Editors' note: This column is a lead commentary in the VoxEU debate on EU economic policy and architecture after Covid.
The stability and adequacy of the monetary and fiscal frameworks of the euro area are increasingly challenged by enduring changes in the economic environment. While the initial legal architecture of the EMU has largely remained unchanged and while experience has shown that there is flexibility enshrined in the system, real-time pragmatic responses have tested the limits of adaptation by interpretation of prevailing legal provisions. Moreover, economic realities have evolved and pose new challenges as regards the relationship of monetary and fiscal policies, the adequacy of the fiscal legal framework and the need for concerted EU responses to unforeseen event such as the current pandemic crisis. Overall, the EMU policy system has been stretched and while effective, responses to events have been distant from first-best strategies.
Against this background, a group of economists and lawyers specialised in EU matters undertook a comprehensive assessment of the economic requirements and legal conditions of a well-functioning macroeconomic policy system for the EU and the euro area (Maduro et al. 2021).
Download CEPR Policy Insight No. 114, "Revisiting the EU framework: Economic necessities and legal options", here
We propose a reform of the legal and economic framework which would bring legal boundaries in line with economic necessities along three dimensions. First, fiscal and monetary interactions should allow for a venue for non-binding fiscal-monetary coordination, for an interpretation of the rules giving more leeway to the ECB’s pursuit of price stability, and for a strengthening of fiscal support to monetary objectives. Second, with uniform and rigid fiscal rules becoming increasingly inadequate in a fiscally heterogenous EMU, we argue for a reform of the fiscal rules that gives higher priority to debt sustainability, creates room for stabilisation, and allows for differentiated medium-term debt anchors and risk-based debt reduction objectives. Third, we suggest building on the NGEU experience to develop new vertical coordination mechanisms between the Union and the member states and to create a standing contingent fiscal capacity at EU level.
These reforms can be implemented without amending the EU Treaties, whose basic provisions remain sound. They would provide better clarity and legal certainty and help equip Europe for rough times ahead.
Stretching and misinterpreting the rules: Economically sub-optimal, legally controversial
The EU is not a federal state. Its ability to reform itself to respond to transformative challenges, even threats to its integrity is bound by both legal and political constraints. Since the Maastricht Treaty entered into force three decades ago, pressing policy challenges were dealt within the framework of largely unchanged EU primary law. By stretching existing legal provisions, it was possible for monetary and fiscal policy to explore unchartered territories, to expand the scope of fiscal rules, and even to assign to the Union’s public finances the new role of supporting the rebound of Covid-hit economies with debt-financed grants and loans. In other cases, remaining leeway under the rules has not been exploited, for either unfounded legal concerns or due to political complacency.
Some initiatives gave rise to legal challenges on the ground that they infringe certain provisions of the EU Treaties, exceed the competences granted to the EU, or are contrary to the constitution of a member state. Furthermore, legal arguments take place against the background of political disagreements among and within member states. As a result, it has become conventional wisdom that the EU should find ways to adapt without treaty revisions or significant legislative adaptation.
Legal tensions and political complacency however contrast with an evolving macroeconomic reality requiring policy changes on various fronts. An overly strict disconnect between fiscal and monetary policy inhibits the effective pursuit of price stability; fiscal sustainability remains essential but fiscal rules have become outdated in a post-Covid world with higher public debts, very low or even negative interest rates, and the limited effectiveness of monetary policy at the effective lower bound; and vulnerability to shocks requires a common budget to offer stabilisation potential as highlighted by the pandemic crisis.
The assumption that Europe should respond to momentous transformations in the economic context without even considering adapting its basic legal framework is a recipe for dangerously suboptimal policies. This may in turn lead to stretching the system more and more, and consequently to making it increasingly vulnerable to legal challenges and political contestation.
This is a dangerous vicious circle. Reflections on the future of Europe should rather start by assessing what are the necessary policy reforms and find out if they are feasible within the confine of prevailing primary law.
Allowing for coordination of fiscal and monetary policies
In the Maastricht architecture, the structural fiscal stance is assumed to be neutral or geared towards sustainability. Consequently, the EMU toolbox did not foresee an effective mechanism for coordinating fiscal support. However, in the face of persistent adverse conditions the decline of equilibrium real interest rates and the effective lower bound on short term interest rates, means monetary expansion may provide little stimulus while expansionary fiscal policy may be more effective. It would be desirable to design a framework to facilitate monetary-policy coordination when this is required for effective stabilisation policy (see discussion in Bartsch et al. 2021).
Legally, any provision on fiscal-monetary coordination must preserve the ECB’s independence (Article 130 TFEU). While independence rules out any coordination that would constrain the ECB’s decision-making power, there are no legal barriers to soft coordination arrangements involving dialogue, exchange of views, the creation of a common analytical basis with other policy institutions that do not commit the ECB. Institutionally, such exchanges could take place through a dedicated board, a permanent forum, or the European Semester process (Reichlin et al. 2021).
It is further pivotal to give the ECB the necessary leeway in effectively pursuing its price stability mandate. Formalistic application of mechanical safeguards as benchmark for compliance with the ban on monetary financing (Article 123 TFEU) ultimately undermines the price stability mandate. In order to remove ambiguity and strengthen legal certainty, Article 123 TFEU should therefore be interpreted in a way that focuses on the objective of the central bank’s policy actions and the preservation of incentives to budget discipline rather than implementation of the specific modalities applied in previous cases such as the level or share of purchases of bonds in relation to the capital key. Bond purchases should not be considered monetary financing so long as (1) the ECB can provide a clear rationale for why they are essential in the pursuit of its price stability mandate, and (2) the bond purchases do not lift the pressure on Member States to pursue sound budgetary policies (Steinbach 2017).
