New EU fiscal rules and governance challenges

Guido Lorenzoni is the Joseph Sondheimer Professor of Economics at the University of Chicago Booth School of Business, Francesco Giavazzi is Professor Emeritus at Bocconi University, Veronica Guerrieri is Ronald E Tarrson Professor of Economics at the University of Chicago Booth School of Business, and Leonardo D’Amico is a PhD Candidate in Economics at Harvard University

In November 2022 the European Commission presented an ambitious plan to overhaul the existing economic governance framework for the EU which includes radical innovations both in the way in which national fiscal plans are formulated and in the governance structure that supports them (for other comments on the proposal, see for example Buti et al 2022 and Wyplosz 2022).

This column argues that while the Commission is right to look at NextGenerationEU as a positive model for economic cooperation, a new system of fiscal rules that goes in this direction requires us to think boldly about further steps in the direction of a political and fiscal union.

The existing system of numerical rules is essentially scrapped. It is replaced by a system in which countries make medium-term plans that are assessed using debt sustainability analysis, and in which the single operational objective to achieve debt stability is the path of net primary expenditure (ie. expenditure excluding interest and unemployment benefits).

From the point of view of macroeconomic stabilisation, this is a welcome innovation. An approach based on medium-term plans and on an expenditure rule tends to deliver adjustment paths that are less sensitive to whether the economy is in a boom or a recession.

The adjustment paths are also potentially more responsive to the quality of spending, as the proposal includes the possibility for member states to obtain longer adjustment periods if they make reform and investment plans conducive to long-term growth.

In other words, the approach in the proposal leaves more room to tailor fiscal adjustment to the circumstances of a country, not only the in terms of its cyclical conditions, but also in terms of policy choices that affect future growth1.

The Commission is clearly influenced in its thinking by the recent experience of the NextGenerationEU recovery plans, as a model of successful economic cooperation in the EU. This influence is visible in the design of the process that produces the four-year plans at the core of the new system. And it’s visible in the strong emphasis on investment and reforms.

It is useful to contrast the Stability and Growth Pact (SGP) with NextGenerationEU (NGEU) as different models of joint economic governance. The SGP essentially leaves all strategic economic choices to member states and only imposes on them a uniform set of rules, to ensure that these choices are consistent with a common objective of monetary/financial stability.

We believe the Commission is right in looking at NGEU as a positive model for economic cooperation. At the same time, a new system of fiscal rules that goes in this direction requires us to think boldly about further steps in the direction of a political and fiscal union

NGEU, on the other hand, is strongly driven by the joint definition of common goals (green transition, digitalisation, reducing inequality), combined with considerable discretion in the formulation of national plans and in adapting them to the institutional reality of each member state. The models are also very different in terms of enforcement.

The corrective arm of the SGP has mostly worked through moral suasion. Fines are in principle part of the enforcement mechanism but have never been applied. NGEU, on the other hand, has the advantage that non-compliance with the commitments made in the national plans can be simply punished by suspending financing.

So far in the NGEU experience, this has worked as a credible threat. For example, Italy – the largest beneficiary of NGEU funds – has more than once made changes to proposed legislation to comply with the Commission’s requests.

Consider two examples from the Italian experience. Italian teachers are traditionally opposed to individual performance evaluations, and career advancement in the Italian school system only depends on seniority. The Commission, as part of the reform package attached to NGEU – which includes large spending programmes destined to schools – asked that the careers of Italian teachers be based more on evaluations. This has been a point of tension between Italy and the Commission, and it was only solved when Italy accepted to introduce teachers’ evaluations.

Another example is in the area of public procurement. Italian municipalities have often created in-house service companies in order to avoid pro-competition EU regulations that require outside services to be tendered. This practice has been severely limited to comply with NGEU requests.

The open question is how to import the successful features of NGEU into a renewed fiscal framework. Overall, we agree that NGEU shows that the Commission and member states can cooperate in the joint design of economic policies, even when that involves a considerable level of detail.

Such cooperation so far has appeared to be more productive than negotiations on the formal compliance with numerical SGP rules we have seen in the past. However, there are important design differences between NGEU and fiscal rules, which in our view raise two critical challenges.

First, NextGenerationEU has the big advantage of starting from well-defined EU-level strategic goals. The negotiated national plans are then designed to pursue those common goals.

