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Making the EU and national budgetary frameworks work together

The conduct of fiscal policy in the EU takes place in complicated environments. It may contain elements that overlap or are inconsistent with each other, thereby undermining compliance. This column suggests that a solution could consist of a Stability and Growth Pact focusing on gross policy errors, combined with some degree of delegation of fiscal surveillance to the national level, provided national fiscal frameworks fulfil adequate minimum standards and medium-term policy outcomes remain consistent with the EU benchmark rules.

Editors' note: This column is a lead commentary in the VoxEU debate on euro area reform.

The conduct of fiscal policy in EU Member States takes place in complex environments. Member States’ policies are shaped by political preferences, but are also subject to (i) the EU fiscal rules laid down in the Stability and Growth Pact (SGP), (ii) national fiscal rules that may or may not be fully aligned with the SGP, (iii) assessment by national independent fiscal institutions (IFIs), and (iv) medium-term budgetary frameworks. These constraining elements may be conducive to an ‘appropriate’ fiscal policy, i.e. one that is sustainable, stabilising, and growth-friendly. However, they may also overlap, thereby creating unnecessary complexity, or they may not be consistent with each other. The lower this consistency, the more scope there is for cherry-picking (i.e. arbitrage among the different elements by the national authorities).

Coming out of the Covid-19 crisis and with the war in Ukraine creating substantial economic uncertainty, the EU fiscal policy framework is at an important crossroad. The severe economic downturn clause (in popular parlance, the ‘general escape clause’) is active at least up to and including 2023, while the European Commission is expected to come up with a proposal for a reform following its review of the EU economic governance.

The ultimate purpose behind the EU fiscal rules is to ensure fiscal sustainability with a high degree of certainty, while also making sure that sufficient space is left for macroeconomic stabilisation. However, these objectives have so far been undermined by weak implementation (e.g. European Fiscal Board 2019a). Hence, fixing this should be at the core of a reform of the rules.

A common surveillance framework for different countries

The SGP does not always do full justice to each Member State’s individual situation. As a result, the SGP is viewed as imposed by ‘Brussels’, and the perception of national ownership is generally low. Not surprisingly, there have been calls to give more responsibility to the Member States themselves, for example by relying on a greater role for the national IFIs in the assessment of compliance or establishing the case for applying flexibilities.

However, a shift towards more national responsibility should not be seen as a panacea. In the period before the EMU, Member States were entirely responsible for their own budgets, and often ran very high deficits; they also often failed to conduct counter-cyclical policies. At the time, though, public debt was on average lower than it currently is, inflation was on average higher than since the start of the SGP, while countries had a certain amount of monetary autonomy, allowing them to deal with potentially unsustainable debt levels.

Reverting to inflationary practices of dealing with excessive debt build-up is not an option, given the common currency. What is more, highly integrated financial markets can lead to severely harmful cross-border spillovers if some country’s fiscal policy spins out of control. Compared to pre-1999, deeper financial integration and a common currency can raise the risk of instability for the high debt countries themselves, as the outflow of capital to government bonds deemed safer is easier and free of exchange rate risk.

Weak compliance

Political considerations taint the enforcement of the SGP. In the period before the 2011 revision of the Pact, all Ecofin decisions about the different steps in the Excessive Deficit Procedure (EDP) were based on a qualified majority vote (QMV). The idea was that countries would discipline each other by exerting peer pressure. However, this mechanism was not very effective, and it is not difficult to see why. Finance ministers interact on a regular basis and, hence, are reluctant to cast a negative vote on another colleague’s policy, as at some future moment they may need the support of this very colleague. 1 In fact, a vote against a profligate colleague is like providing a public good: all other ministers benefit from it, while the cost falls on the minister that casts the negative vote. The problem was thought to be addressed in the six-pack revision of 2011 with the replacement of QMV by reverse qualified majority voting (RQMV) when it comes to imposing the newly introduced sanctions in the package. 2 However, as argued in European Fiscal Board (2019a), this switch may even have been counterproductive, as it effectively shifted much of the responsibility for decisions to the Commission, which seems to have shied back from making politically difficult proposals, such as in 2016 when Portugal and Spain were close to receiving sanctions. Besides these complications caused by the ‘game-theoretic’ setting, the surveillance process is becoming increasingly bilateral, thereby adding to its lack of transparency. There is an increasing tendency for governments to strike a deal with the Commission before cases go to the Ecofin meeting, which undermines the role of peer pressure from other finance ministers.

