Looming Reform Of EU Debt And Deficit Rules: A Look At Current Rules

By János Allenbach-Ammann

(EurActiv) — With the European Commission expected to put forward its ideas for the reform of the much-criticised fiscal rules for EU member states on Wednesday (9 November), EURACTIV takes a look at the current rules and explains why they are criticised.

Initially, common EU fiscal rules became necessary with the introduction of the single currency because it streamlined the monetary policy for the currency union. This meant that member state governments could not unilaterally devalue their currency to reduce their debt burden.

But fiscal policy remained mostly the remit of member states. meaning national governments decided alone about budget deficits and state borrowing.

Many economists argued that only a fiscal union could overcome the mismatch problem of a European monetary policy coexisting with national fiscal policy but there was not enough political will to give up much national sovereignty over fiscal policy.

In this tension between national sovereignty and economic requirements and doctrine, a web of rules has developed to govern member state finances.

The rules

Since 1994, the EU treaties have enshrined an upper limit to the debts and deficits of member states relative to their economic output. Their debt-to-GDP ratio should not exceed 60% and their annual budget deficit should not be higher than 3% of GDP.

Three years later, the “Stability and Growth Pact” (SGP) introduced a process to enforce the fiscal rules by creating the “excessive deficit procedure”, under which EU member states running too high a deficit will have to follow a path of budget adjustment, with possible fines in case of non-compliance.

In the wake of the global financial crisis and the euro crisis, the EU further tightened the fiscal rules by introducing the 1/20 rule and the expenditure benchmark, among other measures.

The 1/20 rule, applying to countries with debt levels above the 60% target, determines that these countries have to reduce their debt-to-GDP ratio by at least 1/20^th of the difference between their current debt-to-GDP ratio and the 60% target every year.

The expenditure benchmark should restrain the net growth of government spending by requiring governments to match all spending increases that go beyond a country’s medium-term potential economic growth by additional government revenues, for example, tax increases.

However, the EU also introduced the “general escape clause”, which allowed the deactivation of the fiscal rules in times of economic turmoil. This escape clause was triggered in the wake of the COVID-19 pandemic and will remain active at least until 2023.

The Criticism

The rules have long been the subject of criticism, which has become louder in recent years. In a 2021 survey of 41 top macroeconomists, 40 of the academics agreed or strongly agreed that the existing fiscal rules required revision.

On the one hand, the supporters of low public spending and debt levels complained that the rules are not enforced strictly enough and that EU member states always find ways to consolidate their budgets less than would be necessary to reduce debt levels.

On the other hand, supporters of more budgetary flexibility argue that the fiscal rules restrain public investments necessary to promote economic growth. They argue that if the goal is to reduce the debt-to-GDP ratio, countries should focus on increasing GDP instead of reducing debt levels, in other words, grow out of debt.

Whichever political view one has on fiscal rules, they do not seem to have delivered either stability or growth. Especially southern EU countries like Greece and Italy have had dismal growth figures in the past decade and their debt levels increased further.

The average debt-to-GDP ratio in the EU was at 87.9% at the end of 2021, much higher than the 60% target enshrined in the treaties.

High debt levels in some countries also make the observance of the 1/20 rule close to impossible. With a debt-to-GDP ratio of 194.5%, Greece would have to reduce the ratio by 6.7 percentage points every year to be in line with the rule.

Another point of criticism is levelled at the expenditure benchmark because it relies on the concept of potential economic output. The potential economic output is a theoretical construct that is hard to verify.

Moreover, it is calculated based on past data, with a risk of perpetuating its own mistakes. If the potential output is calculated too low, government spending is limited to a level that is too low as well, making it hard for the government to stimulate the economy and growth.

Many of these problems were acknowledged by the Commission when it relaunched the revision of the macroeconomic governance framework in October 2021. On 9 November, it is expected to present how the fiscal rules should be changed in response to this criticism.