In the realm of fiscal rules, this combination of EU goals and national plans is not there. In particular, the definition of the strategic goals of national fiscal policy naturally remains with national governments.

However, once we make the paths for primary spending potentially a function of multi-year commitments on investment and reforms, this effectively gives the Commission more power in important national decisions.

We don’t see this additional power necessarily as a bad thing, but it opens the risk of making the Commission the scapegoat of national political parties who might want to deviate from pre-existing plans, either negotiated by them or, more likely, by a previous government.

Such parties may use the excuse, already used in the past, that the old plans come from negotiations with the Commission, a technocratic non-elected body. Since this argument was used prominently even under numerical rules, enshrined in treaties ratified by national parliaments, it is even more likely that it will be used under this new model.

This would put the Commission in a difficult position, making it the target of political animosity and possibly dampening demands for further European integration.

It is possible that the process of approval of the multi-year plans could be designed to reduce these risks. In particular, as in a recent IMF proposal (Arnold et al 2022), more space could be given to National Fiscal Councils, thus keeping within member states the technical evaluation of the effect of reforms and investment plans2.

It is also possible that giving more space to the European Parliament in the process of approval could give it stronger democratic legitimacy.

The second challenge has to do with enforcement. As just pointed out, it is easier to support a system of rewards in which funds coming from the EU centre are used to finance a member state’s project, and this financing can be suspended.

On a pure economic level, what counts is the net value of the transfers implicit in the combination of contributions from member states to the EU and of financing from the EU budget back to member states. However, from both a legal and political perspective, the imposition of fines is different from the suspension of financing, and the latter seems a more credible threat to support multi-year commitments by member states.

The new system of rules could be integrated in programmes like NGEU, and payments can be made conditional on member states being in good standing with the new rules. The Commission’s proposal explicitly mentions this possibility3.

However, given that NGEU is a temporary programme, this conditionality cannot be a structural feature on which to rely in the long run. Creating a more permanent central fiscal capacity for the EU would have the added benefit of strengthening the enforcement of fiscal rules4.

Summing up, we believe the Commission is right in looking at NGEU as a positive model for economic cooperation. At the same time, a new system of fiscal rules that goes in this direction requires us to think boldly about further steps in the direction of a political and fiscal union.

Endnotes

1. These benefits are the reason why multi-year plans and an expenditure rule have been featured and discussed in many proposals, including those of the European Fiscal Board (2018, 2019, 2020) and D’Amico et al (2022).

2. Strengthening the role of national fiscal councils is also in Blanchard et al (2022).

3. The idea of using conditional financial support to facilitate commitment on reforms is not new and goes back to a proposal in European Commission (2012).

4. As centralised fiscal capacity expands in new areas, it is possible that some more essential forms of spending (eg. income protection programmes like SURE) may be less appropriate for this type of conditionality, relative to others (eg. spending for investment programs).

References

Arnold, N, R Balakrishnan, B Barkbu, H Davoodi, A Lagerborg, W Lam, P Medas, J Otten, L Rabier, C Roehler, A Shahmoradi, M Spector, S Weber and J Zettelmeyer (2022), “Reforming the EU Fiscal Framework: Strengthening the Fiscal Rules and Institutions”, IMF Departmental Paper No 2022/014.

Blanchard, O, A Sapir and J Zettelmeyer (2022), “The European Commission’s fiscal rules proposal: a bold plan with flaws that can be fixed”, Bruegel.org,

Buti, M, J Friis and R Torre (2022) “How to make the EU fiscal framework fit for the challenges of this decade”, VoxEU.org, 10 November.

D’Amico, L, F Giavazzi, V Guerrieri, G Lorenzoni, C-H Weymuller (2022), “Revising the European fiscal framework, part 1: Rules”, VoxEU.org, 14 January.

European Commission (2012) “A blueprint for a deep and genuine economic and monetary union: Launching a European Debate”

European Fiscal Board (2018), Annual Report.

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

European Fiscal Board (2020), Annual Report.Wyplosz, C (2022), “Reform of the Stability and Growth Pact: The Commission’s proposal could be a missed opportunity”, VoxEU.org, 17 November.

This article was originally published on VoxEU.org.