Making social science accessible

12 Feb 2024

Economy

Europe

After protracted negotiations, EU finance ministers have agreed a new approach to the fiscal rules and obligations for member states. Iain Begg asks whether there are lessons in the recast EU approach for the UK.

Something about the days before Christmas seems to concentrate the minds of politicians who have been haggling for months. In 2020, it was the Trade and Cooperation Agreement between the EU and the UK, agreed on Christmas Eve. On 20 December 2023, it was the EU’s finance ministers who, having come close twelve days earlier, finally agreed on a new economic governance framework.

It had been a long time coming. Just weeks before the pandemic swept across Europe early in 2020, the European Commission had a launched its economic governance review commenting that it was an ‘opportune and appropriate moment to assess the effectiveness of the current framework for economic and fiscal surveillance’.

These bland words disguised a widespread disenchantment with the system in place up to spring 2020 when a decision was taken to suspend the EU fiscal rules, centred around the Stability and Growth Pact (SGP). These rules were introduced before the Euro was launched, largely to mollify German fears about the risk that fiscal laxity in other members would undermine monetary stability.

Among the main concerns were that the fiscal framework was prone to pro-cyclicality (making the economic cycle more volatile), overly complex and took too little account of differences in national circumstances. In addition, compliance had been erratic, and the EU level lacked effective power to constrain national governments, despite various reforms enacted in the 2010s.

What has now been agreed is intended to deal with these shortcomings and should help to ensure more sustainable public finances, the objective central to the review. The centre-piece is a shift towards country-specific targets and obligations, described in a press release from the Council of Ministers as ‘a risk-based and differentiated technical trajectory expressed in terms of multiannual net expenditure’.

This is quite a mouthful, but what it means in practice is not so complicated: it is about setting the parameters for the fiscal position of countries. For each country, the European Commission will assess whether it conforms to the two key benchmarks – a public deficit under 3% of GDP and public debt of no more than 60% of GDP – and propose a pathway for fiscal policy to ensure either steady adjustment towards these benchmarks or staying within them.

In contrast to the current UK approach to fiscal rules, in which the main emphasis is on ensuring that net public debt should be falling in five years’ time, the new EU framework focuses on the trend in public expenditure.

Part of the reasoning is that the government directly controls spending, but only indirectly controls tax revenue (and, thus, the general government deficit), because tax revenues rise or fall as the economy itself fluctuates. The approach could be construed as leading to a reduction in the size of the state, but as an assessment by Wolf Heinrich Reuter explains, countries remain free to ‘choose the size of government in terms of the ratio of expenditures to GDP’, provided they alter taxes accordingly.

Unsurprisingly, the disputes in the run up to the agreement were about, on the one hand, the differences in the current fiscal positions of member states and, on the other, ideological clashes. As so often in the history of the euro, France and Germany had opposed views and only managed to achieve a compromise when, according to Politico, the French and German finance ministers met over dinner in Paris (was the wine good?) on 19 December to resolve their differences.

The resulting compromise involved concessions to different interests. To placate the fiscal hardliners, mainly the northern member states, two so-called ‘safeguards’ aimed at deterring fiscal laxity were accepted. The quid pro quo for the countries facing the greatest difficulties in their fiscal policies was to extend the deadlines for complying with the new rules.

The first safeguard requires countries with higher public debts (over 90% of GDP) to accept a more rapid rate of convergence towards the 60% threshold of one percentage point per annum, while those in the range of 60% to 90% of GDP have a lower target of half a percentage point of GDP. Second, more indebted countries will have to restrict their government deficits to 1.5% of GDP, half the 3% threshold.

In practice, the EU rules have always mattered most for members of the euro area and the UK, especially, paid little heed to them prior to Brexit. Nevertheless, the new EU framework can be instructive for the UK where the fiscal rules since 2011, as explained in a previous piece, have not prevented a steady worsening of the key fiscal indicators.

Two elements of the new EU approach could be useful. First, specifying an adjustment trajectory would oblige the government to be more explicit about how it will bring the public finances back on track, rather than relying on meeting a target five years in the future. The government might say it already does this by setting out multi-year expenditure plans, but having a rule that creates annual obligations would strengthen commitment and could enhance accountability.

Second, having targets for aggregate public expenditure would make it easier for the government to plan and be more transparent to other interests. In the UK system, there are periodic expenditure reviews that try to set priorities, but there is much less discussion of how total expenditure should evolve. Spending departments say ‘we want…’, and the Treasury then looks for reasons to say ‘nyet’.

In any fiscal framework, there has to be provision for when to suspend rules in response to exceptional circumstances, as happened in the EU as a result of the pandemic. It is one area where the EU might learn from the UK. In the revised EU framework, suspension can be both general and country specific, based on an assessment by the European Commission and a decision by the Council of Ministers.

However, it is a qualitative judgement and suspensions can be extended. As provided for in para. 3.6 of the Charter for Budget Responsibility, the Treasury can temporarily suspend the fiscal mandate if there is a negative shock to the economy. But it must explain why to Parliament and has to present its plan for lifting the suspension in each subsequent budget, a potentially more demanding obligation.

By Professor Iain Begg, the European Institute, London School of Economics and Political Science. Iain is conducting a project on fiscal frameworks funded by a UK in a Changing Europe small grant.

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