Covid Shows That Europe’s Fiscal Rules Are Outdated


One upshot of Covid-19 has been closer coordination between monetary and fiscal powers. This has led to a revolution in macroeconomic policy — one that countries should continue building upon. Just as central banks have been rethinking their frameworks, there is a strong case for governments to similarly reconsider their approach to fiscal policy.

Europe now has the perfect opportunity to do so: The stringent rules of the European Stability and Growth Pact, which limits the fiscal policies of euro-area member states, are suspended until 2022. This gives the bloc time to establish a new fiscal regime that can both stabilize economic activity and address long-term challenges such as climate change.

There is little doubt that governments must play a more active role in getting Europe’s economies back on track. The relentless decline in equilibrium interest rates has curtailed what the European Central Bank can do, and it’s hard to believe that these will go up significantly anytime soon. With rates and a considerable share of government bond yields already in negative territory, the euro area is unlikely to return to full employment without additional fiscal spending.

This is where the Stability and Growth Pact could get in the way. Despite various piecemeal overhauls and extensions, the Pact is still a set of strict and increasingly outdated fiscal rules that, at least in principle, limit member states’ deficits to 3% of GDP and debt to 60% of GDP. This limit made sense when the fiscal framework was first designed three decades ago because interest rates were much higher.

Today, trend growth is outpacing interest rates by a considerable margin, reducing debt servicing costs even at high levels. Hence, government debt levels now seem sustainable at far above 60% of GDP. In fact, at the current juncture, the existing rules could trigger premature fiscal austerity, like they did after the global financial crisis when they forced cutbacks in public services and derailed the recovery.

Such premature austerity could undo the benefits we’ve seen from monetary and fiscal policy working together during this crisis. For example, there is greater burden sharing between countries at the European Union level, with the 1.8 trillion-euro ($2.2 trillion) budget plan, including the 750 billion-euro Next Generation EU fund. And the ECB’s expanded pandemic emergency purchase program also implies a greater commitment to more flexible asset purchases in terms of pace and composition. Pulling back fiscal support at the national level would offset the positive impact of these efforts and thwart a full recovery.

Combined, these initiatives have been essential for assuaging concerns in Europe’s sovereign debt markets around the euro-area periphery and even questions surrounding the euro as the common currency. Both programs mark important steps toward finally issuing a common debt instrument. This will help attract investor interest to the bloc.

As vaccinations are rolled out across the continent, governments have an even stronger incentive to continue bridging incomes until a pandemic recovery is underway. The end is in sight, and the vaccine will ensure that a large part of the unprecedented fiscal measures — granted through short-term work programs, direct government payouts and public credit guarantees — will prove temporary in nature. But for now, additional support is needed.

Well-designed fiscal stimulus — especially programs geared to lift trend growth through infrastructure spending — often pay for themselves by boosting economic activity over the long run. However, such public spending needs to be well executed, which is why the Next Generation EU program is requiring governments to submit “national recovery plans” outlining how they intend to spend these funds. The European Commission must ensure the spending is aligned with the EU’s vision of a decarbonized and digital economy.

The ECB can also push for closer coordination between monetary and fiscal authorities through its policy framework review, which concludes in the second half of this year. In my view, the biggest risk to the ECB’s independence is not a rise in public debt levels, it’s the fact that Europe is still missing a fully-fledged fiscal union. Even an incremental step toward creating one — starting with a jointly issued EU debt instrument to fund the bloc’s stimulus program — would be welcome. Without some progress on a fiscal union, Europe’s economic wounds may take far longer to heal.    

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Elga Bartsch is head of macro research at the BlackRock Investment Institute, which connects the company’s portfolio managers and publishes insights on economics and markets.

©2021 Bloomberg L.P.

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