Germany opens the door to European fiscal rules reform
The proposal is vague and hardly but the ECB has made a number of important recommendations for reforms that could lead to a constructive compromise
The paper of the German government on European fiscal rules is an important moment. It was initiated inside the German Government by State Secretary Sven Giegold (serving under Economy and Climate Minister Robert Habeck) and is set against both a national and a European context.
The national context is a need by the Greens to set some boundaries against an FDP Finance Minister who is turning increasingly conservative and is trying to move the lines of the coalition agreement.
The European context is one where the debate over economic governance reform that has started more than 2 years ago has effectively been grounded in the absence of proposals, consensus and compromise.
The proposal by the German government doesn’t really address the domestic context and the pledge by Finance Minister Linder to try and return to the debt break in 2023. It also doesn’t clarify how much if at all this paves the way to a more ambitious domestic investment plan to achieve Germany’s ambitious medium term climate goals and short term energy independency needs. In that sense, the German government remains in profound denial about the extent of the economic and energy transformations that are necessary and the impact they will have on domestic and fiscal policy. The German Greens here are paying for the weak settlement they agreed to during the coalition negotiations that effectively limited the Green investments to 60bn.
The German proposal could however be useful to the European debate on European fiscal rules that has been effectively entirely stuck since its launch in 2019. There was a lot of expectations that France would make the European economic governance an integral part of its agenda during the rotating presidency of the EU that ended in June, but Macron was uncertain he wanted to lead the fight and the war in Ukraine dwarfed any such discussion.
The debate has nonetheless started by a joint OpEd between Macron an Draghi in December 2021, which was vague on substance but signalled a desire to address the topic in the run-up to the March 2022 Versailles Summit that was meant to hammer out a new consensus and in reality didn’t discuss the issue at all. The joint OpEd was however the occasion to launch some meaningful franco-italian work on evolutions of rules and the broader economic governance, which was created violent reactions in Berlin.
The joint papers by Giavazzi (under mandate from Mario Draghi) and Charles-Henri Weymuller (under mandate from Emmanuel Macron) was both ambitious an original but it was broken in two parts: one part on rules, and one part on debt management.
The debt management paper argued for the creation of a European debt agency that would buy out a portion of the outstanding government debt with a view of relieving the ECB’s balance sheet. This aspect of the paper was profoundly disagreeable to the French Treasury and led to an effective repudiation of this Franco-Italian work that stopped franco-italian efforts in their tracks, to the great satisfaction of the new German government.
As a result, the French Treasury came out with a tentative compromise in a paper released in February 2022 where it essentially argues for:
(i) an expenditure rule alongside previous proposals by the European fiscal board or the IMF (2018) instead of a structural adjustment measure prone to revision and measurement issues,
(ii) lifting the 1/20th debt reduction and introduction country specific targets (although not specified),
(iii) expanding publica investments either by a green golden rule or by a dedicated European fund. All in all, the French proposals were not particularly ambitious but had the merit of being positioned somewhere near the European intellectual consensus.
The German proposal comes in that context as more open than the initial German position, which was essentially a negation of the need for reform. The German paper is important in that it agrees that there is a need but the path it offers is fairly narrow and potentially ineffective without serious amendments.
The position paper of the German government argues essentially for:
a) Suspension of the 1/20th debt-reduction rule.
b) Simplification of the rules by the introduction of an expenditure benchmark but without the abolition of the existing minimum required structural adjustment existing in the current rules. This compromise between the introduction of an expenditure and the persistence of a structural adjustment will certainly prove hard to operationalise.
c) Extension of the investment flexibility clause introduced in 2015 by the European Commission, which remains relatively vague because it explicitly rules out a green golden rule but could potentially enable an extension of European programmes like the current RRF.
d) Finally, the paper calls for a clearer and stricter framework for enacting the general exemption clause. This would essentially remove the discretion currently given to the European Commission and certainly open a difficult negotiation about the appropriate metric/trigger to invoke the general exemption clause.
All in all, the German proposal is an internal political compromise that doesn’t amount to a complete and operational reform proposal. It is however a good basis for discussion.
The European institutions should however rightly be emboldened and put something on the table now that Berlin has signalled its openness to negotiate. To be fair, the ECB has surprisingly put out the most solid work and suggestions on the table, while the European Fiscal Board was trailbrazer.
Indeed, since an important speech by P. Lane pronounced in November 2021 that first expanded on how fiscal rules should take into account the distance to the inflation target; the ECB (2022) has developed its own proposal and simulation thereby setting out the embryo of a framework for fiscal / monetary policy cooperation.
The ECB’s proposal and simulations set out that the two objectives of a prospective
reform of the Pact should:
(i) Simplify the framework and take into account the prevailing macroeconomic context and enhance the balancing of sustainability and stabilisation considerations.
(ii) reflect increasing investment needs related inter alia to the green transition.
The ECB’s proposal essentially builds on:
· An inflation-adjusted expenditure growth-rule linked to a debt anchor.
· A standard increase in net public investment from the 0.1% of GDP observed in 2019 to 0.7% (the 2000-2007 average), which is also the low end of what is deemed required for Europe to meet its emissions reduction targets.
· A suspension of the 1/20th debt reduction to be replaced by a 1/30th debt reduction ceiling as inspired by the ESM proposal, which would effectively reduce the maximum nominal adjustment to 3% per year.
On that basis, the ECB finds that the recommended adjustment would ensure both better stabilisation and better debt reduction that the current framework. For low debt countries, the rule would create fiscal space with respect to a return to the previously observed implementation of the existing SGP framework. Such fiscal space would be available to support increasing public investment needs. Taking account of the ECB’s 2% inflation target in the spending rule would in addition enhance the counter-cyclicality of the SGP framework. For high debt countries, it would reduce the maximum adjustment to something that is more economic sensible and politically sustainable.
This could eventually be further adjusted by introducing country specific debt targets. On the whole and maybe most importantly, the framework would enable a much greater level of fiscal / monetary policy coordination without subordination of fiscal policy to the ECB’s monetary policy but rather as a calibrated in real terms while government budgets are usually designed in nominal terms. The envisaged framework would create fiscal space in times when inflation is below target and vice versa. This should be at the heart of the European Commission’s proposal and it could arguably be a politically realistic compromise.
These discussions are however unlikely to deliver a new framework immediately. In the meantime, the European Commission will play an important role in managing expectations for fiscal policy. The extension of the suspension of the SGP in 2023 is important, especially against the backdrop of a German government that has oddly committed to it despite the adverse economic circumstances. The draft budgetary plans that will be released by October 15th and the assessment that the Commission will provide will drive policy in 2023 but a draft communication / legislative proposal on medium term reform could play an even bigger role in setting out medium fiscal paths.