Editors' note: This column is a lead commentary in the VoxEU debate on euro area reform.
The EU has responded forcefully to the economic crisis brought about by COVID-19. The ECB’s aggressive easing and exceptional national fiscal stimulus measures have been complemented by unprecedented action at the EU level, thereby providing extensive support to vulnerable member states and broadening fiscal space.
Exigent circumstances justify exigent measures. But while responding strongly and effectively to the imminent risk of something resembling the euro crisis, the COVID-19 measures risk leaving the EU more vulnerable in the longer run. While explained as exceptional and temporary, they transform the EU into an incomplete fiscal union, which is fragile in the face of future shocks. These measures need to be balanced with strengthened market discipline and – ultimately – backed up by clear divisions of competence, unambiguous assignment of responsibility, and efficient decision-making structures.
The new instruments entail a policy change
In the Maastricht Economic and Monetary Union (EMU), the pursuit of fiscal sustainability was operationalised through the Stability and Growth Pact (SGP). Market discipline was supported by the no-bailout clause. The euro crisis led to large-scale ad-hoc financial support measures and the establishment of the permanent financial assistance facility European Stability Mechanism (ESM), as well as by the so-called Outright Monetary Transactions (OMT) promised by the ECB to buttress the ‘singleness’ of monetary policy.
A common feature of all these support mechanisms was the provision of assistance in the form of loans under ‘strict conditionality’, deemed necessary to ensure the payment of the loans and to reduce the risk of similar crises in the future. From a legal point of view, conditionality was seen as a necessary element of compatibility with the no-bailout clause (Article 125 TFEU).
The COVID-19 measures stand in remarkable contrast to the earlier policy, as little or no conditionality is now required. This applies equally to the employment policy support facility SURE, the new pandemic lending facility within the ESM, the ECB’s new flexible bond purchase programmes, and quite specifically the Next Generation EU package (NGEU).
Trust in the legal foundations of the economic policy undermined
Following the NGEU, the way in which the Union is funded is about to change drastically. Until last summer, the principles of budgetary balance and the unity of the union budget (Article 310 TFEU) were universally seen as prohibiting the EU from borrowing to finance its expenditure (Leino-Sandberg 2020). The NGEU builds on the Union issuing debt to be spent during the next few years in large part as grants and to be repaid over three decades starting from 2028, with as yet unspecified means. Article 310 TFEU is primarily circumvented by defining NGEU as a one-off crisis measure and by classifying it as extra-budgetary – thus bypassing the principle that all revenue and expenditure should be shown in the budget.
While enabling quick decision making, the solution weakens trust in the EU Treaties (Leino-Sandberg 2021). In term of substance, the creation of a new level of public debt without a clear understanding of how the debts will be repaid reduces incentives to keep overall indebtedness sustainable.
The NGEU also stands in a problematic relationship with the no-bailout clause. While based on the notion of exceptional occurrences in Article 122 TFEU, most of the funding is distributed based on criteria that have little to do with these events. The transfer arrangement effectively ditches the aforementioned requirement of strict conditionality deemed necessary for the compatibility with Article 125 TFEU only a decade ago. It thus gives credence to expectations of unconditional financial support in the future, weakening the constraints the no-bailout clause seeks to impose on member state behaviour.
Outcome: An incomplete and fragile fiscal union in the making
We agree with many commentators who believe that by precedent, and by its very long duration, the NGEU opens the door for pursuing similar arrangements again, now that the legal limits have been dissolved. From here on, the decision will be purely political, and when new emergencies will arise, the power of precedent will be strong.
A fiscal union emerges from the NGEU in two senses: through joint borrowing, which impacts on the aggregate fiscal stance; and through the transfers to member states. The EU is effectively getting a fiscal capacity that many have considered an essential but so far lacking element of a functioning monetary union.
However, the emerging fiscal union is very incomplete. The NGEU model builds on the understanding that similar arrangements require a new Own Resources Decision to be approved by unanimity. While necessary from the perspective of democratic legitimacy (European Commission 2020), this is likely to delay decision making, especially if the sense of crisis is not as imminent as in the context of the current crisis. The chances of swift decisions are also hampered by the focus on cross-border transfers instead of public goods creating ‘winners and losers’ and thus provoking intense political disagreement.
An obvious way to make the incipient fiscal union more efficient and stable would be to take decisive steps in the direction of federalism. Treaty reform would be needed to strengthen the formal roles of EU institutions in relation to matters transferred under Union competence. This would be backed up by more robust delimitation of member state and EU level fiscal competences and responsibilities, which has become increasingly blurred. Matters falling under Union competence would be funded by Union funds. Matters falling under national competence would be funded by national funds and left to national decision-making.
However, the chances of a constitutionalised federal leap in the foreseeable future are nil. Paradoxically, the creative move to joint debt and the disappearance of conditionality are likely to weaken support for any – even modest – formal Treaty revision in the member states where the fears of a ‘transfer union’ are the greatest. ‘What we agreed’ seems to be of little relevance when political circumstances change. These fears have been very clearly present in the lengthy ratification process of the Own Resources Decision in our home country, Finland. When approving the package, the Parliament stressed that “Finland will not accept a repetition of or the arrangement becoming permanent” (Parliament of Finland 2021).
Yet, new moves to further fiscal integration require the support of Northern Europe. Like Bilbiie et al. (2020), we see the fears and lacking trust in Northern Europe as the main obstacle for such steps. Strengthening this trust should thus be the priority for anyone seeking to facilitate a move towards a truly functioning fiscal union.
