The New European Fiscal Rules

The European Union is a monetary union, but not a fiscal one. Twenty of its 27 member states use the euro, but they keep their public accounts. Apart from the small EU budget (which amounts to a mere 1 percent of EU GDP), there is no fiscal union, i.e., Brussels levies few taxes and spends little for the bloc. However, since European economies are highly interdependent and member states’ fiscal policies generate important externalities, common rules must be agreed. These rules are included in the so-called Stability and Growth Pact (SGP), whose aim is to coordinate the fiscal policy of the different member states, as well as to ensure the sustainability of public finances.

The SGP rules, created in 1997 and reformed during the eurozone crisis of the 2010s, were suspended in 2020 to allow countries to spend as much as needed, first to fight the Covid-19 crisis and later to cushion the economic impact of the Russian invasion of Ukraine. But the activation of this suspension clause was only temporary, and rules must now be reapplied. There were intense discussions in 2023 to reform the existing rules, considered to be over-restrictive, untransparent, and inflexible. In particular, the rules forced member states with a debt-to-GDP ratio above 60 percent to reduce their debt by 1/20 per year, requiring extremely austere policies. On December 20, 2023, the Council of the European Union finally reached an agreement on fiscal rules, to be discussed with the European Parliament in the first quarter of 2024 and enforced months later. Ultimately, the new EU fiscal rules represent a compromise between the fiscal hawks of central and northern Europe, led by Germany, and the southern countries, led by France, which insisted on the need to avoid a return to austerity in the European Union (that could cause a recession) and on the need to allow fiscal space to invest in climate transition, defense, and industrial policy.

Q1: What do the new rules say?

A1: The new fiscal rules are based on an a prior assessment of the sustainability of each country's fiscal strategy based on a debt sustainability analysis. This classifies countries by risk levels through a transparent and jointly agreed methodology.

Once the fiscal sustainability of member states has been stated, member states’ fiscal path must lead to the ultimate objective of a deficit below 3 percent of GDP and a public debt below 60 percent of GDP. Member states could have seized the occasion to revise these figures, which date back to the beginning of the euro and do not make much sense today, but they were codified in the EU treaties and required a lengthy legislative reform, unlikely in the current political context.

If either of the two targets (deficit or debt) is not met, the European Commission intervenes. It creates a fiscal adjustment plan to bring the member state back towards compliance. This is known as the "technical path," which will take the form of "national medium-term structural fiscal plans" with a duration of four years, extendable to seven years if certain reforms or investments are carried out.

The main novelty in the setting of the adjustment path toward equilibrium is that it will not be uniform for every country but will be adapted to the characteristics of each country through negotiations between the commission and each member state, which must be endorsed by the EU Council.

Once the adjustment path toward equilibrium has been established, a country´s progress will be evaluated by the evolution of its net primary expenditure. The latter is defined as observable expenditure, net of discretionary revenue measures (i.e., one-off revenues) excluding interest on debt expenditure, EU-funded expenditure, and cyclical unemployment expenditure. This is a clear methodological improvement over the previous rules, which relied on the concept of “structural deficit,” a non-observable variable that is difficult to estimate and created a lot of methodological controversies.

The new rules maintain the Excessive Deficit Procedure (EDP) from the previous rules, although some aspects have been clarified. The EDP will be triggered by both an excessive deficit and excessive debt, and in assessing it the commission and the council will consider, among other elements, "government debt challenges," the size of the deviation, progress in the implementation of reforms and investments and, "where appropriate, increases in government defense spending." The debt-based EDP will be triggered when the debt exceeds 60 percent, the deficit is not close to balance, and when the deviations recorded in the Member State's control account exceed certain maximum amounts.

Q2: What are the new rules and safeguards?

A2: To ensure fiscal adjustment, the EU Council has established the application of several safeguards or conditions applicable to any structural fiscal plan. First, a minimum annual structural deficit reduction rate of 0.4 percent, which may be limited to 0.25 percent if the country is undertaking reforms and investments within a seven-year plan. This minimum reduction will be more demanding, 0.5 percent, if the member state is subject to an EDP. Second, the so-called deficit resilience safeguard forces all countries to reduce their structural deficit even after the 3 percent rule is met, down to a structural deficit of 1.5 percent, to create a fiscal cushion for times of difficulty. Third, the "debt sustainability safeguard," which concerns the pace of public debt reduction requires that debt at the end of the adjustment period should represent, as a percentage of GDP, an average annual reduction of 0.5 percent for countries with debt between 60 percent and 90 percent of GDP and 1 percent for countries with debt above 90 percent, although it will only apply when the deficit has fallen below 3 percent.

