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Europe's Evolving Fiscal Framework: Challenges and Prospects

Introduction In 2020, Europe's fiscal rules were suspended in response to an unprecedented confluence of crises, including the COVID-19 pandemic, the Ukraine conflict, and the energy crisis. The decision to put these rules on hold was deemed necessary to provide member states with the fiscal flexibility required to address the immediate challenges at hand. Now, as we approach 2024, there is a plan to reintroduce a reformed fiscal framework. The European Commission unveiled its proposal for fiscal reform in April of this year, recognizing that the old rules-based system had become outdated and, in some instances, too stringent for certain countries.

Europe's Evolving Fiscal Framework: Challenges and Prospects

The new fiscal framework is designed to be more flexible, granting member states greater autonomy in shaping their fiscal policies. However, as Europe enters a new macroeconomic environment characterized by higher inflation, tighter monetary conditions, and slower economic growth, there are concerns that achieving fiscal sustainability may become more challenging. This, in turn, raises questions about the potential need for austerity measures that the new framework was intended to prevent. Additionally, many member states now find themselves in a more precarious fiscal position compared to when the rules were suspended nearly four years ago, with higher debt levels to contend with.

In this comprehensive exploration, we delve into the intricacies of Europe's evolving fiscal framework. We analyze the central principles and mechanisms of the new framework, compare it to the old system, and assess its potential strengths and shortcomings. We also consider the implications of varying fiscal positions among member states and the possible need for further fiscal integration to address these challenges.

The New Fiscal Framework The central guiding principle of the new fiscal framework is debt sustainability analysis conducted on a country-specific basis. Debt sustainability analysis assesses the likelihood of a country's debt becoming unsustainable under its current fiscal policies. It also establishes a medium-term fiscal adjustment target necessary to reduce the budget deficit and ensure the sustainability of the country's debt. The core principles of the new framework are relatively straightforward, centering on two key requirements:

  1. Deficit Target: The new framework stipulates that a country's budget deficit must be below 3% of GDP at the end of a four-year adjustment period. Under certain conditions, this adjustment period can be extended to seven years.

  2. Debt Sustainability: In addition to the deficit target, the framework requires that after the adjustment period, a country's debt must be on a firm downward trajectory, one that is highly likely to materialize.

The implementation of this framework involves a multi-step process:

  1. Technical Trajectories: The European Commission begins by publishing technical trajectories of net expenditure over a four-year adjustment period for all member states with debt and/or deficit ratios above the Treaty reference values of 60% for debt and 3% for deficits.

  2. National Medium-Term Fiscal Structural Plans: Member states then submit their "national medium-term fiscal structural plans," which include a net expenditure trajectory for the four-year adjustment period and the fiscal structural measures that support this proposed fiscal path.

  3. Dialogue and Extension: The Commission engages in a technical dialogue with member states to review their plans. In cases where a country commits to a set of reforms and investments that collectively support growth, enhance fiscal sustainability, and address EU priorities, the adjustment period can be extended from four to seven years.

  4. Commission Assessment: The Commission evaluates the national medium-term budgetary plans and provides recommendations to the Council, which can endorse the plans or request revisions.

Additional Safeguards For countries with debt ratios above 60% or deficits exceeding 3% of GDP, the new fiscal framework introduces additional safeguards. Cyprus, as an example, falls into this category due to its higher debt ratio. These safeguards entail specific requirements:

  1. Debt Ratio Reduction: At the conclusion of the four-year adjustment period, countries must ensure that their debt ratio is lower than it was at the beginning of that period.

  2. Expenditure Growth Constraint: Expenditure growth must be slower than GDP growth over the same period.

  3. Deficit Reduction: For countries with budget deficits above 3% of GDP, there is an obligation to reduce the deficit by 0.5% of GDP annually, as long as it remains above the 3% threshold.

  4. Long-Term Debt Trajectory: Member states are required to ensure that their government debt remains on a downward trajectory for ten years following the conclusion of the adjustment period.

Comparing Old and New Frameworks To truly appreciate the significance of the new fiscal framework, it is essential to compare it to the old rules-based system. The differences between the two systems are profound.

The old framework was highly complex, relying on multiple and overlapping rules. It was fundamentally driven by the concept of the structural budget balance of the general government.This balance represents the budgetary position that would prevail under a given set of policies when the economy is operating at its full potential. In prosperous times, when the economy grows above its potential, revenues tend to be higher, and expenditures lower. Conversely, during economic downturns, when the economy lags behind its potential, revenues drop, and expenditures rise. Calculating the structural budget balance necessitates estimating potential output, which excludes cyclical factors. However, this estimate is exceedingly challenging to make and remains largely unobservable, as potential output, by definition, is never directly observed. This inherent difficulty makes the structural budget balance an unreliable indicator to anchor fiscal policy. Frequently, the old framework led to fiscal adjustment requirements for individual countries that were overly austere.

In stark contrast, the new fiscal framework replaces the structural budget balance with a more transparent and precise control variable: "net expenditure." Net expenditure comprises discretionary government spending and excludes interest payments and specific well-defined expenditure items. While the 3% deficit limit and the 60% debt ratio benchmark are retained in the new framework, they are part of the Treaty and cannot be removed. However, the primary focus shifts to the medium term, granting member states greater discretion and ownership over their fiscal adjustment paths.

Fiscal Integration The overarching goal of the reform proposal for the new fiscal framework is to gradually reduce debt levels and fiscal imbalances across the European Union while simultaneously creating more fiscal space for public investment in key policy areas. The intention is to avoid imposing painful austerity measures on member states. However, while the new framework does offer member states some latitude in planning their debt reduction paths, it does not reduce the nominal size of the required adjustment, nor does it eliminate the potential for disputes and disagreements.

One of the fundamental challenges lies in the fact that member states enter the new framework from vastly different starting positions. In 2022, approximately half of the member states had debt ratios exceeding the 60% reference value, while nearly another half had budget deficits above the 3% reference value. A quarter of member states exceeded both the debt and deficit benchmarks, including prominent economies like Italy, France, Spain, and Belgium. Notably, debt ratios for 2022 averaged 91% in the euro area, with Italy's reaching as high as 170%. These differences among member states are poised to become even more pronounced in an environment of high interest rates, which would result in higher borrowing costs.

This divergence in fiscal positions poses a substantial challenge, particularly when it comes to public investment in critical areas like green energy, decarbonization, industry, and defense. Achieving these investment objectives would necessitate increased levels of public spending, and the current EU funds, such as the EU's Next Generation Post-Pandemic Fund, can only partially cover these needs.



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