EU bids farewell to austerity with review of debt rules

The European Commission laid out proposals to overhaul the European Union’s debt rules for member states on Wednesday, acknowledging that a system that locked in austerity may have been ineffective and counterproductive.

The announcement will kick off a fierce debate among EU members on a topic that divides the union, pitting fiscally conservative states such as Germany and Finland against a southern bloc that says the spending rules hobbled their economies by preventing them from making investments that would allow their economies to grow.

The rules broadly limit member states to running annual deficits that are no more than 3 per cent of their gross domestic product each year and state that national debt should be reduced once it exceeds 60 per cent of GDP. Debt has nevertheless grown across much of the union, while the rules were patchily enforced and grew more complex over time.

The European Commission’s economy minister Paolo Gentiloni said lessons had been learned from the Covid-19 crisis. This saw a transformation in the EU’s approach as it confronted the economic downturn with massive investment stimulus and supportive spending, which is now credited with cushioning the pandemic’s economic blow.

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“We are building on the positive lesson learned of the RRF,” Mr Gentiloni said, referring to the EU’s ground-breaking €750 billion jointly borrowed Covid-19 recovery fund.

We must finance massive investment needs, notably to support the green transition, energy security, common defence, our European competitiveness

“Ultimately, what matters for debt sustainability and for the markets, is that member states reduce our public debt ratios, especially when it is high, in a realistic, gradual, and sustained manner,” he continued. “This is why we believe we should move away from the unrealistic requirements imposed by the unrealistic 1/20 debt reduction rule.”

The 1/20 rule applies to countries with debt levels above 60 per cent of GDP and states that the gap between their actual debt level and the target should be reduced by one twentieth each year, though countries have often flouted this.

Mr Gentiloni noted the 60 per cent of GDP level was “not a product of the economic sciences”, but had simply been the average debt of the 12 countries that signed the Maastricht treaty that set the rules in 1992.

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The Commission is also arguing that massive borrowing will be required for investments in the years ahead, including hundreds of billions of euro annually to overhaul the EU’s energy system away from fossil fuels.

“We must finance massive investment needs, notably to support the green transition, energy security, common defence, our European competitiveness,” Mr Gentiloni said.

The proposals follow an evolution in thinking over time as a new generation of leaders in the Commission and around Europe consider extreme cuts to spending in the aftermath of the financial crisis to have deepened and lengthened the downturn, while a hangover of fiscal conservatism meant governments failed to take advantage of cheap credit in later years to make economically beneficial investments.

So the political logic of it is very understandable, but the economic damage that that has done is just enormous

A senior European Commission official, speaking off the record, acknowledged that excessive austerity had been a mistake.

“I think we have suffered in particular in the later years of the crisis and the early aftermath of an excess of austerity, if you would ask me,” the official said.

“I think it’s also fair to say that when things improved again later on, that member states have not benefited or have not made use enough of the fiscal space that was created.

“Member states, they cut back massively on expenditure, but the investment part of that was hit the hardest,” the official continued. “That is understandable, because it’s easier to cross out investment than some other measures. So the political logic of it is very understandable, but the economic damage that that has done is just enormous.”

Under the Commission’s suggestions for reform, the fiscal rules would be simplified and focus on economic risks, differentiating between countries according to their particular challenges.

National governments would draw up plans for the reduction of their debt, but these would be highly tailored to national circumstances and be “more realistic” and “gradual”. On the other hand, they would also be more strongly enforced.

The debate will now be handed over to the EU’s member states, among whom there are strongly differing views on the issue, and Minister for Finance Paschal Donohoe will have an important role in trying to find consensus if he succeeds in staying on as president of the Eurogroup club of finance minsters.

Germany, which kept its annual spending in surplus for years and has a respectable debt-to-GDP ratio of just under 70 per cent, is wary of exposure to the debts of other EU countries and has already expressed reservations about the Commission’s approach. Berlin is expected to push for rules that ensure tougher fiscal responsibility for more indebted member states.