Paul Dermine (PhD candidate in EU institutional law, Maastricht University) and Diane Fromage (Assistant Professor of European Law, Faculty of Law, Maastricht University)

EU Fiscal Governance after the Crisis: A Time for Reflection and the European Fiscal Board’s First Report

Recent developments suggest that the Eurozone may be entering a new phase. With the sovereign debt crisis subsiding and economic growth gradually returning, discussions about reforming the Economic and Monetary Union (EMU) are resurfacing at both the EU and member state levels. This presents a timely opportunity to analyze the economic governance system that emerged from the crisis and evaluate the actions taken by the EU institutions and member states within this framework.

This piece aims to examine the area of fiscal governance. The crisis led to a significant strengthening of European fiscal discipline rules and an unparalleled expansion of surveillance in budgetary matters. However, this new set of rules, primarily introduced through the Six-Pack and Two-Pack reforms, along with its primary enforcer, the European Commission, has faced considerable criticism from entities like the European Central Bank (ECB), the International Monetary Fund, and several member states.

Adding to this critique is the recently established European Fiscal Board (EFB). Announced in the June 2015 Five Presidents Report, the EFB’s purpose is to coordinate with and supplement national fiscal councils established under the EU Directive on budgetary frameworks. It provides an independent, public evaluation of how budgets and their execution align with the economic goals and suggestions outlined in the EU’s fiscal governance framework. The goal was to improve compliance with common fiscal regulations, foster a more informed public discourse, and enhance the coordination of national fiscal policies. Operational at the end of 2016, the EFB is led by Chair Niels Thygesen, a Danish economist and former member of the Delors Committee, along with four members.

The EFB’s inaugural annual report, released on November 15th, offers a balanced perspective on the current regulatory environment and the Commission’s performance as its overseer. The report concentrates on three key aspects: evaluating the implementation of the EU’s fiscal framework, assessing the fiscal stance of the euro area as a whole, and identifying successful practices in national fiscal councils’ operations. It concludes by proposing potential advancements for the EU’s fiscal framework.

In its assessment, the EFB underscores three characteristics of the present fiscal governance framework: its complexity, its inherent asymmetry, and the considerable discretion given to the Commission in applying the existing rules. Additionally, it examines the feasibility of centralized fiscal stabilization within the Euro area.

This report provides a valuable chance to delve into some of the primary obstacles confronting EU fiscal governance today and to offer possible solutions.

This endeavor is particularly timely as the Commission’s upcoming December EMU package is set to prioritize the integration of the Fiscal Compact into EU law and the review of the Six-Pack and Two-Pack reforms. This political momentum is expected to create more opportunities to further enhance and refine the Stability and Growth Pact (SGP) and other instruments within EU fiscal governance.

Context for the EFB’s First Report

Before analyzing the EFB’s inaugural report, it is important to remember that the crisis led to a significant restructuring of EU fiscal governance. The procedural framework for fiscal surveillance and coordination was significantly enhanced, primarily by expanding the EU’s oversight over national public finances. Additionally, the core fiscal rules governing member states were tightened and broadened.

In essence, fiscal targets have become stricter, requiring greater annual adjustment efforts from member states. While the deficit remains the central focus of the EU’s fiscal discipline regime, the debt criterion has been further elaborated, and an expenditure benchmark has been introduced. There’s a greater emphasis on structural indicators over nominal ones. These developments highlight the EU’s clear intention to closely and constantly monitor all aspects of national budgets to ensure overall sustainability.

However, acknowledging the need to accommodate various unforeseen events and maintain a degree of flexibility, the Six-Pack reform also introduced numerous escape clauses. These clauses allow member states to deviate from their budgetary commitments under specific circumstances, such as implementing structural reforms or facing severe economic downturns.

The Overwhelming Complexity of EU Fiscal Governance

Undoubtedly, a significant drawback of this new set of rules is its sheer complexity. In the post-crisis era, EU fiscal discipline consists of a dense network of intricate rules and sub-rules regulating public debt, deficit, and expenditure. These rules are highly prescriptive and specific, yet they are counterbalanced by an equally complex array of general escape clauses and opportunities for flexibility and derogation. Further adding to the systemic complexity of the EMU’s fiscal discipline regime, these rules are scattered across various EU regulations and directives, partially mirrored in international treaties and national laws, which don’t always perfectly align.

