Investing in the future and reforming the fiscal rules are essential, while decentralising and democratising economic governance.
In the past few years, the European Union has confronted multiple crises, which have led to a major rethink of economic governance.
The 2010s were defined by the response to the eurozone crisis, focused on reduction of budget deficits and debt. The ‘governing by rules and ruling by numbers’ of the Stability and Growth Pact (SGP) was first reinforced through belt-tightening austerity and structural reforms. These did not work and were slowly reversed, as EU institutional actors recognised the need for growth in 2012, flexibility as of 2014, investment beginning in 2015 and social rights from 2017.
When the pandemic hit in 2020, eurozone economic governance was transformed. Member states engaged in expansive measures to shore up their economies and protect lives and livelihoods. The European Commission suspended the fiscal rules, along with those on state aids, and created the SURE programme to support employment. And the Council of the EU agreed to NextGenerationEU and the €800 billion Recovery and Resilience Facility (RRF), focused on the green transition, the digital transformation and social inequalities.
In the meantime, the commission had also revamped the European Semester. This was a change from top-down, negative conditionality—requiring rapid fiscal consolidation by member states to meet the deficit and debt criteria of the Stability and Growth Pact, along with labour-market deregulation and welfare cuts—to bottom-up, positive conditionality, with more carrots and fewer (but better) sticks. These included RRF grants for green, digital and social projects proposed by countries in exchange for structural reforms to address national economic and administrative problems and social inequalities.
All of this contributed to the largely successful management of the potentially disastrous economic fallout from the pandemic. That was followed, however, by the inevitable inflationary pressures linked to restarting economies with broken supply chains, leading to the cost-of-living crisis. Then came the security crisis resulting from the Ukraine war and the concomitant energy crisis, which only added to the inflationary pressures. Last but certainly not least has been the existential crisis related to climate change, with the incalculable human and environmental costs linked to increasingly hot summers, intense forest fires, cataclysmic storms and rising seas.
Permanent fiscal capacity
How the EU responds to the challenges driven by these crises will determine its future. Will it go back to the status quo ante of the fiscal rules or reform them significantly? Will it leave the temporary RRF as a one-shot, emergency investment or add the new EU-level debt vehicles that would enable it to address its many crises while taking the necessary steps towards a more sustainable, equitable and just transition?
The EU’s answer will determine not only its economic trajectory but also its political one. A return to the failed governance of the eurozone, with austerity and without the investment essential to confront the EU’s many challenges, will also produce the negative spillovers which fuelled the rise of populist, anti-system politics and make EU-level co-ordination to resolve the many crises increasingly difficult.
The EU needs permanent fiscal capacity for investment and redistribution to address the sustainability, social and security risks. The sustainability risks, largely focused on the greening of the economy and the digitalising of society, are already targets of the RRF but much more is needed, given the vast public expenditure required on the green transition alone to fund the transformations of energy, transport and buildings as well as spur private investment.
Such funding is required to ensure all member states—not just the richer ones—can invest in all the ways necessary. With the reapplication of the fiscal rules and in the absence of any EU-level investment fund, it has been estimated that only four countries would have sufficient fiscal space to meet the +1.5C global-heating ceiling; eight could not do so without breaching the deficit limit and the rest would have difficulty. Without such funds, countries with less inclination to meet the targets—in particular, central- and eastern-European countries reliant on coal-powered plants and/or politically ill-disposed—would likely not even try.
The lack of significant investment might not be felt immediately. But once the RRF runs out in 2026, the national spending gap for green investment will in subsequent years become much more problematic for highly indebted countries in view of the fiscal rules, however they are reformed.
The United States, with massive investment initiatives such as the CHIPS and Science Act for semi-conductors and the $369 billion Inflation Reduction Act (IRA) for energy security and climate change, is banking on the multiplier effects of targeted public investment to spur private commitment. Initially, the EU did little in response, other than to complain about unfair competition and European companies relocating to take advantage of US subsidies.
Recently, though, the commission proposed the Green Deal Industrial Plan—with production targets for green manufacturing, temporarily relaxing state-aid rules and promoting skills development—along with the Strategic Technologies for Europe Platform. STEP however repurposes existing funds and will not have the capacity to support the necessary industrial transformation in the EU.
