Opinion

When facts change, change the pact

“When facts change, I change my mind,” John Maynard Keynes famously said. With long-term interest rates currently near zero, the European Union should reform its fiscal framework to allow member states to increase their debt-financed public investments.

By: Date: May 1, 2019 Topic: European Macroeconomics & Governance

This opinion was also published on Project Syndicate

Project Syndicate logo

The European Union’s Stability and Growth Pact, which sets fiscal rules for its member states, is like the emperor’s new clothes. Almost everyone sees it has none, yet few admit it openly. This disingenuous silence is bad economics and bad politics.

For starters, the pact’s rules are so hopelessly complex that almost no government minister, let alone member of parliament, can decipher them. There are now various reform proposals that aim to simplify things, including by a group of French and German economists to which I belong.

Most of these proposals would place less emphasis on estimating member states’ cyclically-adjusted budget deficits – a notoriously difficult calculation – and focus instead on monitoring growth in public spending. Concretely, each government would commit to expenditures consistent with the country’s economic growth outlook and expected tax receipts, and in line with a medium-term debt target. There would be less micromanagement by EU institutions, more room for national decision-making, and more responsibility for individual governments.

Ministers have so far shown no appetite for such radical reform. But there is now a second reason to overhaul the EU’s fiscal framework: today’s economic conditions are very different from those when the pact was designed over two decades ago. “When facts change, I change my mind,” John Maynard Keynes famously said. And the facts have certainly changed.

The pact entered into force in 1997. At the time, the median public debt among the 11 EU countries that would initially adopt the euro was 60% of GDP, while the forecast was 3% growth and 2% inflation. The risk-free long-term interest rate – at which most eurozone countries would soon borrow – was 5%. Stabilizing the debt ratio at its prevailing 60% level therefore required governments to keep their budget deficits below 3% of GDP – or, put another way, to maintain a primary budget balance (revenues minus spending, excluding interest payments) of zero.

Such guidelines made sense. If growth faltered, revenue shrank, or markets started pricing in a default, there would be a real risk of debt spiraling out of control – as Europe’s sovereign-debt crisis of 2010-2012 later showed. The 3%-of-GDP deficit threshold that triggers the activation of a stronger policy monitoring procedure was thus a rough but reasonably calibrated benchmark. Moreover, it was wise to aim for significantly lower deficits, in order to maintain a safety margin.

In 2019, the median debt for the same 11 countries is 70% of GDP, while the International Monetary Fund currently forecasts 1.5% growth and 2% inflation (debt is a bit lower and growth a bit higher if all eurozone members are included). True, projected growth is half the level it was in 1997. Nonetheless, stabilizing the debt ratio requires keeping budget deficits below 2.5% of GDP, which remains close to the pact’s 3% limit.

The big change from two decades ago, however, is the collapse in interest rates. Investors were recently willing to buy ten-year German government bonds yielding essentially nothing. Taking inflation into account, the real cost of German debt is significantly negative – as it is, to a lesser degree, for France, Spain, and most other eurozone members. Even Italy, with debt exceeding 130% of GDP and dismal growth, was able to borrow at 2.6%, or 2.4 percentage points less than Germany in 1997.

Under such conditions, a budget-deficit limit of 3% of GDP is, in fact, fairly lax. If long-term interest rates remain near zero for a few more years, governments will be able to run primary deficits greater than 2% of GDP without exceeding that limit. Many EU countries are likely to use this opportunity to finance current spending on the cheap. But should financial conditions change abruptly, they will be forced to adjust precipitously.

The European Commission insists that the 3% threshold is only an upper limit. Reforms to the pact in 2011 have tightened the screws. Eurozone countries are expected to keep their structural budget deficit (corrected for cyclical effects) close to zero, and those with a debt ratio exceeding 60% of GDP are mandated to reduce it.

However, the resulting constraints are too tight. The zero target for the structural deficit prevents governments from borrowing at today’s negative real interest rates to finance investments and reforms. And, as Olivier Blanchard of the Peterson Institute has forcefully argued, there is no compelling economic reason to cut debt when borrowing is costless.

The EU sits between a rock and a hard place. It should not let member states make a habit of financing recurring current expenditures with debt. But nor should it prevent them from taking advantage of persistently low interest rates to finance economically sound investments that will benefit future generations.

Europe should therefore reform its fiscal framework. Deficit hawks (especially in Germany) will no doubt protest, but prohibition without a rationale is politically unsustainable. Why wouldn’t EU citizens accept channeling debt-financed public investments into environmental research, renewable energy, clean transportation systems, and other efforts to contain climate change, when financial conditions would make such investments collectively profitable?

Longstanding criticism of the pact for neglecting the distinction between investment and current spending is valid, to the extent that investment is defined economically rather than in accounting terms. The EU should therefore agree on a set of goals – such as the transition to a low-carbon economy, broader access to employment, and output-enhancing economic reforms – that justify public spending temporarily in excess of the fiscal rule (unless, of course, the country is in a financially precarious state). Such an exemption should be conditional on long-term interest rates remaining exceptionally low. If rates were to rise, governments would have to trim and eventually discontinue these investments.

The need to revise the EU’s fiscal rules is clear. The main political parties competing in May’s European Parliament elections should recognize it and make the case openly. At a time when the EU’s very purpose is being questioned, economics taboos are the last thing Europe needs.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint.

Due to copyright agreements we ask that you kindly email request to republish opinions that have appeared in print to communication@bruegel.org.

