Sergio Cesaratto – The cat-and-mouse reform of the Stability Pact

The EU is stuck in its fiscal cul de sac and cannot find its way out.

Sergio Cesaratto is Professor of European monetary and fiscal policies, International Economics, and Growth and development at the University of Siena. He is author of Heterodox Challenges in Economics – Theoretical Issues and the Crisis of the Eurozone, Springer, 2020 (reviewed by BNE here).

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Feverish European negotiations are underway on the reform of the Stability Pact that regulates the Union’s budgetary policies to overcome, it is said, its rigidities. The previous pact was suspended in 2020 to allow countries to cope with the Covid pandemic crisis, but would come back into force in 2024 in the absence of reform. The ultimate goal of the fiscal rules is to put high-debt countries on a downward path in terms of their debt-to-GDP ratios, always subject to the 3% deficit-to-GDP ratio. The proposed new rules would be more flexible in that, although based on common targets and criteria, the paths of return would be negotiated by individual states with the European Commission in order to adjust them according to their specific situations.

The current rules on deficit and debt would be replaced by a rule on ‘primary’ public expenditure, i.e. calculated net of interest expenditure (and of other ‘cyclical’ components). The rate of change of this aggregate would be irrevocably agreed with the Commission for a period of four years – or seven in exchange for more stringent reform commitments. In the event of a breach not justified by exceptional events, a sanctioning procedure that can culminate in heavy fines would be automatically triggered. What is the logic? The idea is that primary expenditure growth is set at a lower rate than the expected GDP growth rate. Let us assume that the latter is estimated to grow by 2% on average over the next four years. The growth rate of expenditure could be set at 1%. Thus, since tax revenues would grow (assuming the same tax rules) at 2% in line with GDP, the lower expenditure growth would allow a primary surplus that could be used to reduce debt. An advantage for countries is that if GDP grows less than expected, for instance by 0.5 per cent, the expenditure trend agreed with the Commission would remain unchanged at 1% and thus act as a fiscal stimulus. Against the apparent simplicity and flexibility of the rule opens up a range of problems that ultimately have to do with the technocratic view of European governance.

First, the paths of reduction in the debt ratio are highly dependent on the evolution of the average interest rate on the debt. This is of course taken into account: for example, the higher the expected trend in this rate, the higher the primary surpluses needed to reduce the debt, and thus the lower the growth rate of expenditure. However, large primary surpluses not only have devastating social effects, but also have a negative impact on the GDP growth rate and thus on tax revenues, so that the budgetary adjustment results in a futile Sisyphean effort. The Italian Parliamentary Budget Office (PBA), an independent auditor established in accordance with European rules, points out that the Commission tends to underestimate the negative impact of budget cuts on GDP growth. What is missing in the thinking of European technocrats is even a vague appreciation of the role of aggregate demand and public spending in determining GDP growth. And anyway, what is the basis for estimating future interest rates for four or seven years when the ECB, which governs those rates, avoids forecasts and commitments of even a few months?

Still speaking of forecasts, this time with regard to GDP trends, in its technical estimates on the path of expenditure changes to put the country on a virtuous path of debt reduction – estimates that serve as a benchmark for the ‘dialogue’ with national governments – the Commission continues to refer to the same conceptual armoury as the old Pact. We refer to concepts such as ‘output gaps’, potential GDP, etc., which the Commission uses scientifically questionable methods to estimate and also, as the PBA says again, not very transparent. The truth is that economic (monetary and budgetary) policy is made in real time in the face of constantly changing contingencies. Would you plan in detail a long sailing on the basis of weather forecasts regarding months ahead?

The PBA also denounces the absence in the reform of the Pact of a European perspective on the impact of adjustment policies that if generalised “could impart an excessively restrictive orientation to the common area” (Parliamentary Hearing of 18/10/2023).

What is actually missing from the new pact is the overcoming of instruments borrowed from the more conservative versions of economic analysis, according to which monetary policy serves only to keep prices stable; employment and growth are to be pursued at the national level with the flexibility of markets (labour first and foremost); fiscal policy serves only at the margin and in general is to be brought back to a balanced budget. The unity of economic policy (fiscal, monetary, social, industrial) and its European and international dimension are thus lost. Economic policy is, we would finally add, also made up of foreign policy. How much are we Europeans paying in terms of rising inflation, interest rates and economic instability for the absence of a unified and more assertive European policy that in recent years could have acted to counter the deep-seated reasons for conflicts in the heart of Europe and elsewhere? An economically and socially sustainable perspective of stabilisation and slow debt reduction requires indeed an environment of low interest rates and growth; and the latter requires both a more peaceful geopolitical environment and a concert of expansive European fiscal and monetary policies. Between an impossible Federal Europe and the current set-up in which Europe appears to be just a divisive whipping boy without an enlightened political design, there is a cooperative, progressive Europe aimed at international détente. But this also requires a very different economic policy inspiration.

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