The Green Deal Industrial Plan will thus be unable to match the US in terms of money or multipliers (given the lack of a capital-markets union to galvanise venture capital). Moreover, the EU proposals lack the social conditionality of the IRA, linking funding to collective bargaining, good wages, job creation, investment in training and apprenticeships, taxation of excess profits and bans on corporate stock buy-outs and excessive dividends.
Equally importantly, although the loosening of the rules on state aid through the Temporary Crisis and Transition Framework is key to unleashing more investment, in the absence of a major EU-level funding vehicle it risks unbalancing the level playing-field so important to the single market. Easing state-aid rules on its own enables richer member states with the fiscal space to invest while others will not or can not: Germany alone accounts for almost half the aid approved so far. In short, the EU still lacks the major resources and instruments to achieve effective decarbonisation and digitalisation, despite lots of ‘blah, blah, blah’ (as Greta Thunberg would say).
An EU wealth fund
Even before the impetus coming from the US initiative, many had called for permanent EU-level debt to provide investment funds for all member states on a regular basis, even if this required treaty change. Think of it as an EU wealth fund, akin to national sovereign-wealth funds, which issues debt on the global markets to invest via grants to the member states: in education, training and income support; greening the economy and digitally connecting society; and in big physical-infrastructure projects. Another way to think of this, given continued resistance to EU-level debt by some member states, would be as ‘temporary just-transition funds’ targeting green and productive reforms and investments or as a permanent EU climate and energy investment fund.
Such a facility could also be used to promote solidarity through innovative EU funds targeting socio-economic needs. A European unemployment-reinsurance scheme has been long sought and could be modelled on the temporary SURE social bonds, issued during the pandemic with great success: a 15-year bond raised €6.55 billion, with total funding coming to €98.4 billion, accounting for 16 per cent of global social-bond issuance in 2021.
A refugee-integration fund for municipalities could stem from an enhanced Asylum, Migration and Integration Fund, to adress additional costs for social services, resettlement and retraining—as opposed to principally financing returns, as now—especially in light of the Ukraine crisis and the uptick in arrivals via the Mediterranean. Other objects could be ‘just mobility’ focused on brain drain, early-childhood investment or even a guaranteed (basic) minimum annual income—this could be financed by the ‘digital dividend’ of platforms being required to pay for our data, having established our prior property rights.
Beyond these funds for socio-economic purposes, an EU-level investment fund is needed to address security risks more generally, above or as part of the 2 per cent of gross domestic product pledged by members of the North Atlantic Treaty Organization. Meanwhile, Ukraine needs a dedicated fund to help it rebuild, along the lines of the Marshall plan, with the EU a major donor.
Reforming the rules
Reform of the fiscal rules is of the essence, given the problems that would come from reinstating the unreformed rules. The procyclical rules of the SGP, reinforced between 2010 and 2012 through the ‘six-pack’, the ‘two-pack’ and the Fiscal Compact, inflicted significant damage on the eurozone’s growth prospects, particularly for member states most affected by the excessive-deficit procedure—not to mention those in conditionality programmes. By the latter half of the 2010s the economic situation across Europe had improved, while more was done to ‘socialize’ the European Semester to make it better adapted to member states’ different needs. But the austerity budgeting baked into the rules entailed that those without the fiscal space (read southern Europe) could not invest, while those with the fiscal space (northern Europe) did not invest.
In response to the Covid-19 crisis, the commission largely left behind its roles of enforcer and then moderator in the eurozone crisis to become promoter of the new industrial-strategy initiatives through the National Recovery and Resilience Plans (NRRP). Grants and loans from the RRF were to be disbursed to eligible member states which met certain conditions. Allied to the much more bottom-up European Semester, member-state buy-in is emphasised through ‘national ownership’ of the plans, while the commission exercises oversight via conditionality—such as determining whether agreed ‘milestones’ in economic reforms are met before the next tranche of funding is disbursed.
On the whole, the NRRP have worked effectively, although they have worked best in those countries that have taken ownership—for the most part beneficiaries of RRF grants. This has favoured southern- and eastern-European countries—Portugal, Spain, Croatia and Slovakia developing ambitious plans with significant social-policy components—rather than those in the north, such as Germany, the Netherlands and Austria.
