The EU’s new fiscal framework proposal, the Economic Governance Review (EGR), has already got the ball rolling with its promised bold reforms. But a closer look points to a few loose-ends that can be easily addressed. While the new framework is encouraging, without sufficiently considering climate risks and fully bottom-up fiscal adjustment paths, it feels like a touch of spice from the overall recipe is missing.
A sense of playing the lottery on the next inevitable crisis that comes our way, coupled with the widespread dissatisfaction on current EU fiscal policy, is shaping the debate on the new framework. This is important because this debate is likely to come to a head later this month when the Council is expected to agree on their official position on the EGR.
The Commission’s comprehensive proposal should in theory succeed the current European fiscal rules that were suspended under the General Escape Clause due to the pandemic. If the Commission suddenly pressed the ‘reactivate’ button tomorrow on those rules as they are, most EU countries would be found guilty of breaching the Stability and Growth Pact’s infamous 60 % public debt-to-GDP and the 3 % deficit ceiling. They would need to pull the purse strings tight to reduce their debt gap by 1/20th annually.
In other words, most countries would be moved immediately onto the naughty list.
To avoid this, the proposal aims to set the scene post-escape clause. It must avoid a scenario where all Member States are on this naughty list (otherwise known as triggering the corrective arm of the Stability and Growth Pact) and deal with waning fiscal credibility after recent large-scale spending due to the pandemic and the war in Ukraine.
One key proposition is for four to seven-year fiscal adjustment paths. This would be proposed by Member States (bottom-up) based on a Commission-drafted Debt Sustainability Analysis (DSA) per country (top-down). In theory, this multiannual path would ensure that debt is kept on a downward path by the end of the adjustment time while leaving the big 60 % debt and 3 % deficit reference values unchanged.
A good proposal but more can be done
On the upside, the proposal contains a basket of policies that are agreeable to the ears of leading economists and national stakeholders. Previous rules were complex with a reliance on unobservable variables which undermined transparency. By reducing the number of rules, lowering their reliance on unobservables while adding more emphasis on the medium and long-term fiscal sustainability objectives, the review indicates that a promising reform could – and should – be passed.
The opportunity is there but the Commission’s last communication on the EGR risks missing the mark because the EGR lacks emphasis on bottom-up debt calculations and climate risk considerations.
First, a top-down approach taints the proposal’s sense of ‘national ownership’. The spending ceilings underlying required debt reduction rely on a common methodology agreed under the Commission’s DSA. While using more observable variables is a good ‘new’ move, projections using variables that are determined top-down is a shady business.
Put simply, if Member States follow a DSA that is baked in Brussels, they must know what it is made of – the ‘magic ingredients’ so to speak – as well as the way in which they were cooked up.
The solution is transparency. The Commission’s DSAs translate into reference debt paths for each Member State. These should be clearly communicated. So should their corresponding methodologies. This would allow national authorities but also their supervisory bodies – the Independent Fiscal Institutions (IFIs) – to provide insights and inputs on budgetary projections and stochastic DSA projections.
The benefit of doing this would be an improvement on DSA discussions regarding the cyclicality of country-specific adjustment paths and how targeted they are. Also, governments would be sufficiently warned about their policymaking direction and its possible implications.
It’s the climate, stupid
On top of this, Member States should submit their own adjustment paths, subject to approval from the Commission. A commonly agreed method with each Member State on a bilateral basis on a debt-sustainability framework will do better in debt assessment. This does not negate the need for common key requirements in the adjustment paths to be met by EU countries. Such an exercise would bring nuances in the country’s specifics – including climate-related risks – to the forefront.
Following on from the need to get away from top-down adjustment paths, there is also the issue that new fiscal risks are not sufficiently considered. While getting Member States back on track with their public finances is great, one climate disaster later and we’re back to zero.
The British Office of Budgetary Responsibility estimated in 2021 that climate-related fiscal risks may increase the UK’s debt-to-GDP ratio by 20-45 % by 2050. The urgency of the matter deems it increasingly necessary to consider such forward-looking risks in adjustment path methodologies. This sort of expertise is lacking at national level, both in impact assessments and forecasting. We lack EU-wide climate scenarios that reflect the EU’s regional diversity in terms of the likely exposure to climate disasters.
Consequently, technical support is warranted to deal with climate-related risks. This should be clearly stated in the new framework. Climate risks should be considered in the Commission’s DSAs and in national-level forecasting. Mass expertise exchange on climate risk modelling should shed a great deal of light on the mystery that is climate assessment. We should leverage new EU instruments, such as the Commission’s Technical Support Instrument and actors familiar with climate risk modelling, such as the European Central Bank.
Connecting up the dots, these recommendations would substantially improve the EGR. Giving a bottom-up DSA to the fiscal adjustment paths (which are anyway endorsed by the Commission) could revive fiscal credibility. That is, we need a long-term vision for fiscal imbalances amended for climate considerations to be taken in a bottom-up manner.
But with a pretty decent proposal already, just shuffling a few bits and pieces around might just give the Commission a clearer aim to hit the nail firmly on the head.
To mark International Women’s Day on 8 March, this Expert Commentary is part of a week-long series to highlight the insights and expertise of some of our most talented young female researchers.