A necessary condition: Putting the Recovery and Resilience Facility money to good use
The NGEU provides funding distributed on the basis of loosely defined allocation criteria. While the institutional procedures are elaborate, the key challenge remains the same as before – the EU institutions have always had difficulties to force member states to act against their will.
Despite the vagueness of NGEU conditions, it is of the utmost importance to spend the new debt-financed resources efficiently. First, the grants and cheap loans could be a significant boost for vulnerable economies’ medium-term growth prospects, if efficiently used to advance digitalisation, competence building and infrastructures, and accompanied by structural reforms that reduce constraints on growth. Better growth prospects would in turn reduce the sustainability risks associated with the current high and increasing debt ratios.
Second, making good use of the exceptional solidarity shown to the fiscally constrained countries would help to reduce the mistrust in pooling fiscal resources in Northern Europe. Conversely, wasting this opportunity would endanger any sensible institutional steps and even justified ad-hoc support actions in the future should these prove necessary (Pisani-Ferry 2020 makes this point forcefully).
Finding good use for the new resources presumes a wise selection of funding objects that ensure long term impact instead of short time gain in national politics. The less-than-perfect track record of many Member states in implementing country-specific recommendations suggests that extraordinary efforts are needed.
The overall size of the programme and long implementation period imply that the NGEU can contribute only modestly towards boosting demand in the very short run. The emphasis should therefore be squarely on structural programmes to boost productivity, lifting employment rate, and increasing public sector efficiency. Tax reductions and income transfers aimed solely at raising aggregate demand would not serve the medium-term purpose well. They also raise resentment in the net contributor countries. Such measures should not be allowed to be part of the programmes.
Creating preconditions for effective market discipline
The impact of the NGEU solution on the credibility of the no-bailout clause and market discipline needs addressing as well. A prerequisite is that sovereign debt restructuring becomes a realistic prospect in extreme cases. Some progress in this regard was made in November with the acceptance of the ESM reform in conjunction with the finalisation of the backstop for the single resolution fund. As a result, debt sustainability analysis will be on a slightly more credible footing and the ‘single-limb’ collective action clauses will help overcome holdouts in restructuring situations.
However, without reducing banks’ holdings of sovereign bonds, restructuring decisions entail a substantial risk of bank insolvencies. Given the often overwhelming consequences of banking crises, this could be a very significant hurdle for restructuring. A decision to set effective limits to banks’ holdings of individual sovereigns’ debt instruments should be a priority. The new EU bonds, which are likely to get high ratings, will make such limits much easier to implement, as there will be more alternative safe assets available. Given that a transition not leading to instability takes time, the sooner one begins, the better.
While one cannot put too much trust in fiscal rules in preventing vulnerable fiscal positions, the Stability and Growth Pact needs reforming to reflect the realities of post-COVID-19 Europe with the debt levels further distanced from the 60% level and interest rates much lower than ever before. There are already interesting proposals to that effect. A ‘standards’ approach suggested by Blanchard et al. (2020) essentially replaces the current Treaty stipulations by a very general requirement of keeping debt sustainable based on stochastic sustainability analysis. Martin et al. (2021) propose a less dramatic departure from the current framework but still identify a need to remove the numerical criteria on the debt and deficit thresholds from Protocol 12 annexed to the TFEU. The key challenge of all reform proposals obviously remains their enforcement, as long as the member states remain fiscally sovereign.
Focus on the EU level public goods
Putting the fiscal stabilisation elements of the NGEU on a sound footing would require institutions that can take swift and responsible decisions on both the aggregate stance and the allocation across member states in many different constellations. Establishing such institutions, however, requires Treaty change, which is currently a political no-go.
In these circumstances, the sensible thing to do is to focus common post-NGEU fiscal action on better provision of EU-level public goods instead of financing national spending by member states. Many obvious examples (e.g. research infrastructures, climate and many other environmental measures, several aspects of strategic autonomy) fall under the established EU competences. Country-specific fiscal support needs should be addressed by the existing financial stability mechanisms. The expanded post-NGEU policies should be funded by higher member state contributions or preferably by new own resources. Further issuance of EU debt should be refrained from until this can be based on appropriate and explicit institutional structures in the Treaties.
The expansion of EU-level action on public goods, combined with the aforementioned stronger conditionality on NGEU spending for growth impacts and reforms to reduce chances of fiscal profligacy would contribute to building trust. We believe this is the only way to build sufficient support for a future Treaty change enabling the setting up of a well-functioning EU-level fiscal capacity.
Bilbiie, F O, T Monacelli, and R Perotti (2020), “Fiscal policy in Europe: a helicopter view”, CEPR Discussion Paper 15382.
Blanchard, O, A Leandro, and J Zettelmeyer (2020), “Redesigning the EU Fiscal Rules: From Rules to Standards”, Economic Policy Panel Meeting, 22-23 October.
European Commission (2020), “Next Generation EU - Legal Construction” Q&A Release, Brussels, 9 June.
Leino-Sandberg, P (2020), “Next Generation EU: Breaking a taboo or breaking the law?”, CEPS Blog, 24 June.
Leino-Sandberg, P (2021), “New Generation EU – A Constitutional Change without Constitutional Change”, Reconnect Europe, 13 January.
Martin J., J. Pisany-Ferry and X. Ragot, (2021), Reforming the European Fiscal framework.
Parliament of Finland (2021), “Parliament has approved EU's own resources decision by a vote of 134-57”, Press Release, 18 May.
Pisani-Ferry J. (2020), "Europe’s recovery gamble", Project Syndicate.
Scholz 0. (2020), "Together for Europe’s recovery and for a better, more sovereign Europe", speech at the Bruegel Annual Meetings 2020, 3 September.