A new start for Europe’s stability and growth pact

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

Greetings. This is my last newsletter before Christmas, but fear not — my colleague Valentina Romei will step in for uninterrupted Free Lunch service next week. I will be back in the new year. As we prepare for the festive season, can I ask you to read our deputy editor’s missive about the FT’s charity work on financial literacy and inclusion? If you are moved to contribute to the cause — or just need to find a unique present for someone (or yourself) — please consider bidding for lunch with one of our columnists, including yours truly. With that, let me wish you peaceful holidays and a happy new year.

White smoke at last! EU finance ministers last night agreed how to reform the bloc’s fiscal rules, which have been in suspension since 2020 and have been maligned for much longer than that. To master the details, even EU economics nerds will need to spend some time going through the legislative texts. But here is how I would describe the new rules in a nutshell.

There is one overarching conceptual change. The previous rules applied the “reference values” in the EU Treaty rather literally, with too little consideration of the economic context. This obliged all countries to get public debt below 60 per cent of gross domestic product and the budget deficit below 3 per cent of GDP, requiring tougher consolidation the further they fell short, to the point of counterproductive and unrealistic policy advice.

The new rules differentiate countries by their starting point, growth prospects and content of public spending, requiring them principally to put debt on a downward trajectory after an adjustment period. This requirement is formulated through a single indicator rather than the previous multiplicity of constraints: an agreed path for annual government expenditures net of interest and cyclical and one-off measures.

Out go the blind numerical rules, in other words, in come forward-looking debt sustainability analyses, country differentiation, and an option to extend the adjustment (from four to seven years) if a country adopts reforms and investments expected to boost growth.

However (there is always a “however”), at the insistence of Germany and some other “frugal” countries, elements of the old system were added back in, in the form of “safeguards” to prevent the agreed expenditure paths from being too soft. The result is a hybrid system, where the new approach has old-style numerical constraints bolted on, and whichever is more binding applies. High-debt countries will need to reduce their debt ratio by an average of 1 per cent of GDP per year throughout the adjustment period (less for medium-debt ones). And beyond the adjustment period, deficits should get within 1.5 per cent of GDP to keep a “safety margin” to the old 3 per cent limit. The “excessive deficit procedure”, the EU’s naughty corner for fiscal violators, remains, requiring annual structural deficit cuts of 0.5 per cent of GDP.

Again “however”: countries worried about being caught out as the rules snap into force have negotiated transitional arrangements whereby rising interest costs and EU-funded post-pandemic recovery plan investments will be exempt from the calculations until 2027.

Taking it all together, how should we judge the reform? The original motivation, remember, was that the old rules were ineffective, too complex and often encouraged bad economic policy like procyclical budgets and skimping public investments.

On the surface, one could argue all the effort has not come to much. The blind numerical rules remain. And some are very strict indeed: according to the last figures I have seen, a 0.6 per cent of GDP cumulative deviation from the agreed expenditure path over the adjustment programme (which, remember, can last seven years, so less than 0.1 per cent per year) is enough to trigger a reaction.

In addition, the higher-debt countries failed to get acceptance for either a “golden rule” or a carve-out for investment spending, as many of them had wanted. And they traded stricter discipline in the long term for short-term flexibilities — which is really not the way one should approach a system of rules that should have some staying power.

So if the outcome is austerity 1-investment 0, we have ended up in a bad place. But that would be unfair. While blindly numerical rules remain, they are on the whole looser than before, is the argument heard in some high-debt government circles. And that is true. The notorious 1/20 rule is gone (it demanded debt ratio reductions of 1/20 of the excess above 60 per cent every year — which implied 5 per cent of GDP debt reduction per year for Greece, 4 for Italy, and 3 for France, Spain, Portugal and Belgium). A 1.5 per cent deficit “safeguard” replaces a medium-term requirement for structural near-balance. So there is more room for deficit spending, which one must hope will be used for investment.

There is some beauty in the eye of the beholder, of course. Note how our coverage leads on Germany getting its way on tough numerical constraints, while Reuters describes the agreement as a “deal for more lenient fiscal rules”. The focus naturally varies with how each government can sell the deal as a victory at home.

But this distracts from what I see as the more profound improvements. The long haggling over precise numerical parameters has distracted from the fact that the biggest changes are institutional:

First of all, countries will now have to prepare multiyear fiscal, reform and investment plans and the EU-level discussion will focus on these, not year-by-year budgets. National fiscal councils will have a role in assessing them. Second, when a government changes, it may update the fiscal plan it inherits. Third, both new and revised plans must be justified to the commission and the EU Council. Fourth, in the excessive deficit procedure a number of “relevant factors” can be invoked, including green, digital and defence priorities. Fifth, there is now a country-specific escape clause that would suspend the rules in the case of a serious downturn afflicting only some countries.

Put all of this together, and a very different process emerges for how capitals engage with their peers and with the EU over national budgets from the previous “computer says no” system. The new set-up should encourage a more open back-and-forth, based on economic arguments, about how best to achieve the common goals of sustainable budgets and growth. There will be both more national ownership and more European politics, in other words. The essence of the problem with the previous rules was precisely that they aimed to substitute algorithmic decisions for both ownership and politics. That was never going to be democratically sustainable — and therefore not ultimately conducive to either economic or fiscal sustainability either.

If the reform welcomes back sound democratic politics in budgeting, that will be a much greater achievement than the months-long quibbling over decimal points would make you think. It may even — fingers crossed — draw citizens’ interest back to what their economic policymakers do.

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