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Euro Area Prepares for Fiscal Showdown With ECB Arsenal Depleted

Euro Area Prepares for Fiscal Showdown With ECB Arsenal Depleted

(Bloomberg) --

The euro area does fiscal policy wrong, the European Union’s executive arm will say in a document due to be published next week, echoing ever louder warnings by central bankers about the need to make better use of public purse strings to spur growth.

The currency bloc’s fiscal rules, which aim to keep public debt and deficits in check, are convoluted, lack political ownership, and are difficult to enforce, the European Commission will say in the report. The draft document seen by Bloomberg is meant to kickstart a debate about overhauling economic governance in what is effectively the world’s third-biggest economy.

Euro Area Prepares for Fiscal Showdown With ECB Arsenal Depleted

While there’s consensus among EU officials and politicians that the current set of rules needs a rethink, there’s little agreement on how that should come about. Some governments including Italy have called for greater flexibility, while others, such as Germany, have asked for fewer, stricter limits.

Brussels has often come under fire for failing to punish fiscal pariahs, instead handing out reprimands that have for the most part failed to affect the desired discipline. But it has also been criticized for asking countries for adjustments that are too harsh given their political realities and of constructing a set of rules that’s too complex and opaque, making ownership of the required overhauls more difficult for national governments.

Political Cost

The current rules state that no country should have a budget deficit larger than 3% of gross domestic product or debt above 60% of GDP. Failing that, governments must set annual targets to show they’re moving in the right direction. The 19 countries that use the euro can be fined as much as 0.5% of GDP for consistently flouting the rules, though that’s never happened, largely due to political pressures beyond Brussels and concerns that a fine could fan euroskepticism.

Compliance with the commission’s recommendations is weak, according to the report, which says that simpler rules and implementation could help potentially lower the political cost of enforcement. Still, EU officials don’t expect the discussion could be a catalyst for significant change in the immediate future given the major entrenched differences between euro-area governments.

The discussion of revisiting the fiscal rules, which were tightened during the bloc’s sovereign debt crisis, comes as the sustainability of public finances remains a key concern. The International Monetary Fund warned earlier this week that Italy’s crippling public debt, currently at 135% of output, is set to keep expanding amid chronically low economic growth.

An issue that’s likely to feature prominently in the debate over how to revise the fiscal framework is that of the continent’s transition to a climate-neutral economy and the investment it will entail. The draft report mentions the need to re-assess the existing flexibility within the rules, which allows the exclusion of some investment spending from key deficit calculations, in order to help incentivize more “green” spending.

Fiscal Space

The review of the existing framework follows years of efforts to shore up the euro area so it can better withstand future crises. These have yielded mixed results: a reform of the bloc’s bailout fund has been held up, discussions on common deposit insurance are moving at a glacial pace and a budget instrument that was agreed after much debate is far from the original idea of a tool to help stabilize economies in a downturn.

The draft report acknowledges a perennial discrepancy in the bloc, where countries that need to tighten their belt, spend more, while those that need to spend more to boost growth across the region tend to be overly frugal. Making matters worse, policies are usually pro-cyclical, as countries don’t use the good times to put their finances in order, nor are there sufficient incentives in the rulebook to boost investment and spur growth in a downturn.

Earlier this month, European Central Bank President Christine Lagarde told French magazine Challenges that “a concerted fiscal stimulus at the euro-area level would help speed up growth.” Similar pleas by her predecessor, Mario Draghi, fell on deaf ears in Berlin.

The ECB has already cut rates to record lows and is buying bonds to stimulate inflation but has depleted much of its arsenal. The institution’s chief economist, Philip Lane, has said officials would be able to normalize monetary policy faster if governments step up spending.

--With assistance from Nikos Chrysoloras.

To contact the reporter on this story: Viktoria Dendrinou in Brussels at vdendrinou@bloomberg.net

To contact the editors responsible for this story: Ben Sills at bsills@bloomberg.net, Richard Bravo, Craig Stirling

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