A possible way forward

With these considerations in mind, what could be a good way forward towards more effective fiscal surveillance? First, EU-level surveillance should be tighter in cases that pose more risk to the financial stability of the euro area, thus focusing on ‘gross policy errors’. We would not consider such gross errors exclusively in the context of the EDP. Excessively loose fiscal policy in good times that accentuates sustainability risks during subsequent crises is equally serious. By concentrating on gross errors only it is easier to find a coalition supporting a tough stance on these errors. The clearest example was that of the Italian government’s initial refusal to revise the 2019 draft budget rejected by the Commission (European Fiscal Board 2019b). The latter received broad support from the other countries on its tough stance. 3 It is easy to imagine that in other situations in which a large fraction of the countries commit only minor transgressions of the SGP rules, a coalition could emerge that allows also those running a policy that endangers the collective stability to escape (further steps in) an EDP.

Second, and consistent with the first point, fiscal surveillance could be partially delegated to the national level, provided that an adequate national fiscal framework is in place and budgetary outcomes remain broadly in line with the EU fiscal rules. Such a delegation would allow the Commission to concentrate on those violations that run clearly against the spirit of the SGP and harm the collective interest. In these latter cases, current EU surveillance practice would be continued.  Apart from making it easier for the Commission to gather Member States’ support for a forceful response, this has the advantage that day-to-day surveillance at the national level could be tailored more accurately to a country’s specific situation, including its stabilisation needs, in part by allowing the responsible national institutions to exploit their superior (compared to the Commission) knowledge about the national economy.

How far should decentralisation of fiscal surveillance go? As mentioned, the basic principle should be that EU-level surveillance would be lighter in cases that pose less risk to the financial stability of the euro area and tighter for those that pose more of such a risk, in particular when countries have debt ratios that threaten their fiscal sustainability. This principle is in line with the idea that surveillance ought to be located at the level where externalities across countries can be most effectively addressed.

Delegation of surveillance would never be complete, because that would not be compatible with a well-functioning monetary union in which national fiscal policies are a common concern. The Commission would continue to monitor the budgetary developments in a country in relation to the EU-level numerical limits. The Commission would also be informed by the IFI about national macroeconomic and budgetary developments and how the fiscal process is conducted. This would also provide the Commission with input to advise on the aggregate euro-area fiscal stance, and a desirable breakdown of the stance among (groups of) countries.

Conditions for delegation 

For fiscal surveillance to be delegated to the national level, several conditions would need to be fulfilled, both institutionally and through a record of good fiscal performance. To start, a national IFI needs to meet certain minimum requirements (EU Independent Fiscal Institutions 2019). Its independence requires a solid legal anchoring, it should be assured of sufficient resources and have access to all relevant information. An adequate comply-or-explain procedure should be in place, with the IFI appearing in Parliament to comment on the budget and the government obliged to respond to these comments in sufficiently concrete terms. The minimum requirements need to be raised to a level that guarantees adequate functioning of the IFIs (Arnold et al. 2022). This implies a substantial strengthening of the IFIs in many, if not all, countries. Further, the fiscal framework should feature a sufficiently strong medium-term orientation, so that the fiscal outcomes over time remain in line with the EU-level requirements. 4 Hence, when fiscal policy surveillance is delegated to the national level, the surveillance role of the Commission would shift towards a surveillance of the adequacy of the national fiscal frameworks.  

Importantly, imposing minimum requirements on IFIs and medium-term fiscal frameworks is not the same as forcing a harmonisation of national fiscal frameworks, which could generate political resistance and would therefore be counterproductive. As long as the above conditions are met and  medium-term outcomes remain compatible with the benchmarks set by the EU fiscal rules, any fiscal model would in principle be acceptable. 5 In such a case, the EU-level surveillance would be limited to verifying the absence of the excessive deficits. The national framework could be based on the structural balance, nominal targets, on full discretion of a debt-averse political system, or it could directly apply the EU benchmark rules (the opt-in option; see Debrun and Reuter 2022). 6 Ultimately, what matters are the outcomes.

