On January 17th, the European Parliament voted on a new set of fiscal rules for the members of the European Union. The new rules are supposed to modify the Stability and Growth Pact, SGP, the structure for fiscal discipline that was included already in the Maastricht Treaty in 1992.
The new fiscal rules are considered a ‘big deal’ in EU circles. The idea is to create a new legal structure that encourages fiscal discipline among the member states while avoiding a repetition of the Greek disaster a decade ago.
That is a commendable ambition: I have analyzed the Greek experience under austerity in a book, as well as in several articles—e.g., here, here, and here—and there is only one conclusion to be drawn: When the Stability and Growth Pact was put to work, it wreaked havoc like no other government policies could do in peacetime.
It is worth a lot of work to make sure no other country will ever suffer like Greece did back then. However, even if their ambitions are praiseworthy, it is always good to be cautious when politicians go to work. The outcome of their deliberations is too often well off the target they aimed for.
In this case, the problems for the lawmakers in the EU seem to be even bigger than that: according to Euronews.com,
EU lawmakers and governments will engage in a furious few weeks of haggling over fiscal rules, after MEPs today (17 January) voted for budget deficit curbs that diverge from a deal struck by governments in December.
Primarily, the members of the European Parliament disagree with the plan for a new fiscal framework that the finance ministers of the member states “spent months arguing over,” to the point where “they’re going to have to do it all over again” as a result of the vote in the Parliament.
If they want to get this fiscal framework reform right, the members of the European Parliament and the EU member states should address two major problems. The first has to do with the policy method with which the EU is supposed to enforce fiscal discipline among member states.
The fundamental fiscal requirements remain in place: member states must maintain budget deficits below 3% of GDP cap and keep their debt from exceeding 60% of GDP. Instead of tinkering with these, the new reform package concentrates on the method by which fiscally ‘undisciplined’ member states would be brought back in compliance.
Herein lies the problem. From the November parliamentary briefing on new economic governance rules:
Debt sustainability would be ensured through stricter fiscal monitoring by the Commission, based on a country-specific fiscal adjustment path anchored to a debt sustainability analysis (DSA) framework … The Commission would negotiate bilaterally with Member States on a medium-term fiscal-structural plan
This all sounds good and workable, especially since it replaces the hamfisted approach to fiscal policy that the original and modified versions of the SGP have imposed. However, this new policy method does not solve the underlying fiscal problem. When a government runs a budget deficit for long enough to end up in breach of the fiscal limitations under the SGP (or whatever its name will be in the future), its deficit is structural in nature. This means that the deficit will not end unless there are structural reforms to the spending programs that dominate the government budget.
Government budgets in the EU are dominated by spending programs that provide benefits to targeted demographics. Those who get help are predominantly lower income households, which means that spending reforms—no matter how necessary—are always bound to stir up political controversies.
The EU can avoid those if and only if it accepts that a member state reforms away its traditional welfare state. Such reforms are always likely to be politically controversial, which means that they are better handled by member states as a general policy problem to be solved. Precisely for reasons of political controversy, those reforms should not be implemented with the Damoclean sword of EU-imposed fiscal enforcement hanging over them.
The second problem with the EU’s fiscal reform ambitions has to do with the policy variable in focus. The path to a balanced budget can run on two different tracks: a spending cap or what the EU parliamentary briefing refers to as “net expenditure.” It refers to the budget balance, with some modifications—see page 4 in the briefing:
The basis for setting up the multi-year net expenditure path is a single operational indicator, namely nationally financed net expenditure, defined as public expenditure net of discretionary revenue measures and excluding interest as well as cyclical unemployment expenditure (allowing for automatic stabilisers to work).
It may seem irrelevant which policy variable we focus on, spending or net expenditures, but the difference matters a great deal. When the policy variable of choice is spending, the path to a balanced budget necessarily involves reforms that permanently reduce government outlays. There is a wealth of studies that show the advantages of capping spending; in April last year, Dan Mitchell, economist and president of the Center for Freedom and Prosperity, published a nice overview of the most convincing examples.
Mitchell has also made the point that states in the U.S. as well as countries in Europe that have tried to live by net-expenditure rules, have a sordid record of failure.
It remains to be seen if the European Parliament and the EU member states can unite around a credible reform to its fiscal policy framework. They are up against two challenges:
- If the negotiations over the new fiscal framework drag on for too long, this issue could come to dominate the European elections in June; if voters fear that their countries might be punished under the new rules, they could swing in favor of EU-skeptical parties;
- If the Parliament and the European Council rush negotiations just to have a deal in place, they could end up with a reform that has little promise of actually working.
There is one more challenge, one that nobody seems to want to talk about. The EU has a history of suspending the current SGP when it was convenient for them. Who is to say the same won’t happen with whatever new model they come up with? If member states know that the EU can ignore its own fiscal rules, why should they abide by them?
