EU fiscal rules allow a strong stimulus during a crisis but need an overhaul

The EU Commission and Ministers of Finance propose allowing Member States to depart from the requirements related to the monitoring of their budgets because of the coronavirus crisis. The aim is to enable Member States to take adequate fiscal policy measures to deal with the crisis. The activation of the escape clause of the EU's Stability and Growth Pact shows that there is no reason to worry that the rules would prevent a sufficient economic stimulus during this crisis. This article is part of a series of blog posts dealing with the economic impacts of the coronavirus.

On 20 March 2020, the Commission proposed that the escape clause be activated because of the coronavirus. The aim is to allow Member States to undertake measures to deal adequately with the crisis, while departing from the budgetary requirements that would normally apply under the European fiscal framework. This means that the limits set for government deficit (3% of GDP) and debt (60% of GDP), and the requirements set for the structural fiscal position of general government finances and public spending will not be applied because of the crisis.

On 23 March, the Ministers of Finance of the EU countries issued a common statement where they agreed with the assessment of the Commission that the conditions for the use of the general escape clause of the EU fiscal framework are fulfilled. This is the first time that the general escape clause is activated, and the clause will remain in force as long as necessary.

The rules have been criticized primarily because it has been thought that the rules might prevent expansionary fiscal policy during economic downturns. The activation of the escape clause proves that at least this worry is groundless. Hopefully the Member States will now utilize the flexibility provided to them.

Full flexibility may prove an efficient way of addressing the ongoing crisis. However, in the future, the framework should primarily ensure long-term sustainability of the Member States’ general government finances and the building of financial buffers in boom times. Sustainable general government finances guarantee that the Government can take economic stimulus measures when the next crisis hits. The rules are therefore in serious need of an overhaul – once the current crisis is over.

Flexibility was added to the EU fiscal framework after the global financial crisis

A set of common fiscal policy rules for the Member States of the Economic and Monetary Union (EMU) was laid down in the Maastricht Treaty in 1992. It was then agreed that the Member States’ deficit must not exceed 3% and that their government debt must not exceed 60% of GDP. The aim of these rules was to ensure that the Member States have disciplined fiscal policy so that no country would be a free rider in the EMU. The aim of the corrective arm of the Stability and Growth Pact, adopted in 1997, was to correct excessive deficits. The purpose of the preventive arm, later added to the framework, was to retain the Member States’ general government finances in balance or surplus over the medium term.

The EU fiscal rules and their loose implementation failed to ensure the building of buffers in the Member States during the boom years between the introduction of the Stability and Growth Pact and the collapse in 2008. Moreover, the financial markets did not take the country-specific risks into account in the pricing of Member States’ loans, which was the idea when the Maastricht Treaty was signed. When the financial crisis hit in 2008, the debt ratio of many Member States was close to or even more than 60% of GDP.

The EU fiscal rules had aimed at preventing financial crises by strict regulation of the Member States’ fiscal policy. However, tools for crisis resolution were missing. It was necessary to change the fiscal rules to rectify this shortcoming. The six pack’ reform of 2011 made the rules stronger, while also adding more flexibility and discretion. In addition to the Member States’ structural fiscal position (difference between revenue and expenditure excluding the impact of economic cycles), the assessment of compliance with the rules was complemented with the expenditure benchmark. Under the expenditure benchmark, public spending should grow only to the extent affordable to the country in view of the country’s potential output growth.

If a country did not follow a disciplined fiscal policy based on its structural balance or the expenditure benchmark, the significant deviation procedure would be applied to it. On the other hand, a general escape clause was added to the rules after the financial crises in case of a serious downturn in the eurozone or the entire EU economy.

Concerns that the fiscal framework would prevent any necessary expansionary fiscal policy

Although the fiscal framework was reformed after the financial crisis, it has constantly provoked criticism. One of the first things criticized was the fact that the rules support pro-cyclical fiscal policy. This means that the rules support fiscal policy that is expansionary during an economic upturn and restrictive during a downturn. This kind of fiscal policy strengthens economic cycles and, most importantly, increases the social and financial costs resulting from economic downturns.

In practice, the fiscal policy of many EU countries has indeed been mainly pro-cyclical. A similar fiscal policy has also been implemented in Finland for many years, e.g. in 2018. Some of the critics have even considered that the rules prevent an appropriate fiscal policy in view of the prevailing situation.

Another fact that has provoked criticism is that the agreed rules have not always been firmly held to. Instead, the Commission has applied the flexibility the framework provides for rather widely. It is true that, without the flexibility, not all national decision-makers would have approved the framework. In many countries, however, the fiscal framework has not succeeded in practice in supporting the sustainability of general government finances. The development has eroded the credibility of the framework as a means for coordinating fiscal policy and called into question the transparency and predictability of its application.

Low interest rates have changed the perception of a sustainable debt level and debt externalities on other countries

The credibility and complexity of the framework has provoked criticism even after the changes made to it. Although the framework was updated and modified, particularly through the ‘six pack’, it has been considered unable to respond adequately to changes in the operating environment. The interest rates, which have been low or even zero, play an important part in this.

Low interest rates reduce long-term sustainability problems and debt externalities within the EU and the eurozone. For example, the negative impact of Italy’s debt level on Finland is smaller than previously. At the same time, the positive externalities of expansionary fiscal policy increase between countries. This means that Finland benefits from the stimulus measures taken by Germany, for example. In certain cases, a higher than normal debt level in one country may thus have a positive impact on other countries.

The idea with the above criticism is that the trade-off of such externalities – i.e. how strong the adverse externality of debt is compared with the favourable externality of stimulus measures – changes in an environment with low interest rates. Taking this into account would require an even more complex rules framework.

In short, the problem is that additional debt can be useful in some cases and detrimental in others, depending on many factors. To put it simply, additional debt can be a good thing if the country is relatively big and has tight commercial ties with other Member States and a rather low debt ratio level to start with. On the other hand, if the country is relatively small and has looser commercial ties and a high debt ratio level to start with, additional debt is not a good thing. In a nutshell: if Germany takes more debt, it is a good thing, but if Greece takes more debt, it might be a different thing.

As a solution, the economists Blanchard, Zettelmeyer and Leandro propose that fiscal policy rules be replaced by fiscal standards. In this case, the fiscal policies of Member States would be assessed on a case-by-case basis by means of fiscal policy codes of conduct. Blanchard et al. describe the difference between rules and standards as follows: a rule can, for example, prohibit you from driving faster than 55 miles per hour, whereas a standard only encourages you to drive carefully. According to the above economists, the benefit of standards is that they can be applied to different kinds of situations. In the case of standards, instead of following constantly varying speed limits, the driver should adjust the driving speed according to changes in the conditions, such as the weather or children playing in the street.