A Better Macro Policy Framework for Europe

The new EU fiscal rules and the recently updated ECB monetary policy framework are tangible signs of the region’s improving macro policy backdrop.

Last September, we outlined reasons why investors should revisit their long-standing underweight exposure to European assets. One piece of our argument was the improving macro policy backdrop in the EU. The new EU fiscal rules and monetary ECB operating framework, both announced in the first quarter, are tangible signs of this.

With these reforms, fiscal and monetary policy actions that had previously been implemented as one-off responses to crises, have now become forward-looking features of Europe’s macro policy toolbox . Neither reform is a game changer; however, they are steps in the right direction, enhancing the bloc’s ability to manage crises and strengthening its internal cohesion. They improve the sustainability of the Euro and, indeed, the European project as a whole.

The New Fiscal Rules Are Simpler and Account for Country-by-Country Differences 

In early February, EU member countries agreed on long-awaited reforms to the EU fiscal rules.¹ The reforms are fundamental insofar as they change both the rules themselves and how they are governed.

The prior rules emerged from the eurozone crisis of the early 2010s. Although observers still frequently refer to them by the two nominal limits set for EU members —a 3% of GDP budget deficit, and a 60% debt to GDP ratio—in practice, they were highly complex (both the rules themselves, and how they were applied). Their inability to deliver on the ultimate goal of ensuring fiscal convergence (or even preventing further divergence) made it clear that change was needed.

The top criticisms of the old rules were that they were too procyclical, too complex and too formulaic.² The new rules are simpler, less procyclical, and therefore more credible and more effective than the old ones. However, building consensus around the new rules took almost a decade, partly because varied debt levels among EU countries meant that one size of reforms did not fit all (Figure 1).

Figure 1: Higher Debt Levels Post COVID-19 Coud Spur Fiscal Consolidation

The Specifics of the Revised Rules

The fiscal reforms make two fundamental changes:

• Individual countries have more ownership of their specific fiscal consolidation paths. While previously, countries had to follow a one-size-fits-all path defined by the Commission, the new rules recognise that what is fiscally sustainable can differ among countries. The new fiscal paths will therefore be individually negotiated on the basis of a debt-sustainability assessment that takes a holistic view of a country’s circumstances.
• Rules are simplified. If compliance was previously judged on multiple fiscal indicators, the new rules focus on just one – net expenditure.³ The chief benefit of using this one metric is that it is observable and thus easier to monitor. The overarching idea is that a simpler, looser, and more flexible approach is a better way to manage fiscal risks within the Union.

This is not to suggest that the conservative “Nordics” have capitulated to the profligate “South”. The new rules include a wide range of limits, for example, on the minimum size of the annual fiscal adjustments. What is different is the shift in emphasis. The intent is clearly to reduce the extent of micromanagement by the European Commission. However, the limits prevent the path-setting exercise from becoming a fiscal free-for-all.

Market and Economic Impacts

In the short term, a drag on growth is inevitable, but not because of the new rules; rather, despite them. Since the EU suspended its fiscal rules in 2020 due to the COVID-19 crisis, member states have run fiscal deficits far in excess of the new rules. A fiscal adjustment would have at some point occurred regardless.

In the long term, the effect is more uncertain, but net positive. Most importantly, the reforms strengthen the integrity of the euro and, by extension, the EU itself. They do so in three ways: (1) by modernising the rules to reflect current political priorities; (2) by reaffirming the political commitment to fiscal prudence; and (3) by making it more likely that in a crisis, calls to support the integrity of the bloc will trump concerns over moral hazard.

All else equal, we expect this reform to soften regional business cycles and reduce the likelihood that countries will drop the euro. This is good for both European assets and the euro in the long run.

Gaps to Be Aware Of

Even though we see positive impacts on long-term growth, we note the following headwinds to the effectiveness of the rules:

• Year 2027 may have a cliff effect. Starting from 2028, countries must include interest expenses in their calculations of net expenditure. This leaves fiscal space for highly indebted governments today, but it could result in a fiscal shock later on, particularly if rates stay high.
• Power politics will continue to play an important role. The new rules do not change the political balance of power within the EU. Larger members will still be able to get away with more exemptions.
• Greater politicisation of the fiscal paths. Greater national ownership of fiscal paths implies greater influence from the shifting nature of national politics. Incoming governments have low incentives to follow through on fiscal commitments of the government they replace.
  Moreover, there is a mismatch in timing. The fiscal paths negotiated with the EU will last for four years or seven years—longer than the two years that governments in Europe stay in power, on average.⁴ The problem could be worse in countries with a frequent government turnover. The fact that the new rules exclude national fiscal councils from meaningfully participating in the process is a missed opportunity to reduce this risk.

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Originally Posted April 22, 2024 – A Better Macro Policy Framework for Europe

Footnotes

¹ The Council of the European Union (the political body made of minister-level politicians) and the European Parliament agreed the final outline of the rules. This was the last step of the negotiation on the specifics of the new rules. They are expected to be ratified in the current form shortly. See: st06645-re01-en24.pdf (europa.eu).
² The rules were considered procyclical because they encouraged countries to implement more fiscal stimulus when the economy was improving (and tax revenues increased), while they may have caused countries to enact more fiscal consolidation during weaker economies.
³ Net expenditure is defined as government expenditure, excluding one-off revenues, expenditure funded by the EU, and cyclical unemployment claims.
⁴ There is a wide range, from less than a year in Belgium, Finland, and Italy to over four years in Malta and Luxembourg. Source: Pew Research. “Many countries in Europe get a new government at least every two years.” January 2023.
⁵ See: ECB announces changes to the operational framework for implementing monetary policy (europa.eu).

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