In the past few years, many policy analysts have called for the fiscal rules to be permanently suspended. They could be replaced by a set of ‘standards’ to assess sustainability in context or by a ‘golden rule’ in which future-oriented public investments (beyond NextGenerationEU)—in education and training, greening the economy, digitalising society or improving physical infrastructure—would not be counted toward deficits or debt. Another suggestion has been to eliminate the ‘debt brake’ embedded in national constitutional legislation (demanding that investment by eurozone countries be funded by current tax revenues rather than bonds), to encourage countries to invest in infrastructure or develop a green economy.
In Germany during the eurozone crisis, adherence to the Schuldenbremse (along with fetishism for the schwarze Null) ensured not only that federal spending did not keep up with an expanding economy, despite years of budgetary surpluses. In the federal system—with the Länder responsible for university education and local governments for local infrastructure—the rules also limited new investment for the poorer (and already more indebted) regions and localities, thereby increasing inequalities among sub-federal units while stunting growth. Interestingly, in its 2016 Economic Outlook the Organisation for Economic Co-operation and Development used the example of Germany to demonstrate that debt-financed public investment would have no long-term effect on the debt/GDP ratio.
The commission’s proposal for reform of the fiscal rules—floated in November 2022, revised at the end of April—offers a modest revision, focused on debt sustainability. It keeps the numerical ceilings—a 3 per cent budget deficit and 60 per cent debt/GDP ratio—eliminating only the annual rate (1/20th) at which excess debt would have to be reduced.
The commission was likely cognisant that change would be difficult, since the rules and numbers of the SGP are written into the treaties and legislation in so many places. But this would mean that, as of 2024, the 14 member states (a majority) with budget deficits greater than 3 per cent—representing 70 per cent of EU GDP among them—would be pushed to reduce their deficits by 0.5 per cent of GDP or even 0.7 per cent in the case of four countries.
The commission has recommended longer periods to meet the numerical targets and more country-specific sensitivity in application of the rules. But it has not adopted the golden rule on investment, claiming it would be difficult to assess what might count. It has done little to link rules reform to the NextGenerationEU green and digital targets, other than vaguely suggesting that countries would ‘benefit from a more gradual fiscal adjustment path’ if they were to commit to implementing ‘important reform and investment measures’. And it has made no related proposal for a permanent EU-level debt facility, seeing little agreement coming from a divided council—a missed opportunity.
Within this overall scenario of a proposed return to a modestly revised SGP with no permanent debt facility, many analysts worry about the effects on member states’ economic health, as well as on investment in the green and digital transitions. Some have urged revision of the mathemetical models and statistical instruments of the rules—such as by insuring against procyclical effects by replacing the budget-balance rule with an expenditure rule and the ‘output gap’ methodology used for the former with a potential-output-growth alternative associated with the latter.
Others have proposed going beyond GDP, such as by factoring in sustainability and wellbeing indicators. Member states would commit to achieving climate targets (such as reducing greenhouse-gas emissions) rather than to specific investments. This would avoid the onerous requirements of comprehensive and binding investment plans while benefiting from the flexibility of choosing the most efficient investments over time. The NRRP experience suggests performance-based financing risks emphasising measurable outputs, so that milestones and targets becoming goals in themselves, to the detriment of good policy outcomes.
Despite the more user-friendly reform envisaged, highly indebted member states would remain without the fiscal space or funding to enable them to invest as required to meet their EU sustainability and social-investment obligations—and would arguably be subject to austerity were they not to meet their debt-reduction targets.
As for those countries with the fiscal space, Germany has a crucial role in enabling positive reform of the rules and creation of an EU-level fiscal capacity. But all signs indicate it remains focused on pushing the EU back to the status quo ante, with support for the ‘frugal’ position it took during the eurozone crisis and in the early months of the pandemic, before the historic shift to temporary EU-level debt.
Its finance minister, Christian Lindner, has in particular urged reapplication of the full force of the SGP rules and numbers, to ensure that all member states pay down deficits and debts, or suffer the consequences via the excessive-deficit procedure. He has additionally opposed any permanent EU-level fund, seeing it simply as ‘more debt’ as opposed to investment in a more sustainable future. This while his government has got around the constitutional debt brake by setting up enormous off-balance-sheet funds and relief packages to pay for the Ukraine war and energy needs—on top of its use of state-aid rules to invest heavily in its own industries.