To leave room for counter-cyclical stabilisation, and to take into account short-term divergences in the national and EU fiscal rules’ intermediate targets, the evolution of the fiscal outcomes would be assessed over a period of, for example, five years. However, if during this period the Member State starts to follow a policy that clearly endanger the stability of the entire area, then it would be immediately put back under the surveillance of the Commission in line with the SGP. Hence, although fiscal surveillance would be delegated to countries whose fiscal institutions and frameworks meet the minimum standard, their actions and fiscal outcomes would continue to be monitored by the Commission.

Delegation under a revised Pact

The Commission is expected to come up with a proposal for a revision of the SGP. What such a revised Pact looks like is difficult to say at this moment, although we may be able to see some of its contours. What is essential is to liberate countries from some of the excesses of the current EU rules: reducing overlaps and increasing transparency. In recent years, the European Fiscal Board has in its annual reports provided leads for a potential reform: a focus on a single long-term debt anchor, supported by a spending rule and a general escape clause, which would be invoked based on an independent analysis and advice. A comply-or-explain procedure would accompany the advice.

Among researchers and policy experts, a consensus seems to have been building up towards the proposals made by the European Fiscal Board. 7 Some Member States may resist such a shift, though, and prefer to hold on to the structural balance as indicator, for example because the latter is written in domestic law. Such an opposition could be overcome by the hybrid nature of the preventive arm in the form that we have described here: countries that fulfil the conditions for delegation of surveillance and prefer to retain the structural balance would be allowed to do so.  After all, a well-constructed national rule based on the structural balance should yield similar medium-term outcomes as the new EU benchmark rule.

Concluding remarks

The conduct of fiscal policy takes place in complicated environments. It may contain elements that overlap or are inconsistent with each other, thereby undermining compliance. A solution could consist of an SGP focusing on gross policy errors, combined with some degree of delegation of fiscal surveillance to the national level, provided national fiscal frameworks fulfil adequate minimum standards and medium-term policy outcomes remain consistent with the EU benchmark rules.

Authors’ note: The authors thank, without implicating, Jean Pisani-Ferry and Jeromin Zettelmeyer for their very useful comments on the first version of this column. The views expressed here are those of the authors and do not necessarily represent those of the institutions they are affiliated with.

References

Arnold, N, R Balakrishnan, B Barkbu et al. (2022), “Reforming the EU Fiscal Framework: Strengthening the Fiscal Rules and Institutions”, IMF Discussion Paper 2022/014.

Bénassy-Quéré, A, M. Brunnermeier, H Enderlein et al. (2018), “How to reconcile risk sharing and market discipline in the euro area”, VoxEU, 17 January.

Darvas, Z, P Martin and X Ragot (2018), “European fiscal rules require a major overhaul”, Policy Contribution No. 18, Bruegel.

Debrun, X and W Reuter (2022), “Fiscal is local: EU standards for national fiscal frameworks”, VoxEU, 24 January.

EU Independent Fiscal Institutions (2019), “Network Statement on the Need to Reinforce and Protect EU IFIs”, 22 January.

European Fiscal Board (2019a), “Assessment of EU fiscal rules – with a focus on the six and two-pack legislation”, Brussels.

European Fiscal Board (2019b), Annual Report.

European Fiscal Board (2020), Annual Report.

Ministries of Finance Spain and the Netherlands (2022), “Joint paper by Spain and The Netherlands on priority issues in 2022 on the EU’s economic and financial policy agenda”, April.

Footnotes

  1. An example is the support from Italy and Belgium in the 2003 Council decision not to take further steps against Germany and France’s violation of the rules.
  2. Under RQMV, the Commission makes a proposal, which is deemed accepted unless a qualified majority of the Member States rejects the proposal.
  3. In the end, the Commission did not open an EDP after the Italian government adopted an amended budget with a lower projected deficit.
  4. An example is the Netherlands, where at the start of the new cabinet period spending ceilings are set for the entire period.
  5. Very large shocks could require fiscal coordination, for example in the form of a central fiscal capacity (European Fiscal Board, 2020).
  6. Even if a country fulfils the conditions for delegation of fiscal surveillance to the national level, there is no obligation for the country to accept such delegation. A country may have good reasons to stay within the system of fully-fledged EU-level surveillance. For example, political divisions within a country may run so deep that it prefers to stick with the EU surveillance.
  7. For example, a recent article by the Dutch and Spanish finance ministers supports a spending rule – see Ministries of Finance Spain and the Netherlands (2022). Several other contributions have made proposals for some type of spending rule, see, for example, Bénassy-Quéré et al. (2018) and Darvas et al. 2018).

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