Propelled by changing assessments of what can and what should be done, fiscal policy follows a winding path between reality and ambition, occasionally marked by sudden realisations of what is sustainable and what is not. In the late 1990s and early 2000s, when the advance of fiscal rules was in full swing, the mainstream had converged on the understanding that numerical limits had to be imposed on budgetary aggregates to keep public finances on a sustainable path. The consensus even found a very powerful image rooted in an ancient European legend (Debrun et al. 2008): Ulysses tying his hands to the mast of his ship, lest he fall for the bewitching songs of sirens and sink his vessel together with his chums.
Two decades on, the debate on the future of the EU’s fiscal rules takes place against a very different narrative. We had to learn that not all leaders are ready to have their hands tied when it comes to fiscal policy. To be clear, the majority of observers and policymakers still profess a devotion to rules as means to ensure sustainability, but an important camp sees either limited risks of sinking the ship and/or attaches bigger importance to stabilising the ship in choppy waters; and waters have indeed been choppy in the last 15 years.
To be more concrete, a growing number of pundits and politicians are taking issue with the debt rule of the Stability and Growth Pact (SGP). The rule requires member states to reduce the distance between the debt-to-GDP ratio and the 60% reference value by on average 1/20 per year over the previous three years. Under current circumstances, the argument goes, the implied annual adjustment is too demanding both from an economic and political perspective. In other words: tying oneself to the mast would sink the ship. So, why was the rule introduced in the first place and why has it not worked so far?
The EU’s debt rule: A sudden anti-hero?
The EU’s debt rule was introduced in 2011 as part of a broader reform package. The secular slowdown of economic growth had led to the realisation that keeping budget deficits below 3% of GDP would no longer be sufficient to ensure an adequate pace of debt reduction. At the time of the reform, the prevailing idea was rules and their implementation had been too loose and needed to be tightened to protect against the fiscal imbalances that had accumulated in the good years prior to the Global Crisis and painfully unwound after 2007. Naturally, some countries were less convinced about the specifics of the debt rule but the general sense that stronger rules were needed prevailed.1
In hindsight, the SGP reform introducing the debt rule was predicated on a sanguine view of things. First, the ambition to avert past mistakes, especially those made in the run-up to the Global Crisis, by improving public finances during economic good times, was excessive. The deep-seated asymmetry of launching a fiscal expansion at the slightest prospect of an economic slowdown, while overlooking opportunities for consolidation, turned out to be stronger in several countries (Larch et al. 2021). Second, the SGP reform aimed at strengthening enforcement. It introduced a full set of escalating sanctions for non-compliance. However, imposing sanctions turned out to be daunting in a multilateral setup – the Council never found the necessary majority to fine members who found themselves in dire straits. Third, while accepting the secular slowdown in economic growth, the reform assumed the pace of economic expansion would rebound across all EU member states after the Global Crisis.
And indeed, the pace of economic expansion did pick up markedly but in some euro area countries less than in others. In the single currency area as a whole, average nominal GDP growth moved from around 0.5% in 2009-2013 (the crisis years), to 3.2% in 2014-2019 (the recovery phase). In Italy, by contrast, nominal growth averaged only 1.8% in the recovery phase, when its implicit rate of interest on government debt stood close to 3%. Had the country enjoyed the same interest rate-growth differential as the euro area as a whole (-0.75%), the average primary budget balance needed to comply with the debt rule as of the year of its introduction would have been less than 2% of GDP, pretty much in line with the average primary balance recorded in Italy in 1999-2019.
However, actual numbers called for an average primary balance of close to 4% of GDP, levels that Italy (and Belgium too) had sustained prior to the introduction of the euro in the 1990s, but which were deemed hard to achieve after the Global Crisis. As a result, the Commission and the Council had agreed to play down the debt rule well before the Covid-19 pandemic pushed government debt levels to new highs. The focus of EU fiscal surveillance shifted towards making sufficient progress towards a safe budgetary position regardless of debt developments.2 Since this shift was decided while the recovery from the Global Crisis was in full swing, the cyclical improvement of nominal budget balances offered a deceivingly rosy picture of fiscal performance just before a new major shock struck; an unfortunate pattern observed before. Figure 1, which draws on the latest update of our compliance tracker, illustrates the point.3
Figure 1 Numerical compliance with the rules of the Stability and Growth Pact
Notes: ‘Deficit rule’: A country is considered compliant if, (i) the budget balance of the general government is equal or larger than -3% of GDP or, (ii) in case the -3% of GDP threshold is breached, the deviation remains small (maximum 0.5% of GDP) and limited to one year. ‘Debt rule’: A country is considered compliant if the debt-to-GDP ratio is below 60% of GDP or if the excess above 60% of GDP has declined by 1/20 on average over the past three years. ‘Structural balance rule’: A country is considered compliant if the structural budget balance of the general government is at or above the medium-term objective (MTO) or, the annual improvement of the structural budget balance is equal or higher than 0.5% of GDP. ‘Expenditure benchmark rule’: A country is considered complaint if the annual rate of growth of primary government expenditure, net of discretionary revenue measures and one-offs, is at or below the ten-year average of the nominal rate of potential output growth minus the convergence margin necessary to ensure an adjustment of the structural budget deficit of the general government in line with the structural balance rule.
Source: Compliance tracker of the European Fiscal Board Secretariat
Are not all fiscal rules anti-heroes in the long run?
