Accumulated vulnerabilities in the European economy limit stability and resilience and make it difficult to tackle existing economic challenges. Next to high private and public debts, there are declining growth potential and faltering convergence of growth among EU member states. Moreover, the European economy suffers from the doom loop between governments and banks, a protracted accommodative monetary policy with harmful side effects, and a lack of diversification of activity financing. What’s more, these vulnerabilities interact with each other. For example, the limited growth potential makes it difficult to reduce high public debt. Addressing existing vulnerabilities will help the EU handle major future economic challenges, such as the costs of population ageing and the
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Accumulated vulnerabilities in the European economy limit stability and resilience and make it difficult to tackle existing economic challenges. Next to high private and public debts, there are declining growth potential and faltering convergence of growth among EU member states. Moreover, the European economy suffers from the doom loop between governments and banks, a protracted accommodative monetary policy with harmful side effects, and a lack of diversification of activity financing. What’s more, these vulnerabilities interact with each other. For example, the limited growth potential makes it difficult to reduce high public debt.
Addressing existing vulnerabilities will help the EU handle major future economic challenges, such as the costs of population ageing and the climate transition. Reducing existing vulnerabilities will also increase the economy’s resilience to major economic shocks.
High public debt
One of the most fundamental vulnerabilities of the European economy is high levels of public debt, which reduce the space to respond to future economic challenges, make governments’ finances vulnerable to interest shocks, and undermine the ECB’s ability to respond to increasing inflation. Handling a crisis often requires substantial buffers. For example, half of the financial sector crises in OECD countries produced increases in government debt-to-GDP ratios (‘debt ratios’) of at least 20 percentage points of GDP (European Commission 2021). Because future economic developments are so uncertain, it is important to maintain a sufficiently large buffer.
While average debt is high – on average, 100% of GDP in 2021 in the euro area – the spread is as important, as vulnerabilities are disproportionately driven by the extremes. In the relatively benign period between the euro area debt crisis and the COVID-19 crisis, the debt ratios of the most-indebted countries hardly fell. These were precisely the countries that saw the largest increase in debt ratios during the COVID-19 crisis, by around 20 percentage points on average, compared with average increases of around 13–11 percentage points for medium- and low-debt countries (European Economy Expert Group 2021; see also Figure 1). The increasing divergence in debt ratios was the net result of automatic stabilisers (in particular, lower tax income), negative growth (denominator effect), and discretionary measures to mitigate the impact of the crisis.
Hence, a credible strategy to reduce the highest debt ratios is of crucial importance for the functioning of the EU economy. It will also help reduce divergences among member states. After all, differences in debt ratios create differences in the national fiscal space available for stabilising economies after a shock and financing growth-promoting spending.
Figure 1 Debt developments by country group
Note: Countries are grouped based on their average debt levels in 2011-2019. Country mnemonics are official ones.
Source: European Fiscal Board.
Debt reduction: Replacement of the 1/20th rule
The Stability and Growth Pact (SGP) requires countries to cap their debt at 60% of GDP. If debt exceeds the 60% level, the ‘debt-reduction rule’ requires the country to reduce the difference with the 60% level by 1/20th annually. However, compliance with these requirements is poor (e.g. European Fiscal Board 2019).
While there is no good economic motivation for the 60% reference value, we propose leaving it unchanged as it provides a visible anchor and it would prove politically difficult to change. It seems better to replace the 1/20th rule, which for many countries will pose an unrealistic requirement once bounce-back growth from the pandemic is over. Changing the rule will ‘only’ require a unanimous change to secondary legislation, by a set of agreements among countries in which they commit to a suitable degree of debt reduction over the medium term. Part of the agreement will address the monitoring of the debt reduction and the commitment devices to be deployed (e.g. the legal anchoring of the agreed debt path).
A more countercyclical expenditure rule
Good rules and, in particular, their implementation must encourage countercyclical policy and, by extension, the accumulation of high debt (e.g. Debrun et al. 2008, Barnes and Casey 2019, Thygesen et al. 2021, Larch et al. 2021). Therefore, our second proposal is to adopt an expenditure rule to replace the requirement to achieve a certain structural balance in the medium term. The structural balance is not directly observable and relies on the hard-to-measure output gap. Moreover, it bears no direct relationship to the necessary debt reduction.
The European Fiscal Board (2018) has proposed an expenditure rule in which the maximum expenditure growth (corrected for discretionary revenue measures and cyclical spending) is related to potential growth, with an adjustment in line with the committed debt reduction.1 The permitted maximum expenditure growth is set for the period until the debt reduction path is reset. Revising the permitted expenditure growth less frequently reduces policy uncertainty. While potential output is unobservable, potential growth suffers from less measurement error, as the latter largely washes out by taking (log) differences.2
The advantages of the proposed rule are that expenditure growth is an observable control variable of the government, while the link to potential growth has a stabilising effect: when actual GDP growth is below potential growth, expenditure can grow faster than actual GDP growth and vice versa (adjusted by the component required to reduce debt, if necessary). This way, the ceiling gives room to the automatic stabilisers from both the spending and revenue sides. Setting the expenditure ceiling based on nominal growth would allow for additional stabilisation when demand shocks dominate (Lane 2021): when demand is low, actual inflation undershoots its forecast, and spending is allowed to grow even faster relative to actual output.