Overhauling fiscal rules
The fiscal framework has been a construction site since its inception. On several occasions, the fiscal rules, especially the Stability and Growth Pact (SGP), have been tweaked. Common to all these amendments and additions is, however, that they did not challenge the principle of uniform debt and deficit reference values (nor their level). But the problem with country- and time-invariant debt and deficit reference values is that they miss a large amount of information that is relevant to whether a country’s debt is sustainable. Further, post-pandemic environment led to both higher average debt levels and higher differences in debt levels across EU members, while ECB monetary policy risks remaining constrained by the effective lower bound on interest rates.
Current reform proposals vary in the degree of state contingency of fiscal rules as well as legal feasibility: either numerical fiscal rules are given up altogether (Blanchard et al. 2021), or reference values are maintained but would be customised to the conditions of the country concerned (Martin et al. 2021), or emphasis is put on more flexibility along the path of convergence towards these objectives (EFB 2021). These proposals share the reform direction that uniformly applied numerical reference values do not sufficiently reflect diverse debt sustainability situations and that more differentiation in fiscal governance is preferable.
We argue for a reform of the fiscal rules that gives higher priority to debt sustainability, creates room for stabilization and allows for differentiated medium-term debt anchors and risk-based debt reduction objectives. Some room for manoeuvre exists under current rules with regard to greater attention to debt sustainability analysis or the use of escape clauses. More far-reaching deviations from the current fixation to uniform numerical reference values (i.e. 3% deficit, 60% debt ratio) could be implemented via special legislative procedure outlined in Article 126(14) TFEU and changes to EU secondary legislation, which is less cumbersome than ordinary Treaty changes.
Building a standing contingent fiscal capacity at EU level
The launch in spring 2020 of the Next Generation EU (NGEU) programme was a pathbreaking initiative taken in response to an exceptionally severe economic downturn. It connected to two previous discussions on EU public finances – the creation of a budget or a ‘fiscal capacity’ for euro area stabilisation purposes as well as the financing of EU-level public goods, for example on climate change. Yet, NGEU cannot be legally and functionally regarded as paving the way to a fundamental reform of the EU budget or the creation of a permanent EU ‘fiscal capacity’. It is built on an exceptional and time-bound off-budget, debt-financed programme of investment grants and loans to member states. Its establishment does not affect the EU annual budget as legally defined by the Treaty.
We suggest building on the NGEU experience to develop new vertical coordination mechanisms between the Union and the member states and to create a standing contingent fiscal capacity at EU level. This facility could only be activated in predetermined circumstances and through agreed procedures. The strongest option legally would be to set up a fund within the RFF and to secure corresponding resources. Activation would consist in the release of resources accumulated in the fund and in the commitment of new resources to replenish it. Activation triggers, both substantive (the definition of the circumstances that would require it) and procedural (the majority threshold), should set the bar high enough to ensure that the facility would not serve as an off-budget device but rather have the character of an insurance mechanism.
With secured resources and a design granting activation of the facility only in exceptional cases, the legal basis in Article 122 TFEU forming the fundament of NGEU could be replicated. While demanding criteria and procedures should be relied on to ensure that recourse to such a facility would be limited to extraordinary occurrences, we consider that Article 122 TFEU could provide the legal basis for Union initiatives involving loans and grants to Member States as well as Union-level investments in response to specified and temporary challenges of exceptional severity.
To respond to the new economic and financial environment, the legal framework needs to rely on firm principles but be adaptive. Our proposals aim at significant improvement that can be brought to the policy system. It turns out that they can be implemented while leaving the existing primary law framework unchanged, provided there is political will for such reforms and that existing flexibility in the legal architecture is exploited, for example in the area of fiscal and monetary coordination.
Political constraints are in fact more binding than the legal ones. This especially applies to the establishment of a common fiscal capacity. Absent such a reform, however, a standing contingent instrument designed for specific circumstances can be established in line with the current Treaty rules.
We are convinced that our limited set of proposals would prepare for rougher times ahead: a world where the independence and credibility of the central bank remain essential but the range of policy initiatives it should be able to conduct has broadened considerably; where the threat of solvency crises has increased due to the high level of government debt but macroeconomic stabilisation must regularly rely on fiscal support; and where tail risks of financial, sanitary, climatic or geopolitical origin materialise more frequently and call for extraordinary responses.
Bartsch, E, A Bénassy-Quéré, G Corsetti and X Debrun (2020), It’s all in the Mix: How Monetary and Fiscal Policies Can Work or Fail Together, Geneva Reports on the World Economy 23, ICMB and CEPR.
Blanchard, B, A Leandro and J Zettelmeyer (2021), “Redesigning EU fiscal rules: From rules to standards”, PIIE Working Paper 21-1.
EFB (2021), Annual Report 2021.
Maduro, M, P Martin, J-C Piris, J Pisani-Ferry, L Reichlin, A Steinbach and B Weder di Mauro (2021), "Revisiting the EU framework: Economic necessities and legal options", CEPR Policy Insight No. 114.
Martin, P, J Pisani-Ferry and X Ragot (2021), “A new template for the European fiscal framework”, VoxEU.org, 26 May.
Reichlin, L, K Adam, W J McKibbin, M McMahon, R Reis, G Ricco and B Weder di Mauro (2021), The ECB Strategy: The 2021 Review and its Future, CEPR Press.
Steinbach, A (2017), "Effect-based Analysis in the Jurisprudence on the Euro Crisis", European Law Review 42: 255-270.