Finally, and in the case of countries subject to an EDP, an additional safeguard is included, relating to the maximum deviation of expenditure from the planned adjustment path, to avoid systematic errors. Thus, actual net primary expenditure in each year may not deviate by more than 0.3 percent of GDP from the annual target, nor by more than 0.6 percent cumulatively over the total adjustment period.

The assessment of these safeguards is complicated, pending details from the commission on certain calculation rules. It should be noted that the deficit safeguards, although they reduce flexibility, make some sense. The debt safeguard, however, is unnecessarily complex.

Q3: Will the new rules work?

A3: The new rules undoubtedly represent considerable progress and modernization compared to the previous ones, but they have two fundamental problems: they only partially meet the objective of creating a simple, flexible, and credible framework, and they are inadequate for the current geopolitical context.

As far as simplicity is concerned, the abandonment of the “structural deficit” as a control variable for a criterion such as net primary expenditure is to be welcomed because it will reduce controversies around the discussion of the “structural deficit” and the “output gap.” However, structural variables are still present (in the debt sustainability analysis, in the calculation of cyclical unemployment expenditure, and the minimum deficit reduction and deficit resilience safeguards, for example). On the other hand, the safeguards unnecessarily multiply the control variables and reduce simplicity.

As for flexibility, it has been improved with the customization of adjustment plans and their possible extension, but it has been limited with various restrictions, such as the maintenance of the three percent deficit and 60 percent debt benchmarks—arbitrary values that reflect nothing more than the legacy of the era that created the euro that now has little to do with the investment needs of today's world. This is true both in terms of green and digital transition and defense, as well as with the safeguards, which introduce strong restrictions on this customization of adjustment paths, forcing the adoption of minimum deficit and debt reduction rules that often do not make economic sense.

Credibility, unfortunately, is the most fragile part of the new rules. The likelihood of effective compliance with them is affected by several factors. First, the maintenance of the 3 percent deficit and 60 percent debt benchmarks, which have no theoretical justification, and therefore whose compliance is not very credible. Secondly, the institutional distribution of roles: the mere advisory role of the independent fiscal institutions places the burden of compliance on the commission and the council, as in the previous rules (a model that has proven ineffective). Moreover, the commission's credibility is undermined by the management of NextGenerationEU funds, particularly when it comes to demanding structural reforms (largely limited to calling for legislative milestones, regardless of their actual implementation) or assessing investments (focusing on control of the legality of spending, rather than on control of efficiency or structural impact).

As for sanctions, their amount has been reduced in exchange for a theoretically stricter application. In case of noncompliance, half-yearly fines will be imposed amounting to 0.05 percent of GDP until the country reacts (with no limit on cumulative fines). Other proposals of moral sanctions or conditionality on EU funds were finally rejected. The problem is that fines continue to be pro-cyclical, further damaging the member state's fiscal position, and undermining their credibility.

Finally, an essential problem with these rules is that they are inadequate for the current geopolitical context and that their negotiation has not been linked to the creation of a permanent fiscal capacity at the EU level. The current rules, by focusing exclusively on ensuring the sustainability of ember states' finances, jeopardize the growth of the European Union as a whole. If effectively implemented, they will significantly reduce public investment in the most indebted member states, increasing real divergences in the European Union and generating underinvestment in the provision of public goods at the European level. The European Union needs fiscal rules—of that there is no doubt—but it also needs to finance its long-term investment needs, its green and digital transition, an agile and competitive industry able to compete with other blocs that are pursuing aggressive industrial policies, and a defense framework capable of dealing with growing global threats.

Federico Steinberg is a visiting fellow with the Europe, Russia, and Eurasia Program at the Center for Strategic and International Studies in Washington, D.C, and a senior analyst at the Royal Elcano Institute. Enrique Feás is a senior analyst at the Royal Elcano Institute.