Consequently, national authorities struggle to understand their precise obligations and the extent of their maneuvering room within this framework. This lack of clarity also hinders transparency for the rules’ ‘indirect’ audience—the public and the markets—which could, in the long run, undermine the effectiveness of public oversight and market mechanisms as enforcement tools for fiscal discipline within the EMU.

A simplification is clearly needed, a sentiment seemingly acknowledged by the European Commission. An excess of rules and operational targets hinders compliance, monitoring, enforcement, and overall comprehensibility, ultimately jeopardizing the legitimacy of the EU’s actions. To this end, intriguing reform proposals are being considered. Rightfully arguing that the ultimate goal of the EU’s fiscal regime is to maintain debt sustainability, IMF officials and, to a lesser extent, the EFB, suggest that the system would be more transparent and efficient if it were centered around one fiscal anchor (debt ratio instead of headline deficit) and one operational target (possibly the ‘fiscal effort’ variable). Similarly, streamlining the existing escape clauses appears necessary.

The Inherent Asymmetry of EU Fiscal Discipline

Another critical problem with the current regime is its inherent asymmetry. From its inception, the SGP was designed to address excessive deficit and debt levels and control overspending states. Consequently, its rules and procedures are solely driven by this objective, and the crisis further solidified this focus. However, the rules fail to consider situations where states might be overly austere. Under the SGP, surplus equates to balance, and surplus countries are not obligated to return their fiscal position to equilibrium. This asymmetry makes the SGP a one-sided tool, ineffective in addressing overly “virtuous” countries.

This has proven particularly challenging in recent years, as the Commission aimed to achieve a positive fiscal stance for the Euro area and encouraged member states with substantial budget surpluses (such as Germany, Luxembourg, or the Netherlands) to adopt mildly expansionary policies by utilizing their fiscal space and increasing public investment. Under the current regime, such appeals lack legal backing and are, at best, wishful thinking.

This asymmetry should be addressed, especially when Europe is grappling with an investment deficit. Does this necessitate an “Excessive Surplus Procedure”? That might be excessive. However, if budgetary equilibrium is the ultimate aim of the SGP, its provisions should be modified to allow for mandated fiscal expansion when appropriate.

How Complexity and Flexibility Empower the European Commission

The inherent complexity and flexibility of the current regime, coupled with the conceptual ambiguity of some of its core concepts (like the output gap), have created considerable room for administrative discretion, which the Commission has readily utilized. It’s noteworthy that the Commission enjoys discretion and must exercise judgment at every crucial stage of the surveillance process outlined in the SGP, both in its preventive and corrective arms.

Within a supposedly rule-based system, this raises concerns and undeniably impacts the predictability, impartiality, and efficiency of the entire regime. The primary risk is that certain Commission decisions may deviate from economic justifications and instead be based on political or ad hoc considerations that contradict the economic rationale behind the EMU’s fiscal framework. Examples include the Commission’s generous decision to grant Italy access to the ‘structural reforms’ escape clause or its lenient stance towards France under the Excessive Deficit Procedure, where escalation was avoided despite France’s insufficient consolidation efforts (Juncker’s explicit justification being, ‘Because it is France’).

The Commission’s unexpected decision in the summer of 2016 not to impose sanctions (even symbolic ones) on Spain and Portugal for failing to take corrective action within their EDP framework highlights how discretion can undermine enforcement and ultimately, compliance. Nevertheless, a system of intelligent rules cannot function without a degree of flexibility and discretion. Future efforts should focus not on eliminating administrative judgment but on ensuring that such judgment is primarily guided by economic, not political, considerations.