View comments
Read article More on this topic More by this author

Opinion

The EU needs a bold climate strategy

Scientists report that global temperature increases must be limited to below 1.5 degrees Celsius. With global greenhouse gas emissions continuing to increase and rising temperatures driving up the frequency of extreme weather events, the world needs a greater commitment to climate policy.

By: Guntram B. Wolff Topic: Energy & Climate Date: July 19, 2019
Read about event More on this topic

Past Event

Past Event

The 4th industrial revolution: opportunities and challenges for Europe and China

What is the current status of EU-China relations concerning innovation, and what might their future look like?

Speakers: Elżbieta Bieńkowska, Chen Dongxiao, Patrick Child, Eric Cornuel, Maria Demertzis, Ding Yuan, Luigi Gambardella, Jiang Jianqing, Frank Kirchner, Pascal Lamy, Li Mingjun, Gwenn Sonck, Gerard Van Schaik, Reinhilde Veugelers, Wang Hongjian, Guntram B. Wolff, Xu Bin, Zhang Hongjun and Zhou Snow Topic: Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: July 12, 2019
Read article More on this topic More by this author

Podcast

Podcast

Deep Focus: Making a success of EU cohesion policy

Bruegel senior fellow Zsolt Darvas talks to Sean Gibson in this Deep Focus podcast about how the EU can improve its cohesion policy, citing the best examples of its implementation and stressing the methodological difficulties in measuring its effectiveness.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: June 20, 2019
Read about event More on this topic

Past Event

Past Event

What reforms for Europe's Monetary Union: a view from Spain

How is a successful European Monetary Union still possible in today's ever-shifting political landscape? What reforms need to occur in order to guarantee success of cohesive policies?

Speakers: Fernando Fernández, José Carlos García de Quevedo, Gabriele Giudice, Inês Goncalves Raposo, Javier Méndez Llera and Isabel Riaño Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: June 19, 2019
Read about event More on this topic

Past Event

Past Event

Past, present, and future EU trade policy: a conversation with Commissioner Malmström

What was trade policy during the last European Commission? What will be the future of European trade under the next Commission?

Speakers: Cecilia Malmström, André Sapir and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: June 13, 2019
Read about event More on this topic

Upcoming Event

Oct
29
08:30

Bank resolution: its impact in the EU

Closed-door workshop on various aspects of bank resolution.

Speakers: Jon Cunliffe, Martin J. Gruenberg and Elke König Topic: Finance & Financial Regulation Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article Download PDF More on this topic

External Publication

Effectiveness of cohesion policy: learning from the project characteristics that produce the best results

This study by Zsolt Darvas, Antoine Mathieu Collin, Jan Mazza, and Catarina Midões analyses the characteristics of cohesion policy projects that can contribute to successful outcomes. Their analysis is based on a literature survey, an econometric analysis and interviews with stakeholders. About two dozen project characteristics are considered, and their association with economic growth is studied using a novel methodology. Based on the findings, the study concludes with recommendations for cohesion policy reform.

By: Zsolt Darvas, Antoine Mathieu Collin, Jan Mazza and Catarina Midoes Topic: European Macroeconomics & Governance Date: June 11, 2019
Read about event More on this topic

Past Event

Past Event

EU-LAC Economic Forum 2019: New perspectives in turbulent times

The third edition of the EU-LAC Economic Forum.

Speakers: Diego Acosta Arcarazo, Ignacio Corlazzoli, Maria Demertzis, Mauricio Escanero Figueroa, Alicia García-Herrero, Carmen González Enríquez, Bert Hoffmann, Edita Hrdá, Matthias Jorgensen, Juan Jung, Tobias Lenz, Carlos Malamud, J. Scott Marcus, Elena Pisonero, Belén Romana and Guntram B. Wolff Topic: Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: June 11, 2019
Read article More on this topic

Blog Post

A European atlas of economic success and failure

Economic growth was diverse across EU regions, yet it is crucial to control for region-specific factors in assessing growth performance. We find that there are rather successful regions in many EU countries, suggesting that the EU can provide a good framework for growth. Yet the worst performers are more concentrated in some countries, suggesting that country-specific factors can play a major role in regional development.

By: Zsolt Darvas, Jan Mazza and Catarina Midoes Topic: European Macroeconomics & Governance Date: June 3, 2019
Read article More on this topic More by this author

Blog Post

European Parliament election results: The long view

Following the latest European elections, the author updates his previous analysis of trends in the share of European Parliament seats among ‘mainstream’ and ‘non-mainstream’ parties.

By: Nicolas Véron Topic: European Macroeconomics & Governance Date: May 29, 2019
Read article Download PDF More on this topic

Policy Contribution

How to improve European Union cohesion policy for the next decade

This policy contribution investigates the performance of the design, implementation and effectiveness of cohesion policy, the most evaluated EU tool for promoting economic convergence. By analysing the effects of cohesion policy on economic growth through reviewing literature, conducting empirical research by comparing regions, as well as considering attitudes and expectations collected through interviewing stakeholders, the authors provide reform recommendations.

By: Zsolt Darvas, Jan Mazza and Catarina Midoes Topic: European Macroeconomics & Governance Date: May 23, 2019
Read article More on this topic More by this author

Blog Post

The latest European growth-rate estimates

The quarterly growth rate of the euro area in Q1 2019 was 0.4% (1.5% annualized), considerably higher than the low growth rates of the previous two quarters. This blog reviews the reaction to the release of these numbers and the discussion they have triggered about the euro area’s economic challenges.

By: Konstantinos Efstathiou Topic: European Macroeconomics & Governance Date: May 20, 2019
Load more posts