Will COVID-19 change the EU’s approach to fiscal rules?
In response to the COVID-19 outbreak, the Lithuanian Government approved an economic stimulus package that has prompted concerns over the country’s fiscal position. As the public debt will increase significantly this year, there are concerns that it could eventually exceed the debt limit set by the Maastricht Treaty for EU Member States – 60% of GDP. The question is, however, whether the EU’s key fiscal discipline requirements, which were established almost 30 years ago, are still relevant in the context of today’s challenges. At the beginning of this year, the European Commission (EC) announced a review of the EU fiscal framework, which is taking on particular importance in the face of the pandemic.
Emilė Šreiberytė, Senior Economist at the Economic Policy Analysis Division of the International Relations Department of the Bank of Lithuania
COVID-19: A challenge for public finances
In order to mitigate the negative economic and social consequences of the COVID-19 pandemic, the Lithuanian Government approved an economic stimulus package with an overall envelope of €5 billion. It is estimated that due to the measures taken, the country’s budget deficit will increase significantly and, depending on the course of the pandemic and further response of the Government, reach from 9.1% to 11.4% of GDP in 2020. Having said that, this year Lithuania will exceed the 3% budget balance requirement set out in the EU fiscal rules by more than three times. Moreover, the slowdown in economic growth and the said stimulus measures will also raise the level of public debt, which is another indicator of fiscal rules enshrined in EU legislation. Lithuania’s debt, maintained at around 40% of GDP over the last decade, will reach 50% in 2020 and move closer to the 60% threshold allowed for EU Member States.
It is true that not only Lithuania, but all EU Member States have implemented such fiscal response in order to stimulate economic activity, ensure the necessary social protection for citizens and strengthen the health care system. Although the measures taken and their scope vary significantly across countries (which, incidentally, poses new challenges in terms of distortion in the single market), it is estimated that all EU Member States will exceed the requirement to keep their budget deficit below 3% of GDP. On top of that, this year the aggregate national debt is expected to increase by 15 percentage points to 95% of GDP.
Normally, countries that do not meet fiscal requirements are subject to a number of corrective mechanisms and, if the situation does not improve, financial penalties; however, COVID-19 is an exceptional case. As soon as the pandemic began, the EC temporarily suspended fiscal procedures, which allowed Member States to implement wide-ranging measures to stimulate the economy. It is important for fiscal stimulus measures to be continued in 2021 as well (or even longer, taking into account the course of the pandemic), as early withdrawal of such support could undermine the already fragile economic recovery. On the other hand, prolonged stimulus could create debt sustainability risks in some EU Member States, hence sustainable and responsible management of public finances must be ensured once the economies recover.
EU fiscal rules: How and why?
The foundations for the EU fiscal rules regarding the general government deficit and debt levels – 3% and 60% of GDP respectively – were laid down in the Maastricht Treaty, signed back in 1992. Although it is not clear why such indicators were chosen (according to some assessments, it did not have an economic reasoning and was merely the result of political consensus), the decision to lay down fiscal discipline rules was indeed necessary. Already then, public sector balance and debt levels differed significantly across Member States, and in some countries had exceeded the requirements even before the Maastricht Treaty was signed.
EU Member States, especially those in the euro area, must comply with budgetary discipline and coordinate fiscal policies. This is necessary as the European Central Bank (ECB) implements the single monetary policy in the single currency area, while budgetary policies are carried out in a decentralised manner at the Member State level. Coordination of fiscal policies fosters convergence between Member States, since individual countries that are in economic slowdown can use the fiscal reserves accumulated in good times to promote job creation and ensure stable social benefits. Greater convergence in terms of the economic cycle also leads to more effective implementation of the ECB’s monetary policy, since measures applicable to the euro area as a whole are less effective if one Member State is experiencing an upturn in the economic cycle and another is in a downturn.
A few years later the requirements laid down in the Maastricht Treaty were included in the Stability and Growth Pact, which is the main pillar of the fiscal rules to this day. Since the Stability and Growth Pact has been reformed several times, it has now become a complex and multifaceted framework with a wide range of procedures and rules. It is true that a number of Member States repeatedly failed to achieve the set targets: for example, since the 2008 crisis, debt ratios of as many as seven euro area countries have increased above the allowed threshold. In addition, the growing number of various fiscal discipline oversight procedures has also led to an increase in the role of the EU executive authority, namely, the EC, in interpreting the rules and decision-making. In some cases, this has led to political tensions between Member States, particularly considering that no financial penalties have been imposed so far, although some Member States have persistently failed to meet the requirements laid down in the rules.
It has become evident that the time has come for change. Prior to the pandemic, the EC initiated a review of the fiscal rules and launched a public consultation on the possible direction of such a revision (the process is currently suspended). At the beginning of the review, no fundamental reform was expected, as a change of the indicators of 3% and 60% would require changes to the EU Treaty itself, which seemed difficult to implement. However, in the context of the COVID 19 pandemic, it is worth reassessing whether the underlying requirements of budgetary discipline remain relevant – the fiscal measures currently in place will make it particularly difficult for some Member States to meet the 3% and 60% threshold set in the Treaty.
A look to the future: Quality over quantity
One of the main reasons for reviewing the EU’s fiscal discipline requirements is that over the years, the rules have become a complex and multifaceted system geared towards difficult to implement objectives, especially in the case of public debt. According to preliminary estimates, as many as 13 of the 19 countries in the euro area will exceed the 60% debt requirement in 2020, making the underlying debt target difficult to achieve for the majority of them. The situation could be remedied by setting an individual debt-to-GDP ratio target for each country and a single criterion for achieving this target and replacing all debt reduction-orientated measures (e.g. ensuring that expenditure in Member States does not grow faster than income). Setting a clear target would make the fiscal surveillance framework simpler and more predictable and would reduce the scope for interpretation by the EU institutions. Among other things, facilitated implementation of targets could strengthen accountability and control at the national level.
Moreover, the system of sanctions is currently ineffective; therefore, it is necessary to establish a more effective control mechanism by tightening the imposition of fines and potentially introducing a system of incentives. Member States would be more motivated to comply with fiscal rules if, for example, compliance was considered an eligibility criterion for EU funds, which is becoming particularly relevant in the context of the new EU economic recovery fund, Next Generation EU.
Overall, Next Generation EU could provide guidance for assessing the quality of public spending. The fund will be embedded in the European Semester: Member States will have to link the funding received to the country-specific recommendations issued by the EC. The recommendations identify key structural challenges and propose areas of public investment which should become a priority for Member States in planning national budgets as well. In addition, it is worth including the green dimension in the fiscal rules, as there is an increased focus on climate change-related issues. For example, with the introduction of the so called Green Golden Rule, the expenditure of a Member State on growth-enhancing green investment would not be included in the overall deficit indicator of the Member State.
It is also important that expenditure geared towards long-term growth and creation of jobs is not constrained during the economic slowdown. Until now, Member States have tended to implement pro-cyclical fiscal policies, thus the rules need to be complemented with a stronger countercyclical element. For example, by identifying higher budget deficits in periods of economic downturn, while redirecting expenditure towards growth-enhancing areas. This would ensure faster convergence between Member States and support the common monetary policy pursued by the ECB.
The review of fiscal rules launched before the COVID-19 pandemic has become particularly relevant today, as the new challenges have reinforced the need to review not only certain procedures but also the underlying principles of the fiscal rules. The difficult period opens up a window of opportunity to implement such changes that would be difficult to accept during a normal period, and it is important to make good use of this.