that. And hamstringing them with codified numerical benchmarks ignores these political realities, once again forcing the Commission into weakly enforcing the rules, or failing to do so at all.

But member countries are right that blind trust in the Commission isn’t sufficient — its proposed reforms need to be improved by a savvier enforcement process.

Thus, the objective of the new framework should be the prevention of dangerous fiscal policy errors — not fine-tuning policy. And in order to avoid Brussels nit-picking about policy details, the Commission should avoid getting involved with countries where the debt trajectory is clearly on a safe path, only intervening in cases where there’s a reasonable suspicion that a gross policy error may be in the making.

Currently, the Commission proposes that countries with high debt should come up with a plan to get their debt falling after four years. But these countries can get another three years in exchange for growth-boosting reforms and public investment — which is seen as too lenient. However, there’s also little incentive for a government with a year to go before elections to try and satisfy Brussels. Countries’ fiscal plans should thus cover a shorter period, such as two or three years, so that a government can reap the rewards of good policy while still in office.

Moreover, the fact that sanctions have never been used in this manner is also portrayed by hawks as undue laxity from the bloc’s institutions. But in reality, this simply reflects that the political cost of imposing fines on fellow EU countries is too high — and making the fines smaller won’t make them more credible. However, it is true that stand-offs between Brussels and capitals over fiscal policy do feed into higher government borrowing costs. Enforcement actions should, therefore, be recast as signaling devices to bond markets when budget policy is on the wrong track, even if fines won’t be imposed in practice.

Finally, enforcement would become more credible if some EU funding was only disbursed when governments ran sustainable fiscal policy. So far, the Commission has steered clear of proposing a fiscal capacity to that effect, but after the 2024 European elections, the bloc will start mulling the future of its regular budget, and its already considering new fiscal instruments for industrial policy. Such a commitment to turn a portion of future funds into carrots for rule compliance should be part of an agreement on revamped rules.

Overall, rearguard action by the frugals may well return the EU to the ancien regime of political conflict being hidden within overly opaque, complex and inflexible formulas, with weak enforcement. As the EU starts legislating its fiscal reforms, however, it should think more creatively about ways to avoid egregious policy errors — not only on paper but in practice.

Sander Tordoir is a senior economist at the Centre for European Reform. Jasper van Dijk is the head of research for the Instituut voor Publieke Economie in the Netherlands.