Europe has not been spared the impact of the global Covid-19 pandemic. In medical and economic terms France, Italy and Spain have been hit especially hard – the latter two still reeling from the euro crisis. After a somewhat shaky start, the European Union has now responded, with collective financial support to repair the damage. Safety nets worth 540 billion euros were approved in April 2020, with credit lines for all member states. Encouraged by the joint initiative of Emmanuel Macron and Angela Merkel, the European Commission proposes creating a one-off recovery instrument of 750 billion euros (“Next Generation EU”), of which two-thirds are earmarked as direct support for especially badly affected states. The funds are to be raised through borrowing in the name of the EU, to be serviced through the EU budget – partly through its own tax revenues.
Expand the role of fiscal policy
Even though the agreement reached on the EU summit of July 2020 scaled down the direct support to 390 billion euros and increased conditionality, it is clear that this represents a major step on the road to reforming the EU’s fiscal governance – which had largely come to a standstill before the crisis. While this is very welcome, it must not obscure the urgent need to reform the Stability and Growth Pact (SGP), which lays out the rules for the member states’ financial policies. In fact, fiscal policy as a whole needs to be expanded for at least four reasons. Firstly, the abolition of national monetary policy in the euro area means that fiscal policy plays a much larger role in stabilising the economy. The ECB has to orientate its interest rate policy on the EMU average, and is unable to respond to specific economic situations in individual countries. In the absence of fiscal countermeasures at the national level this threatens to create persistent boom-bust cycles capable of endangering the stability of the EMU. Secondly, particularly during periods of crisis, fiscal policy must support the stabilising role of monetary policy, whose possibilities are restricted by current interest rate policies. As recent empirical results show, fiscal policy is – thirdly – much more effective macroeconomically than had often been assumed, especially in periods of crisis. Fourthly, fiscal policy must enable strong long-term productivity growth through high and consistent public investment in traditional and ecological infrastructure and in education and research.
SGP and Fiscal Compact still need reform
Even if the Commission’s planned reconstruction fund was completely successful, the SGP would still need reforming. A properly configured fund could give a decisive boost to growth in weak economies, but it is conceived as a one-off measure in response to the exceptionally deep Covid-19 crisis. Even if it was permanent, the need to adapt the fiscal rules of the SGP would remain, because their grave deficits were baked in from the outset. The limits of 3 percent of GDP for budget deficits and 60 percent of GDP for state debt are economically arbitrary and contradict other official targets (such as Europe 2020 or the Macroeconomic Imbalance Procedure). The inadequacy of the SGP became glaringly obvious during the euro crisis, where it was revealed to be pro-cyclical and crisis-deepening, and in particular incapable of preventing a dramatic collapse in public investment.
If the acute euro crisis in the European periphery is to be overcome at all, this will certainly require a looser fiscal framework. After the tightening of European fiscal rules (“Six-Pack”, Fiscal Compact, “Two-Pack”) contributed to strict austerity policies in those countries, the new Commission under Jean-Claude Juncker applied a rather milder interpretation of the rules. In tandem with the ECB’s 2012 decision to support the government bonds of the affected states in the financial markets, this paved the way for economic recovery.
So the decision to immediately suspend the SGP in the Covid-19 crisis was absolutely correct. In view of rapidly growing budget deficits and debt-to-GDP ratios, reinstating it in unaltered form after the crisis would in all likelihood drive many states back into austerity policies that they have only just more or less overcome. These states would not withstand another wave of austerity – neither economically nor in social and political terms. Instead it would risk the end of the euro and possibly even the demise of the EU. Quite apart from the political turmoil, this would plunge Germany – and the so-called frugal four (Austria, Denmark, the Netherlands and Sweden) – into deep economic crisis. Alongside the EU reconstruction fund, reforming the SGP is therefore also in Germany’s own interest.
Four aspects to reform: targets, investment orientation, flexibilisation and democratisation
So what direction should reform of the SGP take? Firstly, in order to avoid member states with predictably high levels of post-crisis debt being plunged immediately into counterproductive austerity, the SGP state debt limit would have to be raised significantly, for example to 90 percent of GDP. The current limit of 60 percent was merely the EU average at the time the Maastricht criteria were adopted, and is in no sense an evidence-based critical threshold. So such a move would not be expected to impair debt sustainability, especially in a situation where interest rates are low and can be expected to remain so. In line with a higher debt limit, the deficit variables of the SGP, which ultimately correspond directly or indirectly with it, could also be adjusted (the 3 percent budget deficit limit and the medium-term structurally balanced budgetary objective).
It would be even more important, secondly, to reform the SGP to encourage investment. Public investment is frequently cut hard during consolidation phases, as one of the few areas where economies can be realised rapidly. But this is extremely damaging from an overall economic perspective, because public investment has strong multiplier effects in the short term and is an especially effective growth promoter in the long term. A reformed SGP should therefore strengthen public investment and protect it from crisis-driven cuts. To this end net investment should be removed from the calculation of relevant deficit variables in the preventive and dissuasive arms of the SGP. This would finally anchor the Golden Rule of public investment, which enjoys broad acceptance in the traditional economic literature: For the sake of generational justice and economic growth, governments should borrow to fund investment but not current spending. The argument is that public investment increases the public capital stock and stimulates growth, which is in the interest of future generations. It is therefore justified to require future generations to contribute to its financing via debt servicing.
Thirdly the cyclical flexibility of the SGP should be significantly improved. One central reason for the existing SGP’s difficulties coping with the economic cycle is that the – fundamentally sensible – cyclical adjustment procedures do not function properly. This raises the possibility of a very effective adjustment to make the SGP better able to cope with cyclical developments, which could be realised purely technically without amending the EU treaties: The simplest route would be to always apply medium-term averages for potential growth, or even better merely a medium-term revision of the estimates (for example every three or five years rather than three times a year which is the present practice). This would effectively prevent a purely technical downward revision of medium-term growth expectations forcing states already in recession to make crisis-deepening spending cuts. Conversely, during recovery the consolidation should be greater and faster.
The fundamental need for a reorientation of fiscal policy objectives runs through all the reforms described here. Instead of blunt technocratic limits on borrowing and deficits, the top-line goal should be sustainable development of society’s prosperity. That means making the SGP procedures considerably more transparent and a great deal more democratic. Overhaul of the EU’s economic governance has already begun. The Union must grasp this as an opportunity for deep reform of the SGP.
(Translated from the German)
Achim Truger is Professor of Socioeconomics at the University of Duisburg-Essen, member of the German Council of Economic Experts, and Senior Research Fellow at the Macroeconomic Policy Institute (IMK) within the Hans-Böckler-Foundation, Duesseldorf.