October 15th marks the deadline for EU member states to submit fiscal plans, influencing economic stability and public debt for years to come.
October 15th is the deadline for member states to send their multi-year fiscal plans to meet reformed EU fiscal rules to the European Commission (EC). These plans are extendable up to seven years in the presence of investments and structural reforms consistent with the EU’s objectives. The plans will have to move within the constraints defined by the EC for each Member State, consistent with the debt sustainability analysis (DSA) on which the new system of fiscal rules relies heavily.
In this framework, the DSA plays a crucial role in defining the perimeter of fiscal policies implemented at the national level. By defining individual countries’ margins of manoeuvre over a multi-year horizon, the new scheme is supposed to ensure that the debt ratio is “on a plausible downward trajectory or remains at prudent levels, even under adverse scenarios”. The criteria used to define expenditure trajectories require that, without resorting to further fiscal consolidation, the public debt ratio falls or remains below the 60% of GDP threshold by the end of the adjustment period and in the following ten years; the debt ratio should fall with a “sufficiently” high probability; and the fiscal deficit should fall below 3 per cent and remain there in the medium term.
In a recent study, we have raised important questions about the potential impact of the wave of consolidation that governments will have to implement to meet the new rules. We analyse the sensitivity of the official DSA assumptions on how fiscal consolidation affects growth and public debt ratios. By introducing assumptions that are in line with the scientific literature and more realistic than the official assumptions used by the EC, we show how fiscal consolidations resulting from the new fiscal framework could affect economic growth more adversely than the European Commission suggests, which will also make it more difficult to bring down public debt ratios. This is particularly true in countries with high debts.
The analysis focuses on the four largest EU economies, which comprise about three-quarters of overall economic activity in the euro area: France, Germany, Italy and Spain. The latter face different challenges in terms of deficit reduction: while Italy, France and Spain have to undertake historically large adjustments from 2025 onwards, Germany needs a much more modest adjustment plan. Under a four-year adjustment plan, Italy is required to improve its structural primary balance by about 1.08 per cent of GDP per year to meet the new parameters. France and Spain will have to make an annual adjustment of 0.94 and 0.89 per cent of GDP, respectively, while Germany’s required consolidation is much lower at 0.11 per cent per year.
Our study identifies three key elements that, in the context of the DSA model currently used by the EC, may lead to an underestimation of the negative growth effects of fiscal consolidation.
- Fiscal multiplier. In the short term, a fiscal consolidation of EUR 1 billion reduces economic output by EUR 0.75 billion (a multiplier effect of 0.75). This multiplier value is presumably too small, particularly in times of crisis and for expenditure-based consolidations, and it is also smaller than in the study to which the EU Commission refers.
- Persistence of consolidation effects. In the medium term, the EC assumes that the multiplier effect will disappear completely three years after the adjustment and that economic output will return to its previous growth path. Here too, the DSA lags behind the EC’s own publications, which discuss longer-lasting negative growth effects. The more recent literature shows that fiscal policy measures typically continue to have an effect in the medium term.
- Absence of spillover. The EC considers the effects of consolidation for each member state individually. However, the austerity measures in France, for example, may also have a considerable impact on the export-dependent German economy and therefore on German public finances due to close trade links. These spillover effects of fiscal consolidation measures are discussed elsewhere by the EC as an important influencing factor, but are currently ignored in the DSA.
The simulations presented in our study compare the DSA projections for GDP growth and the public-debt-to-GDP ratio for Italy, Germany, France and Spain based on the official assumptions with alternative scenarios obtained by modifying the basic assumptions, in line with the academic literature. The changes concern a somewhat larger fiscal multiplier (0.9 instead of 0.75), slower dissipation of the consolidation effects (5 years instead of the 3 years) and the presence of ‘spillovers’ (consolidation in one country also influences its partners based on how tight the trade links are).
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If one compares the combined scenario (where all the changes just illustrated are present) with what the EC envisages, a more worrying picture emerges, particularly for those economies that currently show a high debt/GDP ratio. Although GDP returns to the original potential GDP path in all countries as early as 2033, the weak growth in the meantime leads to significantly higher public debt ratios in 2038: +3.9 percentage points of GDP in France and Italy, +3.1 percentage points in Spain and +1.7 percentage points for Germany.
In Italy and France, GDP will almost stagnate in the EC’s baseline adjustment scenario from 2025 to 2028. In our alternative scenario, economic output even shrinks over this four-year period. Due to these effects, public debt ratios will initially continue to rise despite the strong austerity measures. It is not unlikely that the consolidation targets will be missed in the political process under these conditions and that governments will therefore have to go for even larger fiscal adjustments during the economic downturn.
The large euro area countries with high public debt ratios France, Italy and Spain will have to adjust significantly more than their EU peers. These countries may experience more adverse domestic growth effects than officially expected under the new fiscal rules. In particular, this will be the case if fiscal multipliers turn out larger and/or if the negative short-run growth effects from fiscal adjustment dissipate more slowly than assumed by the EC. Although a level shift in public debt ratios need not endanger debt sustainability in the medium run, economic stagnation and a larger than expected increase in public debt ratios in the short run may erode the confidence of voters and bond investors. Should cross-country spillovers materialise, Germany and other EU countries with strong trade links will experience lower growth due to the restrictive fiscal policy stance by important trading partners. Compensating for the drag on growth due to lower import demand from EU trading partners may not be an easy task in the current environment. This is especially worrying, since the German export-led engine is now facing renewed headwinds, as highlighted by ECB’s Isabel Schnabel just a few days ago.
The results from our study suggest that a discussion about the negative growth effects of the upcoming austerity policy and the implications for public finances is urgently needed. The DSA assumptions are essential to the reformed EU fiscal rules and should be discussed scientifically and politically. With the renewed focus on austerity, expanding public investment to meet the challenges of renewing infrastructure, climate change, and European sovereignty is becoming a distant prospect. As Mario Draghi’s recent report suggests, policymakers should be open to changes that allow for more public investment, including a European investment fund.
Sebastian Gechert is Professor of Macroeconomics at Chemnitz University of Technology in Germany and a fellow of the Forum for Macroeconomics and Macroeconomic Policies (FMM).
Dario Guarascio is an associate professor of economic policy at the Sapienza University of Rome. He is also affiliated to the Sant’Anna School of Advanced Studies in Pisa. His research covers the economics of innovation, digitalisation and labour markets, the European economy and industrial policy.
Philipp Heimberger is an economist at the Vienna Institute for International Economic Studies (wiiw) and the Institute for Comprehensive Analysis of the Economy (Johannes Kepler University Linz).
Bernhard Schütz is an economist at wiiw in Vienna and Research Associate at the University of Duisburg-Essen.
