Europe needs a strong macroeconomic policy core—but not a Six (or Two) Pack

In light of the eurozone and, now, climate crises, EU macroeconomic policy co-ordination needs a reboot.

Europe’s fiscal rules have been in a near-constant state of flux and under a persistent cloud of controversy since the Maastricht treaty of 1991 set out convergence criteria, in terms of deficit and debt ceilings, for membership of economic and monetary union.

The Stability and Growth Pact (SGP) of 1997 effectively made the Maastricht criteria permanent for EMU members, and in the wake of the eurozone crisis, in 2011 and 2013 respectively, two packages of directives, usually known as the Six and Two Pack, were introduced. Their aim was to strengthen compliance with the fiscal rules and to extend EU surveillance of eurozone member-state economic policies to address the issue of macroeconomic imbalances—in particular, divergences of competitiveness and current-account imbalances.

Significant opportunity

The European Commission has just published a review of the two directives, which is to be the basis for a public consultation. This is a significant opportunity for a debate on substantial reform of Europe’s fiscal rules.

The review has weaknesses—most obviously skating over the huge and lasting damage done to economies in southern Europe in the wake of the eurozone crisis—but it constitutes a step forward in that the commission does clearly set out a number of issues with the economic governance regime to which critics have long drawn attention. These include the frequently pro-cyclical nature of fiscal policy, the difficulties in achieving a co-ordinated fiscal stance and the lack of traction, especially on surplus countries, of the Macroeconomic Imbalance Procedure (MIP). It also recognises changes to key parameters, such as low interest rates and persistent ‘lowflation’, and new policy challenges, above all the climate-change imperative.

The commission has largely refrained from pointing out policy options, not to speak of recommendations, merely setting out a number of issues for debate as a prelude to the consultation. This contribution takes up the challenge.

Goals and principles

National fiscal policy (and economic policy more generally) must be such as to avoid a dangerous build-up of public debt, to ensure that budgets are sustainable. It should at least avoid pro-cyclicality and be as counter-cyclical as possible, compatible with a need to ensure long-term sustainability.

Fiscal rules and those governing other economic policies—such as the MIP—should be symmetrical, exerting pressure equally on surplus (excess supply) and deficit (excess demand) countries. Where rules refer to specific indicators, these should as far as possible be reliably measurable, under the control of governments and consistent with each other and with other goals. And the likely impact of government spending items on medium-term growth potential (and thus debt-servicing capacity) should be taken into account.

The rules should be linked to an effective system of incentives, whether positive or negative (carrots and sticks) to ensure compliance wherever there are significant spillovers between countries, and they should be as simple and transparent as possible.

There are tensions between these principles. For instance the move from nominal ceilings as a proportion of gross domestic product (debt 60 per cent, deficit 3 per cent) under the SGP to cyclically adjusted ones reduced pro-cyclicality in principle, but the new indicators—the ‘structural deficit’, with its reliance on estimations of the ‘output gap’—are unobservable and have led to contradictory, even absurd, policy recommendations.

A reform package

As to the institutional and regulatory changes required to realise these principles, choices in one area will affect those in others and the goal must be a balanced package. Of course, considerations of political feasibility are also important. But a sensible and feasible package could be built around the following elements.

First, the leeway granted to member states to set their fiscal stance should vary in accordance with their longer-run fiscal sustainability. A simple measure such as the debt/GDP ratio is not adequate to determine sustainability: the analysis needs to take into account factors such as interest rates, debt-maturity profiles and so on. (While not the focus here, at the same time measures should be taken to limit dramatically the fundamental risk to government-debt sustainability, via greater support for national sovereign bonds from the European Stability Mechanism / European Central Bank, if not a common fiscal capacity.)

Member states’ fiscal stances should symmetrically aim to balance domestic demand and supply. Given the well-known problems with assessing output gaps, key indicators should be medium-run, domestic-price and unit-labour-cost inflation rates—the benchmark being the area-wide inflation target of the ECB (which should also be symmetrical). Short-run fiscal monitoring should focus on discretionary (non-cyclical) policy but take in taxation as well as expenditure, to avoid prejudging the desired size of the public sector.

The MIP should in turn be made symmetrical (setting appropriate upper and lower limits to the variables in the scoreboard). Then it, rather than the SGP, should become the prime lens with which to evaluate national economic policy in a more forward-looking way—and, where necessary, to insist on corrective measures. This requires prioritising for surveillance those MIP indicators, such as unit labour costs, that are critical for stable and mutually consistent economic development in the medium run.

Wage and price setting, in which social partners play a key role, and macroprudential policy (the purview of national central banks) should be more closely incorporated into economic governance by implementing or broadening the remit of institutions that bring together governments, monetary authorities and social partners at national and EMU level, including the Macroeconomic Dialogue and fiscal councils or productivity boards.

Meanwhile the traction of automatic stabilisers should be enhanced nationally (such as via minimum standards in national unemployment-insurance systems) and/or cross-border (by way of an effective EU unemployment (re)insurance scheme).

A conceptual and institutional solution is required to permit member states to finance through borrowing those expenditures that raise potential output and create publicly owned assets, particularly where these are clearly in line with common EU goals. There are more or less ambitious ways to achieve this, ranging from a general exemption for (suitably defined) public investment (a golden rule), to more specific exemptions (such as for national measures under the European Green Deal), to solutions involving resource-pooling from which member states can finance agreed projects.

Finally, the compliance and sanctions regime should be refocused as far as possible on making access to European public goods (such as investment-support and emergency funds) conditional on adhering to agreed economic-policy principles and rules. It also needs to be graded so as enable a flexible response by EU policy-makers, but one which, ultimately, results in a substantial loss of national economic-policy sovereignty. Relying on market pressures as a sort of sanction mechanism has been shown to be risky and should be limited as far as practicable.

Feasible but effective

A package of measures such as this would address many of the issues correctly raised by the commission in its review. In each area different options exists, requiring different degrees of political ambition.

The task must be to devise an interlocking set of policies that is politically feasible but effective. The planned consultation is an ideal opportunity to work out the nuts and bolts of such a compromise, which would enable the euro area to leave the bitter crisis years behind it and turn to new and vital challenges.