EU’s wobbly budget rules can bolster shaky economy

Europe’s new budget rules can work only if Brussels can stretch them. Eleven countries including France, Italy and Belgium, posted 2023 deficits above 3% of GDP, the official high-water mark for debt. But not all of them may end up being sanctioned. The regime includes ample wiggle room, allowing countries plenty of time to adjust. That’s good news for a bloc that needs growth more than guardrails.

To keep up with the United States and other global competitors, the 27-country European Union needs to square a circle. It has to grow faster than the anemic 1.4% annual expansion the bloc has averaged since 2006. But it also needs to fund the green transition and increase defence spending. And it can’t abandon the fiscal safeguards built into the bloc’s founding treaties that limit government borrowing and aim to cap member states’ total debt at 60% of GDP.

At first sight, the exercise got off to a shaky start: last month European Commission data showed that more than a third of EU countries, including heavyweights France and Italy, had gone above the deficit limit. But the new budget rules put in place in April allow countries at least four years to cut back on red ink before they face sanctions that could include fines or a loss of EU funding.

The Commission, the EU’s executive arm, is due to put out its official assessments of those found to be in breach of the new rules in June. Countries will have until around November to show how they plan to act.

Markets have so far been calm, and the gaps between the bond yields of countries with big deficits and those of Germany have been relatively stable. Still, the stakes are high. The whole point of having EU-wide fiscal rules is to prevent governments from spending their way into fiscal crises that can affect the whole of the bloc. Yet, even with the old, stricter, rules, between 2010 and 2015, budget problems in Greece spilled over into a crisis that caused five countries to seek bailouts and threatened the viability of the single currency. At the same time, straitjacket number-crunching, as fostered by the previous Stability and Growth Pact, risks forcing countries to cut spending and raise taxes in ways that entrench, rather than alleviate, economic difficulties.

The new regime’s first test looks daunting. The rules require countries with a deficit of more than 3% of GDP to make a fiscal adjustment – lowering their budget balance under a country-specific plan – of at least 0.5% of GDP a year. Some critics worry this will rein in spending too much and prevent countries from making the investments needed to pull their economies upright, while others fear the emphasis on annual deficits will take the focus away from reducing total debt levels.

The 11 countries now at risk of official “excessive deficit” rulings show the breadth of the challenges ahead. Italy recorded the bloc’s highest deficit shortfall in 2023, at 7.4% of GDP. That figure is expected to fall to a still sizeable 4.4% in 2024. Nevertheless, the reduction gives Prime Minister Giorgia Meloni momentum as she puts together a plan to keep the numbers moving in the right direction. For Spain, its 3.6% deficit last year is projected to fall to 3% in 2024 alongside a healthy 2.1% economic growth rate, enabling Prime Minister Pedro Sánchez to argue that it could squeak under the limit and not need corrective procedures at all.

On the other hand, France’s budget deficit clocked in at 5.5% of GDP in 2023, and it’s projected to be 5.3% in 2024 and 5.0% in 2025, while the economy is forecast to grow at just 0.7% and 1.3%, in those two years respectively. This is exactly the sort of lackluster fiscal improvement that backers of more stringent mechanical limits want to avoid. In their view, the new rules might encourage government to kick the can down the road, or to the next sets of politicians, despite explicit “no backloading” provisions to avoid delays in deficit reductions.

The International Monetary Fund – which has warned Europe that its puny growth prospects are a big threat to economic stability – has cautioned that countries shouldn’t be allowed to plan all their changes into the later years of the planned adjustment periods, lest they get caught up in a perpetual cycle of extension.

And yet the new rules may have just enough flexibility to work. Take, for example, member states like Spain and the Czech Republic, which were over the deficit limit in 2023. For them, rosier 2024 budgetary projections may mean they will sidestep the sanctions process altogether. The longer horizon also offers opportunities for traditionally frugal countries like Finland, which is expected to join the over-3% club this year, due to extra defence spending in response to the war in Ukraine.

The new rules further open the possibility to extend the four-year path to seven years, if countries can show they’re making growth-producing investments in their economy. They will also negotiate their plans with the Commission and submit yearly updates. The process aims to be more credible than earlier iterations, such as the 2003 move to let Paris and Berlin off the hook for fines despite breaching the limits.

While Germany was the loudest voice calling for tougher rules, it hasn’t shown that balanced budgets lead to a stronger economy. Rather, the euro area’s biggest economy shrank 0.3% in 2023 and its 2024 forecast of 0.1% growth is practically a flatline. Despite that, Berlin wants to shrink the budget deficit from 2.5% in 2023 to a projected 1.6% in 2024 and 1.2% in 2025.

Ideally, the political compromises that allowed the new EU rules to go forward will pave the way for workable action as well. After all, the old regime had been suspended for three years, since the 2020 pandemic forced the EU to put all its focus on keeping the economy afloat during the lockdowns and border closures that followed.

As the new process spools out in the coming months, the Commission has a chance to reinforce confidence in the euro and the EU as a whole, if it can make the new process seem credible. But if countries push the new leeway to its limits from the get-go, they could undermine the whole process, unsettle markets and lead to an austerity backlash. That would be a mistake.

The EU needs public financing to meet the substantial challenges coming its way. Wobbly budget rules can be part of the solution rather than yet another problem.

The European Commission on May 15 found that 11 member states have budget deficits of more than 3% of GDP. That may require them to take extra measures to cut debt in coming years. A report due on June 19 will decide how many of these countries must follow official “excessive deficit” procedures to bring their balance down in coming years.

Alfred Kammer, head of the International Monetary Fund’s Europe Department, on May 14 said Europe needs to do more to lift its “miserable-looking” medium-term growth prospects, by taking steps to boost productivity as well as rein in government debt. [Reuters]