More independent oversight of compliance with the fiscal rules
Our third proposal aims for more independent oversight of compliance with the fiscal rules, by sharper separation of the responsibilities within the European Commission. The Commission is responsible for both macroeconomic and budgetary projections and making recommendations. Hence, technical analysis and political assessment take place under one roof.
Proper institutional organisation of oversight becomes all the more important, however, if extra flexibility is granted to take account of country-specific situations, as in the case of differentiation in debt reduction paths, or when a general escape clause is introduced (as proposed by the European Fiscal Board 2018). Assessing whether the general escape clause can be invoked requires independent advice produced by independent analysis, which need not be followed by the political level of the European Commission, as long as the Commission publicly explains it is not being followed. A ‘Chinese wall’ separates the analysis and advice from the recommendation phase. An alternative would be to allocate the analysis and advice to an independent external entity with its own sufficient resources.
Compliance with the rules can also be improved by strengthening the national independent fiscal institutions (IFIs). This can be achieved in several (complementary) ways:
1) Increase (the security of) their funding.
2) Assign IFIs to produce macroeconomic projections. A majority of IFIs only consents to the government’s projections; allowing IFIs to make these projections would increase the reliability of the macro forecasts (by reducing potential systematic bias in the forecasts) and enable the IFIs to build critical analytical mass and expertise in this area.
3) Task IFIs to make their own budgetary projections. Deviations from the government’s projections would require the latter to explain the source of these deviations.
4) Strengthen the ‘comply-or-explain’ rule: if the government must explain in greater detail why it does not follow a certain recommendation, it is forced to take the recommendation seriously.
5) Improve coordination among IFIs (they could, for example, align their analyses and reporting templates).
6) Mandate IFIs to assess the government’s (proposed) debt reduction path and whether deviations from the committed path are justified (see also Martin et al. 2021).
Despite all the potential improvements, EU fiscal rules and central surveillance would remain necessary, as cross-border spillovers need to be internalised.
Link between compliance with fiscal rules and financial instruments
Our fourth proposal is to substitute ‘negative’ incentives, i.e. penalties for non-compliance with the fiscal rules, with ‘positive’ ones in the form of access to financial instruments. Financial sanctions have proved politically difficult to impose, while they likely work out pro-cyclically. An alternative is to reward compliance.
Current examples are of countries given access to the European Stability Mechanism (ESM) precautionary credit lines (loans) or the EU Structural and Cohesion Funds (grants) if they fulfil relevant conditions. A similar link was foreseen for the European Investment Stabilisation Function, for which the Commission tabled a proposal in 2018 but on which no agreement was reached.
Conditions to access new EU arrangements could be tighter than a formal adherence to the SGP. In the negotiations on the new ESM Treaty, Germany and the Netherlands insisted that mere compliance with the SGP be insufficient for a country to access the existing Precautionary Conditioned Credit Line. Instead, countries must adhere to firm, quantitative criteria. Although the SGP parameters (3% of GDP for a deficit, 60% of GDP for debt, 1/20th rule for debt reduction) are used as criteria, no reference is made to compliance with the Pact. For example, a country not involved in an excessive deficit procedure but not compliant with the 1/20th debt-reduction rule could still be denied access to the Precautionary Conditioned Credit Line.
A very narrowly defined link between the fiscal rules and collective facilities would still have limited effectiveness. Once countries have gained access to a facility, it will be more difficult to deny them future access based on poor compliance with fiscal rules. Financial markets could overreact to such a denial. Furthermore, to make compliance with the rules more attractive, there must be no alternative, more easily accessible public-financing vehicles. For example, if access to the ESM Precautionary Conditioned Credit Line is tightened, this may increase pressure on the ESM Enhanced Conditions Credit Line.
A European climate investment fund
Reducing high public debt should not be a punishment; it frees up space to absorb adverse shocks and make growth-enhancing expenditures. In particular, reducing high public debt would generate room (by creating budgetary buffers and by stimulating political support especially from lower-debt countries) for an EU climate fund that could raise stable economic growth, enhance the sustainability of the European economy, and promote economic convergence among member states.
