The agreement on how to reform the Stability and Growth Pact requires a meaningful rethinking of the EU budget.
Originally written for IEP@BU – Institute for European Policymaking @ Bocconi University. Original link: https://iep.unibocconi.eu/new-eu-economic-governance-framework-raising-stakes-eu-integration
Few endeavours could be expected to be as polarizing as the reform of the EU economic governance framework. After more than six months of negotiation, EU economic and finance ministers managed to get a deal over the finishing line, just in time for Christmas. As with Christmas gifts, however, not all that shines is gold. While the agreement is a step forward, it will not be enough for the EU to achieve its strategic goals, absent a meaningful rethinking of the EU budget. As such, this agreement further increases the stakes for EU integration going into the 2024 parliamentary elections.
The European Commission’s proposal for a reform of the EU economic governance framework was published in April. Overall, the spirit of that proposal was to simplify the preventive arm of the Stability and Growth Pact (SGP) and to increase the structural flexibility naturally embedded in the system, while strengthening the effectiveness of the corrective arm in the Excessive Deficit Procedure (EDP).
The central tenets of the Commission proposal have been retained in the final agreement, and this is a positive achievement.
The new framework has a higher degree of built-in flexibility. By tailoring fiscal adjustment to the situation of individual countries, the reform overcomes one major issue with the previous set of rules – namely the excessive use of flexibility clauses to soften the otherwise too strict and uniform adjustment paths. The focus on net expenditure will make the framework less pro-cyclical and more transparent, reducing reliance on the often-criticized output gap estimates.
Based on the European Commission forecasts for 2024, approximately 17 of the 27 EU members will be in breach of either the 60% debt ratio or the 3% deficit limits at the time when the new framework will enter into force. Under the new rules, the Commission will set a technical trajectory for the net expenditure of these countries, covering an adjustment period of 4 years with a potential 3-year extension. The trajectory will be risk-based and differentiated for each Member State, provided that the resulting adjustment puts debt on a “plausibly downward path” and deficit is brought below 3% of GDP.
While the choice to evaluate debt sustainability in a state-contingent manner is a welcome move away from mechanical dogmatism and towards a proper risk management approach, the achievement is tempered by the re-introduction of fixed thresholds in the form of debt and deficit “safeguards” (see figure 1).
Countries with debt above 90% will need to cut by 1% per year (0.5% for countries with debt between 60% and 90%) and to bring the deficit down to 1.5% of GDP in structural terms, at a speed of 0.4% per year over 4 years or 0.25% per year over 7 years. Countries with a deficit larger than 3% of GDP would fall under the corrective arm and be required to adjust by 0.5% of GDP annually in structural terms – although they will be able to carve out interest payments for the 2025-27 period.
In the short term, the aggregate EU fiscal stance will be less constrained than it would have been if the original SGP provisions had been switched on unchanged. 12 countries will find themselves in the corrective arm, but they will be able to benefit from the carve out of interest costs from the adjustment. In the case of Italy, for example, the structural adjustment pinned down in the government’s budget for 2025 and 2026 would already be fully in line with the required adjustment under the new rules.
The medium term however is more concerning. While less draconian than the previous regime, the combined effect of safeguards can become constrictive on the fiscal stance when countries get back in the preventive arm. The case of Italy again illustrates this well, as the country’s structural primary balance requirement would increase to 4% of GDP after all safeguards are accounted for.
The lack of carveouts for investment expenditure risks disincentivizing investment at the national level, precisely at a time when investment will need to be massively ramped up to meet EU objectives on strategic priorities. It currently seems that hopes for Next Generation EU to morph into a federal spending capacity are delusional, and while the talks on the Multiannual Financial Framework of the EU are paused until next year, the latest negotiation box points towards a reduction (rather than increase) of the central funds allocated to strategic EU spending. In the current geopolitical junction, EU-level public goods such as climate, technology, and security, cannot remain underfunded. That would pose an existential threat to the EU. Whether knowingly or unknowingly, by signing off on a sub-optimal new economic governance framework for national fiscal policy EU economic ministers have in fact raised the stakes on the whole process of EU integration.
Silvia Merler, Head of ESG & Policy Research (Algebris Investments)