How do we explain the German government’s obsession with debt and its failure to learn the policy lessons of the eurozone crisis, when the turn to austerity through rapid deficit reduction brought anaemic growth and the rise of populism? Why has Germany not moved away from its pre-pandemic preference for fiscal restraint to embrace ‘internal revaluation’—boosting domestic demand to rectify the eurozone’s structural imbalances—or EU-level fiscal redistribution via common debt?
Possible explanations include the inertia generated by ordoliberal ideas and a ‘stability culture’ blinding German policy-makers to alternatives to fiscal consolidation, as well as German companies’ resistance to a ‘revaluation’ which might deprive them of their competitive advantage in the single market, given Germany’s export-oriented growth model. But Germany’s position fails to recognise the economic risks of a return to restrictive fiscal rules without any EU-level investment facility, including the fact that Germany depends on flourishing neighbours for robust exports—China will soon have its own ‘Ch(m)ercedes’. Moreover, Germany ignores the political risks related to any return to austerity in the guise of fiscal stability, likely only to ignite further populist contestation.
Democratisation and decentralisation
Whatever the outcomes of the reform of the fiscal rules and EU-level debt initiatives, the turn towards industrial policy and investment entails an enhanced role for state actors at the EU and national levels, with public entrepreneurs devising industrial strategies to revive economies and invest in the future. NextGenerationEU and the RRF are clear examples. The European Semester has had an important role, given its elaborate architecture for co-ordination, but it remains a technocratic exercise largely concentrated in the executive branches of member states in co-ordination with the commission. Although in the NRRP context it appears to have worked well, it has reinforced centralising tendencies between the commission and national capitals. The European Parliament and national parliaments have had little input and the same goes for the social partners and civil-society actors.
Given the NRRP experience and the possible eventuality of a more permanent EU-level investment fund, national planning processes must be not only democratised but decentralised. Democratisation means reinforcing the role of national parliaments in vetting national plans while ensuring broad social participation. Decentralisation involves enhancing involvement of all stakeholders—employers, unions and other non-governmental organisations—at regional and local levels. This is not only to ensure that industrial-policy initiatives are appropriately targeted and most effective but also to guard against clientelism and corruption. Together these would promote national ownership while helping to combat populist claims to be the only alternative to EU ‘technocracy’.
The commission should also consider democratising the EU planning process by opening up dialogue with all stakeholders on its goals for industrial policy. Such a ‘grand industrial strategy dialogue’ could generate overall goals and targets for greener investment and more society-driven digitalisation, while tackling social inequalities and promoting the EU’s ‘strategic autonomy’ or economic ‘sovereignty’. This could build on the economic and monetary dialogues regularly organised by the parliament with EU executive actors. But it would need to be more inclusive with regard to civil society and citizens—arguably on the model of the Conference on the Future of Europe—and more ambitious in terms of setting objectives for sustainable and equitable growth.
More inclusive EU-level dialogues, accompanied by a more bottom-up approach to national planning in the European Semester—in particular if supported by permanent EU-level investment—are likely not only to promote better economic performance but also enhance political legitimacy. At the national level, they would help to counter the populist drift in many countries, which would certainly be fuelled by any return to austerity. At the EU level, moreover, they would allow for more democratic deliberation about goals for sustainable and equitable development.
At a crossroads
The EU is at a crossroads. Will it come up with a unified commitment to invest in the union’s future, including new industrial-policy and investment vehicles to combat climate change and social inequality while responding to the security risks it faces? Or will it at best muddle through, returning to a slightly modified version of the fiscal rules and leaving the member states to their own devices? The only correct answer entails recognising the interdependence of European economies and the need for solidarity—in particular in a political context of populist contestation of liberal values and democracy.
EU economic governance needs to be democratised and decentralised, with enhanced roles for the European and national parliaments, given the redistributive function of EU-level fiscal capacity, and with more bottom-up involvement of social partners and citizens at local, national and EU levels. Dialogues should be opened up between EU institutional actors and all stakeholders on general industrial strategies as well as macroeconomic targets. This would democratise and legitimise economic governance, replacing numbers-targeting rules.
A version of this essay appeared in EconPol Forum, CESIfo
Vivien A Schmidt is Jean Monnet professor of European integration in the Pardee School at Boston University and honorary professor at LUISS Guido Carli University in Rome. Her latest book is Europe’s Crisis of Legitimacy: Governing by Rules and Ruling by Numbers in the Eurozone (Oxford University Press).