Fiscal Rules and Reforms by way of Greening Public Investment
Macroeconomists have largely failed to move the European rules debate but the climate crisis and a new German consensus might.
The debate about the German and the European fiscal rules has been raging for the past few months in intellectual and policy circles but there is no consensus in sight. The Commission first announced it would resume in the second part of 2021 (read, after the German elections), the European Commission has announced that it would withhold a new proposal to reform the rules promised by the end of 2021 until Member States had converged enough. Under growing pressure, it has now announced that it would restart the discussion with a communication on October 19th and that this would allow using the time until the end of 2023 during which the rules are formally suspended to agree on a reform proposal.
In Germany, while this topic has not been at the heart of the election campaign, it will become an important issue in the coalition agreement negotiations. Initial positions were very staunch but there seems to be a path for compromise emerging in Germany that could play a critical role in the European debate. Indeed, other than the Greens, all the mainstream parties are suggesting that the constitutional debt break cannot be changed. In fact, many of the most progressive voices in Germany have also adopted that line and have spent considerable time and energy trying to create flexibility within the rules rather than overhaul them altogether.
The consensus that is seemingly emerging in Germany is that the Constitutional debt brake should not be changed but that Germany must nonetheless find the fiscal space to invest in its Green transition. Even the FDP, has conceded that much. In addition, a recent ruling by the German Constitutional Court on the Climate Protection Act is setting the stage for a conflict between Germany’s fiscal strictures and its emissions reductions commitments. The best way to square this impossible circle is presumably to create a specific and timebound exemption for Green investments. This would suit all parties around the table. The fiscal rules would stay intact but public investment could increase substantially and all camps could claim victory.
This emerging consensus seems to be transposable to the European level and a recent Bruegel paper presented to the ECOFIN arguing for a green fiscal pact in September seems to have gotten some support amongst the Eurogroup and opened the door for more exploratory work by the European Commission. But the central problem of this solution is that it relies on defining what is a green investment and establishing proper Green budgeting rules and standards. There are several ways of doing this:
· The first is to use the European Taxonomy on sustainable activities that was passed in June 2020 and that aims to frame the regulation of the financial system and reorient capital towards sustainable activities. There has been considerable work to agree to this taxonomy and it could provide a good framework for public investments too. But the methodology is not without flaws and several countries have already opposed its expansion to the public realm.
· The second option is to expand the work on Green budgeting that has been started by the OECD, the United Nations and that some countries, notably France has tried to implement to measure the green performance of their budget. This requires quite a bit of international / European alignment. As a result, these exercises can vary considerably in form. Although some standards such as the Climate Public Expenditure and Institutional Review (CPEIR) have been replicated in many countries, there is no universal definition of green budgeting today, let alone a universal “blueprint”. The objectives of such reviews can also differ widely: from aiming to simply identify expenditure to applying a weighting to different types of expenditure according to their “relevance”.
· The last option is to proceed with the methodology that was used by the European Commission for deciding to approve or reject national recovery and resilience plans. This has allowed to disburse some EUR 750bn of European resources and while still fragile has been accepted by all Member States. In addition, it has the benefit of giving the European Commission extensive discretionary powers to decide what is green or not. This could prove useful to ensure both consistent but also flexible application.
An agreement to proceed along these lines could be major. It would be somewhat of an intellectual defeat for macroeconomists (like myself) who have long made the case to reform the rules on economic and political grounds, but it would certainly mark the greatest policy inflexion in decades paving the way for 1 to 2% of GDP of additional public investment.
The big question is when this could come into effect? There are essentially two related but separate debates:
· The first is about the framework for reintroducing the rules when the suspension lapses.
· The second is about the medium-term agenda. Indeed, the European fiscal rules are an intricate mix of national, European, intergovernmental legislations and eventually treaty reform.
The Commission has not decided yet whether it would choose to modify the rule simply by modifying its interpretation of the rules (ie. issuing a new Communication), or whether it would embark on a real legislative proposal which would probably take a good 18 months of negotiations before it is negotiated. The uncertainty about how rules will be reintroduced is holding fiscal policy back today.
The Commission is likely to be forced to clarify its stance on the matter in the spring of 2022 when Member States start preparing their budget for 2023. It will have several options then:
o Kick the can down the road further and extend the suspension of the rules until an agreement is found on the green investment framework. This would put great pressure on the hawks to come to an agreement.
o Put all Member States under Excessive Deficit Procedure (EDP), which would allow the commission to set the pace of the adjustment over the medium term. It would send a confusing political message about the reintroduction of the rules but would provide economic certainty over the medium term given adjustments could be set very low (0.1% of GDP for instance) for a long time (5 or 10 years). This would provide more time to negotiate an ambitious reform.
o Reintroduce the rules as is and risk a rapid fiscal tightening (at least 0.5% of GDP per year under the preventive arm), which could certainly accelerate negotiations and political tensions around the reforms.
All in all, the fiscal debate in Europe is finally moving albeit slowly. But not along the lines pushed by economists but along the fault lines imposed by the climate emergency. This could be an important macroeconomic change for Europe but it’s still hard to size and to time it. The compromise that emerges from the German coalition agreement will be central.