Eurozone reform—it’s not just the fiscal rules

At least as important is the reform of the procedure for preventing and correcting macroeconomic imbalances.

The Covid-19 pandemic has eclipsed the general overhaul of the economic-policy framework of the European Union and the eurozone initiated in February by the European Commission. Comprehensive reform of economic governance remains nevertheless urgent and indispensable.

Reform of the Stability and Growth Pact (SGP) and the Regulation on the Prevention and Correction of Macroeconomic Imbalances (MIP), within the framework of the ‘six-pack’ and ‘two-pack’ of the European Semester and other regulations, should again be at the centre of discussions, as soon as—at the latest—the consequences of the pandemic have been dealt with.

Intensive discussion

The focus of debate seemingly will be on fiscal rules, as in the past. Currently, the post-Maastricht deficit and debt rules are suspended, a return to ‘business as usual’ seems impossible, and alternatives are being intensively discussed.

The concern is that at best—not least because of the differing positions of the member states—there will only be a revision of the fiscal rules. If this were to happen, however, the reform of economic governance would remain piecemeal and far behind the requirements of sustainable, stability- and employment-oriented macroeconomic development, in the member states and in the eurozone as a whole.

Fiscal rules only cover part of economic performance and are in themselves complex and problematic. They rely on estimation of a ‘structural’ deficit, which is fraught with the well-known problems of cyclical adjustment and, in particular, of gauging potential output. An inherent flaw is the exclusion of the ‘golden rule’ in the financing of public investment.

Last but not least, the cyclical component of the deficit is in any event directly linked to the macroeconomic context. The cyclical surplus or deficit stems from overall macroeconomic development and the operation of the ‘automatic stabilisers’. Discretionary fiscal measures can from the other side stabilise the cycle. In times of massive economic fluctuations and shocks, such as in the financial and eurozone crises and currently as a result of the coronavirus, these mutual effects around the cyclical component of fiscal outcomes are of major importance.

Discretionary measures

In the wake of the pandemic, reform considerations have been replaced in the short term by two massive discretionary measures, the Multiannual Financial Framework 2021-27 and in particular the Recovery and Resilience Facility (RRF), within the Next Generation EU programme. But these must be co-ordinated and aligned with the macroeconomic challenges to have strong and focused effects.

The volume of the RRF is considerable, as is the additional debt incurred. Since neither of these can probably be repeated, success must be assured.

First and foremost, the facility must be designed to reduce—and certainly not exacerbate—macroeconomic divergences and imbalances among member states. A recent policy brief provides a positive forecast. Overall, it must foster sustainable and stable recovery.

The RRF cannot however accomplish these tasks alone. As unprecedented as it may be in absolute amount, its scope remains relatively limited, set against the volume of eurozone macroeconomic aggregates. It must be consistently embedded in a sustainable policy mix of all macroeconomic instruments by all decision-makers, in each member state and at the eurozone and EU levels.

Macroeconomic aggregates

The MIP is aimed at all macroeconomic aggregates. This distinguishes it from the Stability Pact, which only targets fiscal aggregates and these depend on macroeconomic development and policy at least as much as they influence them.

In the commission’s programmatic paper on the Economic Governance Review, as well as in the scientific and political discussion, the MIP occupies only a small space compared with the Stability and Growth Pact. This weighting must be reversed.

That is the lesson to be learnt from the crisis in the eurozone around ten years ago, as high-ranking actors now acknowledge. ‘It was a mistake to focus primarily on public finances. We should have monitored a broader spectrum of macroeconomic parameters … the development of unit labour costs, current account deficits, real estate bubbles. The commission would have needed a mandate to tackle these imbalances in the same way as it tackled excessive public debt,’ said Klaus Regling, current head of the European Stability Mechanism (ESM), as early as 2010.

With the MIP, there is now such a broad-based set of rules to prevent the central mistake identified by Regling, with its dramatic consequences, from happening again. But this requires reform of the procedure, especially the symmetrical alignment of upper and lower limits for the indicators and their concentration on exogenous variables economic policy can affect.

Macroeconomic wage and price trends play a central role here. Via a chain of effects, including on the real interest rate, wage and price developments have decisive influences on domestic demand, employment and the budget balance. And, taking into account additional imports induced by domestic demand, there is also an impact via price competitiveness on the balance of payments.

Information exchange

Moreover, the MIP regulations must be implemented in a targeted manner. Because of the procedure’s comprehensive approach, all macroeconomically responsible actors must participate.

At euro-area level, these include the European Central Bank, the commission, the finance ministers of all member states and representatives of the social partners. An analogous body should be set up in each member state. Both formations must exchange information, internally and with each other—about the prevention and if necessary correction of macroeconomic imbalances and divergences, the regaining of a stable growth and employment path and the use of RRF resources towards these objectives.

A suitable format could be a Macroeconomic Dialogue at the level of the member states and one for the euro area. Both could be modelled on the existing EU Macro Dialogue, whether by creating a new forum or building on existing ones.

The discretionary measures introduced in the wake of the pandemic and comprehensive reform of the economic policy framework of the eurozone and the EU must be co-ordinated, simultaneously and consistently. At least as important as reform of the fiscal rules is reform of the procedure for preventing and correcting macroeconomic imbalances—and then their mutual co-ordination.

A German version of this article, ‘Reform der Eurozone—nicht nur die Fiskalregeln reformieren’, was published in Makronom