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Steady as she goes: Key takeaways from the Commission’s new fiscal guidance

Economic governance / COMMENTARY
Marta Pilati , Frederico Mollet

Date: 10/03/2021
As expected, the European Commission has extended the general escape clause and advised member states to avoid any premature withdrawal of economic support measures. But this still may not ensure a sufficiently supportive fiscal stance and, given that member states’ recovery rates will diverge further, effective fiscal coordination will become ever more challenging.

On 3 March 2021, the European Commission published new guidance to coordinate European fiscal policy. This comes one year after it first activated the general escape clause of the Stability and Growth Pact, and as the European economy continues to reel from the pandemic. The Communication’s extension of the clause is welcome, as is its guidance to avoid premature fiscal tightening.

However, there is still a real risk that the EU’s aggregate fiscal stance is not sufficiently supportive and that diverging recovery rates will complicate effective fiscal coordination and potentially undermine the current consensus against premature tightening. Looking ahead, the Commission outlined a timeline for activating its dormant review of the economic governance framework. The higher debt loads from the pandemic and the uneven recovery across member states are likely to increase calls for reform. Nevertheless, the debate will be contentious.

Current fiscal support must remain, but is it enough?

The Commission committed to maintaining the general escape clause until the EU or eurozone economy reaches its pre-pandemic GDP levels. Based on current projections, it is likely that it will only be deactivated near the end of 2022. As we argued previously, this level of certainty and clear, objective criteria for deactivation are essential for budgetary and fiscal authorities to plan and coordinate their fiscal stances.

The Communication is clear that fiscal support should be maintained to sustain the COVID-19 recovery, avoiding any premature withdrawal. For the moment, this is in line with the policy consensus across member states. It is equally clear that the quality and composition of that fiscal support will be placed under greater scrutiny than during the initial peak of the pandemic. The measures should be “timely, temporary and targeted”, and the composition of overall public spending should shift to growth-enhancing investments. This approach is welcome and would improve the sustainability of the debt accumulated in 2020 by promoting future GDP growth.

However, although the Commission’s guidance reduces the chance that current supportive measures are withdrawn prematurely, the aggregate fiscal stance still looks too tight. Despite the consensus on maintaining economic support, the Commission estimates that many member states will nevertheless be far from recovering by the end of 2021, and Italy and Spain will not have recovered by the end of 2022.

These estimates do not include the Recovery and Resilience Facility (RRF), but as we argued last year, while it will help, the difficulty of frontloading effective public investments makes it unlikely to substitute short-term national stimulus. Other estimates bear this out, showing that EU and national measures are still well short of making up the economic output lost during the pandemic. This indicates that current fiscal support is insufficient in many countries, especially considering the dangers of long-term economic scarring.

Furthermore, the Commission’s guidance on the RRF is potentially counterproductive to its wider goal of maintaining a supportive fiscal stance. On the one hand, the guidance emphasises that RRF funds should complement, not substitute, national measures. In particular, they should not displace existing investment spending.

On the other, the guidance also indicates that member states with more precarious fiscal positions should use the RRF to maintain prudent fiscal policies. The Commission should be cautious about suggesting that the RRF can replace national measures, as this could precipitate premature tightening and ‘austerity style’ pressure on some countries.

Over the longer term, the RRF will facilitate fiscal consolidation whilst promoting growth-enhancing investment. But over the short term, supporting a swift economic recovery also requires national measures.

Uneven national recoveries create coordination challenges

The Communication commits to using “all the flexibilities within the Stability and Growth Pact” when dealing with member states that have not fully recovered by the time the general escape clause is deactivated. This is a welcome step, as it acknowledges that some member states have been hit harder by the pandemic than others and have diverging recovery rates.

Nevertheless, some member states could begin to withdraw support much earlier than others as their national economies return to 2019 levels. This will tighten the Union’s overall fiscal posture and have spillover effects on other member states. Given that some of the member states with the slowest projected recoveries are also among those with the most challenging fiscal position (e.g. Italy, Spain), some of the burdens of adjustment would be shifted unto the balance sheets of more vulnerable member states.

For example, Germany is expected to return to 2019 levels by the end of 2021, while Italy is not forecast to reach them even by the end of 2022. The RRF would alleviate some of the burdens if Germany started consolidating, but its effectiveness will still depend on how aggressively recovered member states retrench. In other words, fiscal coordination still matters. The Communication urges member states with greater fiscal space to maintain a supportive stance through 2022. But whether they can effectively enforce this is doubtful, especially if their support clashed with the guidance on fiscal consolidation.

The debate over reforming the economic governance framework will return

The Communication and the accompanying public announcements also outline a timetable for restarting the review of the EU’s economic governance framework. The Commission will not reactivate it until the COVID-19 recovery takes hold, and coincidentally after the German elections. This provides enough time for the member states to engage in an honest conversation on whether to reinstate the fiscal rules as they were before the pandemic.

Since the pandemic began, there has been a remarkable consensus across member states over fiscal policy and the need to suspend the deficit and debt reduction rules. But as the economic recovery commences, we are likely to see a reignition of the debate over the fitness and appropriate enforcement of fiscal rules. Even before the pandemic, all sides of the discussion were unsatisfied with how they operated, concerned with either their substance or enforceability. The rise in debt burdens and uneven fiscal and economic trajectories following the pandemic will exacerbate these tensions and increase the challenge of coordinating the aggregate fiscal stance.

A credible, coherent, and sustainable fiscal framework is essential to guaranteeing Europe’s future prosperity. All stakeholders should reflect on the experience of responding to the pandemic and the challenges to effective EU economic governance to hold a mature and comprehensive debate on reforming the existing framework.

Frederico Mollet is a Policy Analyst in the Europe’s Political Economy programme.

Marta Pilati is a Policy Analyst in the Europe’s Political Economy programme.

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