To be clear, the climate fund would not entail tweaking the fiscal rules to allow more green public investment (e.g. Pekanov and Schratzenstaller 2020). Such a ‘green golden rule’, which excludes investment from the deficit measure relevant for the SGP’s 3% reference value, could pose a risk to the sustainability of public finances and would limit the integral budget assessment. Moreover, governments will use their creativity to ‘greenwash’ expenditures, especially when they are under budgetary pressure. In fact, empirical evidence on the link between fiscal rules and investment levels – which could justify a green golden rule – is weak. For developed economies, there is little evidence that fiscal rules as such limit investment (Basdevant et al. 2020). Structural factors such as inadequate implementation capacity, poor governance, and weak institutions are more important reasons behind lagging investment.
A European climate fund would allow for joint expenditure to green the European economy. These are one-off investments that are necessary now to make the transition to a net-zero-emission economy by 2050. The fund could initially focus on investments made before 2030. This expenditure would fall outside the regular national budgetary framework and therefore not come at the expense of a country’s other expenditures.3 Ideally, this climate fund would replace the patchwork of national climate plans.
Indeed, the EU budget delivers most added value when it is used to finance public goods with clear cross-border spillovers, in line with the subsidiarity principle, thus benefitting the EU as a whole. Examples are investments in innovation and fundamental research, as well as climate investments. Some climate-related investments are so sizeable that the cost is prohibitive for any individual country, especially when the benefit is enjoyed more widely – which makes economies of scale particularly relevant. This is likely the case for power grids for sustainable electricity, hydrogen infrastructure, and high-speed railways. Moreover, such investments at the EU level have the potential to raise long-term growth in the entire area.
The need for a European climate fund seems less obvious if the EU opts to uniformly price greenhouse gas emissions. A (sufficiently high) carbon levy on all emissions rewards the most innovative and creative entrepreneurs, who can reduce emissions at the lowest cost. More expensive polluting technology will be driven out by cleaner technology. Uniform pricing can only be brought about when collectively decided at the level of the EU.
However, the carbon levy does not overcome the high fixed cost of infrastructure investment, implying that the climate fund would serve a useful independent role. In fact, the carbon levy can be used to help finance the fund. Moreover, targeted investments financed by the climate fund can overcome the resistance of members states that stand to lose from the carbon levy, for example, because a substantial part of their workforce is active in polluting industry.
Authors’ note: The authors are members of the Dutch Independent European Economy Expert Group (2021). Their report, commissioned by Dutch government, outlines possible action strategies for the Dutch government in order to contribute to making the European economy more stable, robust and resilient. Baarsma is CEO of the Rabo Carbon Bank and Professor at the University of Amsterdam. Beetsma is Professor at the University of Amsterdam and Member of the European Fiscal Board. The views expressed here do not necessarily represent those of any institutions they are affiliated with.
Barnes, S, and E Casey (2019), “Euro area budget rules on spending must avoid the pro-cyclicality trap”, VoxEU.org, 17 June.
Basdevant, O, T Chaponda, F Gonguet, J Honda and S Thomas (2020), “Designing fiscal rules to protect investment”, in G Schwartz, M Fouad, T Hansen and G Verdier (eds.), Well spent: How strong infrastructure governance can end waste in public investment, IMF.
Bénassy-Quéré, A, M Brunnermeier, H Enderlein, E Farhi, M Fratzscher, C Fuest, P Gourinchas, P Martin, J Pisani-Ferry, H Rey, I Schnabel, N Véron, B Weder di Mauro and J Zettelmeyer (2018), “How to reconcile risk sharing and market discipline in the euro area”, VoxEU.org, 17 January.
Claeys, G, Z Darvas and A Leandro (2016), “A proposal to revive the European fiscal framework”, Bruegel Policy Contribution No. 2016/27.
Darvas, Z, P Martin and X Ragot (2018), “The economic case for an expenditure rule in Europe”, VoxEU.org, September 12.
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European Fiscal Board (2019), Assessment of European fiscal rules with a focus on the six and two-pack legislation.
Lane, P R (2021), The future of the EU fiscal governance framework: A macroeconomic perspective, panel intervention at the European Commission webinar “The Future of the EU Fiscal Governance Framework”, November 12.
Larch, M, E Orseau and W van der Wielen (2021), “Do EU fiscal rules support or hinder counter-cyclical fiscal policy?”, Journal of International Money and Finance 112.
Martin, P, J Pisani Ferry and X Ragot (2021), “Reforming the European fiscal framework”, Note No.63, French Council of Economic Analysis.
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Thygesen, N, R Beetsma, M Bordignon, X Debrun, M Szczurek, M Larch, M Busse, M Gabrijelcic, L Jankovics and J Malzubris (2021), “The EU fiscal framework: A flanking reform is more preferable than quick fixes”, VoxEU.org, 10 November.
1 The case for an expenditure rule has been made by others as well (e.g. Bénassy-Quéré et al. 2018, Darvas et al. 2018).
2 See also Claeys et al. (2016).
3 Of course, expenditures out of the fund should be financed. However, the financing can be spread over time by issuing EU debt that can be serviced with the EU’s future resources or additional future contributions by member states.