To allow governments to mount a forceful response to the economic fallout of the Covid-19 pandemic, the EU decided in 2020 to de facto suspend all fiscal rules by activating the severe economic downturn clause. However, the prospect of returning to the current set of rules meets little enthusiasm in certain quarters. There has been a general sense of frustration with the EU fiscal rules for quite some time (Beetsma and Larch 2018), but member states are increasingly polarised about what should be done next.
As chances for a swift and radical reform of the EU’s fiscal rules are not improving, growing criticism is being levelled against the rule imposing the toughest constraint on fiscal policy: the debt rule. If applied to the letter, the rule would indeed require a frontloaded profile of fiscal adjustment, especially for countries with very high debt levels and low rates of economic growth. Figure 2 shows simulation results for Italy and Germany. Using the long-term macroeconomic projections of the Commission available at the time of writing, the Italian government would have to turn a current structural primary deficit of more than 2% of GDP into a surplus of 2¼% of GDP in 2023 and keep running such surpluses for the next ten years.4 By way of comparison, our simulations also present the adjustment implied by two other fiscal rules: the SGP’s structural budget balance rule and an expenditure rule proposed by the European Fiscal Board since 2018. These or similar simulations are taken as irrefutable evidence of how unrealistic the debt rule would be for certain countries.
Figure 2 Debt simulations for Italy and Germany
a) Government debt ratios
b) Cumulative adjustment effort (cumulative adjustment in structural primary balance relative to the baseline)
Notes: The ‘baseline’ scenario assumes no change in the structural primary balance after 2022. The ‘structural balance rule’ scenario assumes an annual adjustment of the structural balance of 0.5% of GDP from 2023 until the country’s Medium-Term Objective (MTO) is reached. The ‘debt rule’ scenario assumes an adjustment of the structural primary balance from 2023 that is consistent with the EU debt rule from 2025. The ‘expenditure rule (EFB 2018)’ follows a recursive approach: the growth rate of primary expenditure is re-estimated and fixed every three years with the aim to reduce government debt to 60% of GDP in the successive 15 years.
Source: European Commission, own calculations.
However, an immediate and strict return to the debt rule would be an unlikely proposition anyway. Since 2020, the EU has deliberately accepted increasing debt ratios by asking member states to run expansionary fiscal policies in response to the Covid-19 pandemic. Due to its backward-looking nature – the reduction of 1/20 is to be achieved on average over the past three years – an immediate and strict application of the debt rule would amount to an overt inconsistency in policy advice. A phasing-in arrangement would be necessary.
More importantly, Figure 2 highlights a point that usually falls by the wayside due to the short-term focus of the debate. If the ultimate objective is to achieve a given debt target over a given period of time, the overall adjustment effort is broadly the same across alternative fiscal rules. The SGP’s debt rule is more demanding in the initial phase but turns comparatively soft further down the road. In contrast, the SGP’s structural budget balance rule and the European Fiscal Board’s expenditure benchmark imply less demanding adjustments in the first few years but very demanding fiscal positions later on; in the case of the European Fiscal Board’s expenditure benchmark, in less than five years from now.
Hence, the real debate on fiscal rules is about compliance over time. It comes as no surprise that the debt rule has become increasingly unpopular, whereas the fan community of expenditure benchmarks has grown. The prospect of doing less now and leaving the hard bit for later is appealing. But what about the well-documented tendency in some countries to systematically shift adjustments into the future? Will the expenditure rule fall out of favour too once its back-loaded adjustment profile starts biting? The expenditure benchmark has many advantages; to sidestep a given debt reduction is not one of them.
In the current framework of multilateral EU surveillance, the effectiveness of fiscal rules ultimately hinges on the determination of national policymakers to stick to an agreed fiscal trajectory over an extended period of time. Some argue ownership will automatically improve as adjustment requirements become more realistic. This is well possible; the proof of the pudding is still in the eating.
In the Odyssey, it is Ulysses himself who decides to be tied to the mast and makes his crew put wax in their ears to avert disaster. Later on in the same legend, the outcome is different. When confronted with a new temptation, Ulysses’ men fall for the beguiling words of the enchantress Circe just to find themselves transformed into animals. Ulysses limits damage by accepting advice from Hermes. Let us assume, policy guidance collectively generated at the EU level can be this kind of advice in these challenging times for national public finances.
Authors’ note: The views expressed in this column do not necessarily reflect the official position of the institutions with which the authors are affiliated or for which they work.
Beetsma, R and M Larch (2018), “Risk reduction and risk sharing in EU fiscal policymaking: The role of better fiscal rules”, VoxEU.org, 10 May.
Debrun, X, L Moulin, A Turrini, J Ayuso-i-Casals and M S Kumar (2008), “Tied to the mast? National fiscal rules in the European Union”, Economic Policy 23(54): 298–362.
European Fiscal Board (2018), Annual Report, Brussels.
Larch, M, D Kumps and A Cugnasca (2021), “Fiscal stabilisation in real time: An exercise in risk management”, Economic Modelling 99 (105494).
1 As a matter of fact, the introduction of the debt rule required unanimity.
2 The European Fiscal Board highlighted the new practice in successive Annual Reports starting in 2018.
3 See https://ec.europa.eu/info/business-economy-euro/economic-and-fiscal-policy-coordination/european-fiscal-board-efb/compliance-tracker_en
4 The initial effort and the primary surpluses would be significantly higher in an increasingly likely scenario where yields on government bonds increase and exceed the projected rate of economic growth.