However, this could prove difficult as the Commission also needs to maintain legitimacy in the eyes of the public while ensuring the EU’s fiscal stability. It must consider that its decisions to impose fines on non-compliant member states can only be overturned by a qualified majority in the Council. Simplifying the rules should help in achieving this goal of economically-sound decisions. The Commission should also be more transparent about its methodologies and apply them consistently. The risk of biased, political application of the SGP by the Commission stems primarily from its current hybrid nature, which sits “between an independent executive agency and a political government,” as the EFB aptly points out.

This risk can be mitigated by relying more on economic advice that is independent of short-term political considerations. The source of this input remains to be determined, though the EFB has naturally offered its services. On the surface, the EFB’s role differs significantly from national fiscal councils as it isn’t directly involved in implementing the EU fiscal framework; its role is to evaluate the Commission’s actions in this regard.

Conversely, even though national councils typically don’t issue binding decisions to their governments, they are involved in producing or endorsing macroeconomic forecasts, declaring the activation of automatic correction mechanisms, etc. In its evaluation, the EFB proposes taking on responsibilities that are closer to those of national councils.

Lastly, to further minimize discretion, the consistency, predictability, and congruence of EMU fiscal discipline could be enhanced by relying on more effective enforcement mechanisms like financial sanctions. Past experiences have shown the limitations of financial sanctions. Linking access to EU funds to (near) compliance with the SGP’s fiscal rules, known as macroeconomic conditionality, could be a viable solution. While already employed under the current multiannual financial framework, its application is limited. This model could be expanded under the next framework.

Toward a Fiscal Union?

Beyond the issues of complexity, asymmetry, and discretion within the EU’s fiscal framework, the question of centralized fiscal stabilization requires attention. The Euro crisis exposed the inherent shortcomings of the rules-based paradigm. It is clearer than ever that this approach needs to be replaced by providing the supranational level (the EU or the Eurozone) with its own fiscal capacity.

This transition from negative to positive fiscal integration could involve unemployment insurance or investment protection, potentially exempting investments from the golden rule. The creation of a rainy-day fund, as suggested by the Commission, is another possibility. This fund could be a valuable option as it would operate based on accumulated resources regularly contributed by member states, who would then have a direct incentive to adhere to SGP rules. While the EFB acknowledges that this discussion falls outside its purview, it does offer an opinion “as economists involved in the analysis of public finance more generally,” seemingly asserting its standing within the broader EU financial landscape. The specific form this budget should take, whether as a dedicated euro area budget (as recently proposed by President Macron) or as a dedicated budget line for the euro area within the EU budget (as envisioned by the European Commission), remains undecided. In the absence of a dedicated euro-area parliamentary system, the latter option might be preferable to avoid exacerbating the European democratic deficit.

Ultimately, such a move would go beyond mere fiscal stabilization and represent a more comprehensive approach to fiscal policy. This shift, essentially a return to a perspective considered in earlier stages of European integration, would be welcome as it could address several shortcomings of the current fiscal policy design.

Key Takeaways from the Report

This report is significant for two key reasons. Firstly, it offers a valuable evaluation of the current EU fiscal framework as implemented by the Commission at a time when discussions about the Eurozone’s future architecture are high on the EU agenda. Secondly, it addresses some concerns that arose when the EFB was initially established, particularly regarding its capacity to provide a genuinely independent assessment of the Commission’s actions. Indeed, some uncertainty existed due to the close relationship between the EFB and the Commission and the lack of European Parliament involvement.

Additionally, the EFB’s ability to act as a credible institution was not guaranteed, given its status as a completely new entity that needed to establish its reliability and independence. The content of this first report suggests that the EFB is likely to succeed in overcoming both hurdles, at least under the leadership of the prominent and respected expert Niels Thygesen.

Regarding the future of the EU fiscal framework, the report provides a useful and timely assessment. It highlights weaknesses in the current framework and its enforcement by the Commission, and contributes meaningfully to the reform debate. This contribution is particularly valuable as it originates from the EU institution tasked with conducting this assessment, not from external entities like the ECB or the IMF, as has been the case so far. It remains to be seen whether and how the Commission will incorporate these proposals in its December announcement.

Barnard & Peers: chapter 19

Photo credit: Supertrader