December 21, 2018 / 4:56 PM / 4 months ago

Commentary: The case for reforming Europe’s budgetary rules

This week’s compromise between Rome’s populist government and the taskmasters in Brussels rewrites the fiscal script for 2019. Gone is the impending choreographed bust-up, culminating in the first-ever fines imposed on a budgetary miscreant. Spared that drama, European leaders should now overhaul Europe’s hopelessly convoluted fiscal rules.

Italian Prime Minister Giuseppe Conte with European Commission President Jean-Claude Juncker ahead of a meeting at the EU Commission headquarters in Brussels, December 12, 2018. REUTERS/Francois Lenoir

Both sides in the dispute have made concessions. Italy has lowered its planned budget deficit for 2019, from 2.4 percent of GDP to 2.0. That will involve delays in introducing a lower retirement age and a basic income for the poor, manifesto pledges made by Matteo Salvini and Luigi Di Maio, the leaders of the ruling coalition parties.

But the European Commission has ceded ground, too. Crucially, there will be no tightening in fiscal policy as it had previously demanded, insisting that this was essential for a country with such high public debt, at around 130 percent of GDP. The Commission had to drop its hardline stance because of French President Emmanuel Macron’s costly concessions to the “yellow vest” protesters (gilets jaunes). These look set to push France’s headline deficit next year above 3 percent of GDP, breaking Europe’s cardinal fiscal commandment.

This made it politically impossible to press ahead with a punishment beating for Italy. Even before Macron’s measures the French deficit of 2.8 percent of GDP was higher than Italy’s. It was tricky to explain that this was acceptable because the underlying shortfall was 1.9 percent after excluding one-offs associated with a tax reform. It was trickier still given that last year was the first time in a decade that France’s headline deficit came in lower than 3 percent of GDP. By contrast Italy, in such hot water with Brussels, kept its deficit at or below that limit for most of that period.

The Commission has got into a mess because of the ever-growing complexity of the fiscal rules that it oversees. They started as the relatively simple budgetary criteria among the conditions for joining the euro, which were set out in the 1992 Maastricht Treaty. Countries could become members of the monetary union (which celebrates its 20th anniversary on Jan. 1 2019), only if their budget deficits did not exceed three percent of GDP; and their debt 60 percent.

In a harbinger of what was to come, there was already a wrinkle, through a get-out clause for countries with excessive debt. They could nonetheless be eligible provided that debt was falling at “a satisfactory pace” (which was conveniently not defined). This enabled Italy to join at the outset even though its debt was double the 60 percent limit in the late 1990s.

Enshrined in the stability and growth pact, the fiscal rules have become ever more intricate over the past two decades, leading the IMF to describe them in 2014 as “exceedingly complex,” graphically demonstrating the point with a cat’s cradle of constraints and control totals. The original Maastricht criteria remain in force, but the main goal is to achieve broadly balanced budgets. The Commission judges countries according to their efforts in improving their fiscal position in structural terms (taking into account the business cycle and excluding one-offs). There is an additional benchmark for expenditure growth. And excessive debt as well as excessive budget deficits can now trigger disciplinary actions, which is why the Commission could threaten Italy with fines despite a deficit below the 3 percent limit.

The tinkering has continued. Under the presidency of Jean-Claude Juncker since 2014 the Commission has sought to apply the rules more flexibly. If countries are, for example, making structural reforms which will improve the underlying economy and thus the tax base, then the Brussels umpires cut them some slack. Whatever the merits of such flexibility it has further muddied the waters. Indeed, the rules have become so complicated that the Commission now publishes a “Vade Mecum” guide – a “compendious encyclopedia” in its own words, that is over 200 pages long.

The sheer complexity of the rules makes them unfathomable for all but a tiny tribe of technocrats. That compounds a crucial weakness. Budgetary decisions are intensely political. Monitoring compliance with the rules embroils the Commission in national politics, playing into the hands of euroskeptic leaders such as Salvini. Fiscal goals intended to underpin the single currency can instead undermine it by souring popular support for Europe.

As well as being politically incendiary, the rules make little economic sense. Their original rationale was to prevent fiscal freeloading as countries exploited sharing a currency with Germany and its strong public finances by going on a borrowing binge. That risk appeared to materialize in early 2010 when a surging budget deficit meant that Greece could no longer finance itself in the markets, starting the euro crisis. Germany interpreted this as a sovereign-debt crisis and insisted on tougher rules and sterner enforcement to try to avoid bailouts ever recurring.

But the German diagnosis was faulty and incomplete. The euro crisis was as much a banking as a public debt crisis. Resolving it required above all the European Central Bank to reinvent itself under Mario Draghi as the ultimate guardian of the euro, halting the panic.

The way to protect the single currency against a further crisis is not to tie countries in knots over their fiscal policies. Instead the euro area should rely mainly upon the markets to police its member states, backed by the fact that any bailout comes with stringent fiscal and economic remedies. Salvini is not afraid of the Commission but has good reason to worry about Italy’s borrowing costs rising to unsustainable levels. The institution striking fear into euro zone states is not the Commission but the European Stability Mechanism, which exacts a harsh price for any rescue.

In 2002, Romano Prodi, who was then president of the Commission, described the stability pact as stupid because it was too rigid. Now it contrives to be complex and intrusive yet ineffective. European leaders should take a scythe to the thicket of rules. Instead there should be just two simple fiscal constraints, one based on debt and the other limiting increases in public expenditure (net of any permanent revenue measures) to potential GDP growth. Taming feckless governments should primarily be the job of the bond markets, not that of the fiscal examiners in Brussels.

About the Author

Paul Wallace is a London-based writer. A former European economics editor of the Economist, he is author of “The Euro Experiment,” published by Cambridge University Press.

The views expressed in this article are not those of Reuters News.

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