After years of debates, the Commission, Council, and Parliament have agreed on a reform of the fiscal rules at the last minute before the EU elections. These determine how much debt the Member States are allowed to have – and consequently, how radically they have to cut spending or raise taxes. Due to the rules now in force, a series of billion-euro consolidation packages can be expected by 2028, which are very likely to put the brakes on the economy, the welfare state, and climate protection.

Rules for a different time

Limits on the maximum level of government debt or new debt have shaped the Eurozone since it was founded. Every country that wanted to join the euro had to reduce its deficit to at least below 3 percent of its economic output (GDP). If the government debt ratio exceeded the then EU average of 60 percent of GDP, it had to at least approach this value. In 1997, these rules were adopted into European permanent law under the “Stability and Growth Pact”.

While the rules have been changed several times since then, the values have remained the same, although their relationship has changed significantly: long-term interest rates and structural deficits are significantly lower and the government debt ratio has increased, but much less rapidly than in the other major economies such as the USA, China, or Japan.

Even before the outbreak of the pandemic, the Commission had initiated a new reform to correct the mistakes of the last tightening in the wake of the financial and economic crisis, which had led to social upheavals and an unprecedented collapse in public investment in some countries. The rules were suspended in order to be able to cushion the economic slump caused by the pandemic. The measures to combat the pandemic led to deficits and government debt ratios skyrocketing – and with them the pressure to reform.

European trade unions, NGOs, and some economists warned of the consequences of insufficiently relaxed regulations or even a reinstatement of the old rules. Pension cuts, job losses, cuts in healthcare services, massive tax increases, a collapse in investments, including those in climate protection, etc., just like the population of Greece suffered in the early 2010s, could lead to another economic collapse, mass unemployment, and social misery – and thus to an even higher government debt ratio.

Medium-term budget plans and problems

The warnings were partially heeded: the most recently applicable, unrealistically radical guidelines for debt reduction have been dropped from the fiscal rules that have now been adopted. In the medium term, a stabilization of the government debt ratio or a debt level approaching 60 percent of GDP could now be sufficient. This would benefit future generations in particular, as it would be more likely to avoid greater delays in public investment in climate protection or cutbacks in plans to expand education and childcare.

Instead of concrete budget targets that are recalculated annually and thus fluctuate, fiscal structural plans, which are generally valid for four years, are now to be decisive. They focus on maximum limits on the annual growth of government expenditure, compliance with which is continuously monitored as a result. If a package of reforms and investments is put together, the member states will be given up to three more years to achieve the budget targets.

However, there are three major problems:

1. In tough times, the public sector needs more leeway to be able to implement countermeasures. The fiscal rules only contain the mechanism for their suspension, for which there are strict prerequisites – but nothing that allows for rule-compliant action, for example, to address rising unemployment in the current economic downturn.

2. The EU Commission has too much leeway when it comes to assessing the reform and investment packages. There is a risk that it will again demand pension cuts, restrictions on labour law, or the like, in order to permit more time and thus a less severe course of cuts. Member States would then only have the proverbial choice between the plague and cholera. However, there is also the opportunity for more sensible conditions such as a stronger expansion of childcare, more education and training opportunities, acceleration of climate protection, etc. The outcome of the EU elections and the composition of the new Commission will play an important role in this respect.

3. The new regulations grant the Commission far-reaching freedom in choosing the method by which it assesses whether the government debt ratio is being reduced sufficiently quickly. The method that has now been chosen leads to further problems.

What lies ahead?

Only after the trilogue agreement did the Commission publish how the so-called debt sustainability analysis is conducted. The result is sobering: although, as a precautionary measure, the EU Commission will only publish the exact figures just after the EU elections, the Bruegel Institute has, however, calculated initial estimates based on the Commission’s new forecast (public preliminary version here):

The Eurozone faces progressively more spending cuts until 2028, which will amount to over 360 billion euros (around 2.1 percent of economic output) by the end. This amount will then be unavailable each year, measured as the deviation from a scenario without consolidation. Without compensatory tax increases, this cannot be achieved without significant reductions in education, social security, and climate protection.

Italy will be particularly affected: the government would have to consolidate at least 100 billion euros over the next four years – with dramatic economic and social consequences that again would put debt reduction at risk more than ever.

Absurd assumptions lead to tightening

If you take a closer look at the method, the absurdity of the exercise becomes apparent: according to the rules, it is not enough just to reduce the national debt ratio; it must also be ensured that the ratio continues to fall in the ten years after the end of the plan – even if the fiscal rules are broken again in the future. Specifically, the Commission assumes that the long-term increase in public spending due to demographic changes will not be offset in the following fiscal structural plans, but will be financed exclusively through higher debt – despite the fact that the fiscal rules explicitly exclude this. And in order to prevent this increase in debt, consolidation must therefore already be all the tighter in the current plan.

It would be more reasonable to assume that rules which everyone is supposed to follow will actually be adhered to now and in the future. Simply switching to this latter assumption would provide billions in budgetary leeway. Applying the above Bruegel guidelines shows that each country would need to consolidate more than the safety margin of 3 percent (specifically 1.5 percent of GDP) negotiated by the Council and Parliament would require. In countries with particularly high estimated increases in ageing costs, such as Spain or Portugal, there are thus now implicitly even stricter medium-term budget targets in some cases than with the old rules. This is particularly dangerous for welfare state financing in Europe, because, for example, underestimating the increase in the workforce would lead to an increased focus on cutting pension, health, and care expenditure. The situation is similar with overestimating the interest rates.

Insufficient scope for future investments and social progress

The looming wave of consolidation could delay the transition from fossil-based production and consumption by years or slow further social progress – even though European societies have already experienced five years of setbacks due to the pandemic and the inflation crisis. Especially since, after the expiration of the EU’s additional stabilization funds in 2026, it would already be unclear how even the current level could be maintained without any rules. Because the expenditure rule also applies to the growth of public investments, instead of excluding them as advocated by the frequently demanded golden investment rule, the risk of extending, postponing, or even cancelling investment projects is particularly high.

However, in the final phase of the fiscal rule negotiations, under pressure from the EU Parliament, an improvement was added that co-financed investments are not restricted by the spending rules. How much difference this exception will make depends not least on the upcoming European elections, because it only holds significant potential for political improvements in the medium term: on the one hand, in relation to the 2028-2034 EU financial framework, and on the other hand, in relation to whether new additional EU funds will be laid out. Whether this potential is increased will be a major factor in determining whether the EU will be able to meet the high and urgent need for public investment to achieve its climate goals in the next decade.

And what about the social dimension of the reform? In the course of the budget review by the EU Commission, social goals will be given greater consideration in the future. However, we are facing a wave of consolidation. Although this will be mitigated and extended over time compared to the old rules, cuts in social spending are still inevitable: social, education, and health expenditures are the largest budget items in all member states, so consolidation will almost inevitably impact them significantly – at least if there are no corresponding measures on the revenue side.

Conclusion

The fiscal rule reform has missed an opportunity to anchor a balanced, prosperity-oriented economic policy at the European level. It remains unilaterally fixated on restrictions on the budgetary policies of the Member States – although in view of the manifold challenges, it would have been better to work on how Europe can become more capable of taking action.

What it has brought about is a weaker commitment to consolidation – however, it will only become clear in practice how large the relatively larger budget margin will actually be, as essential aspects such as the Commission’s handling of the investment and reform packages are still an open question. A linking of reform measures that are at the expense of the workers – as was common practice in Greece or Portugal in the context of the Troika negotiations, for example – would be highly problematic.

Additional EU funds are now called for again, because without support, the wave of consolidation will come at the expense of important other goals – such as social equity and climate protection in particular.

This article was first published by A&W Blog