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The European Semester must acknowledge that the EU recovery fund is not a stimulus package

Economic governance / COMMENTARY
Frederico Mollet

Date: 11/12/2020
When determining the governance of the EU’s economic recovery, policymakers would do well to remember that the Recovery and Resilience Facility is not designed to stimulate an immediate rebound.

The Recovery and Resilience Facility (RRF) is a structural investment programme to place Europe on a higher sustainable growth path – primary responsibility for the immediate recovery from the COVID-19 pandemic will continue to lie with member states and their balance sheets. The EU must acknowledge this and ensure that the European Semester follows the European Central Banks’s (ECB) lead in giving member states the policy space and medium-term certainty they need to forestall premature budget tightening. This clarity would also guard against rushing through the national Recovery and Resilience Plans (RRPs) needlessly, risking waste and misdirected long-term investment.

The Recovery and Resilience Facility is not a quick recovery stimulus

Following the historic fall of GDP over 2020, the European Commission estimates that GDP levels will still not have fully recovered by the end of 2022. Even under the assumption that emergency fiscal and health measures are rolled back over 2021, the euro area’s headline deficit will remain at 5.9%. In 2022, they range from 8.1% to 2.5%. Only five countries are expected to be (slightly) below the 3% deficit target in 2022.

These forecasts do not account for the RRF. However, despite some of the rhetoric from policymakers and commentators, the RRF is not designed to be a recovery stimulus but rather a structural adjustment package. The payments from the RRF will be spread out until 2026, and early Commission estimates indicate that only around 30% of funding would be distributed by 2022.

The International Monetary Fund’s (IMF) latest Fiscal Monitor provides a salutary reminder of the limitations of investment-led fiscal stimulus. While urging that projects be identified and implemented within 24 months, it highlights that infrastructure investments take on average 3 to 8 years to prepare, and a further 3 to 7 years to implement. Several EU countries spent only 40% of the European Structural and Investment Funds allocated for 2014 to 2020. The IMF has good reason to urge a focus on routine maintenance – governments often learn from bitter experience that good projects are hard to find quickly. ‘Shovel-ready projects’ was Barack Obama’s mantra when campaigning for the 2009 American Recovery and Reinvestment Act. Two years later, he remarked, “there’s no such thing as shovel-ready projects”.

Certainly, if immediate stimulus was the goal, the European Commission has not made that task any easier. Its RRP guidance highlights 5G, hydrogen and renewable energy infrastructure, semiconductor and microelectronic manufacturing, and industrial data infrastructure. These are complex endeavours to plan and implement, and none are conducive to quick, large-scale stimulus over the next two years. Indicative modelling by the Commission shows that the RRF could deliver additional growth of between 0.7-1.4% and 0.8-1.7% of GDP in 2021 and 2022 respectively, depending on additionality and whether the payments are over 4 or 6 years. This is hardly negligible, but even this estimate relies on an assumption of equal distribution of payments across the years, in sharp contrast with expectations. In truth, the lion’s share of the stimulus over 2021 and 2022 will be delivered by national budgets.

The RRF’s focus on longer-term investments is no bad thing. Such investments are critical for long-term growth, providing business with the certainty they need and responding to structural adjustments in the economy. However, it also has significant implications for the EU’s macroeconomic governance, which are obscured by discussions of the RRF as a stimulus package.

Member states need fiscal policy space and certainty

In order to support the immediate recovery and prevent further hysteresis, member states must continue to run significant deficits into 2022. As Ms Christine Lagarde made clear at her recent talk to the EPC, the ECB will ensure a supportive environment for such fiscal action. However, the Union’s fiscal governance must provide the necessary policy environment to match.

While the Commission has made it clear that member states should continue to provide support during 2021, there is considerable uncertainty around the medium-term status of the fiscal rules and how the European Semester will adapt to the current situation. Member states need greater clarity on these fronts. They cannot undertake adequate budget planning while second-guessing the policy constraints they might face months hence. Although the 2021 headline deficits are high, member states have already begun tightening their structural balances.

The Semester should explicitly consider the fiscal space created over the medium term by future RRF investments. It should also provide a clear, medium-term timetable for the reintroduction of the Stability and Growth Pact and for phasing in fiscal adjustments that protect against premature tightening. For example, over an interim period, debt levels might only be required to stabilise before reintroducing the full set of fiscal rules. There may also be a case for the Semester explicitly matching the necessary fiscal support in the short term, with cyclically adjusted tightening that places countries on adjustment paths only once the economy recovers fully. This would also reorientate the Semester towards assessing medium-term sustainability and away from the current focus on annual budgets – a welcome development.

If the Semester does not provide the appropriate certainty and medium-term framework, Europe runs the risk of stumbling into pre-emptive contraction. After all, in a tightly integrated economy like the EU, member states bear the cost of fiscal stimulus that benefits the whole block. In the absence of central fiscal stabilisation, which the RRF clearly does not provide, poor coordination and mixed messaging could lead to suboptimal policy.

Of course, over the long term, the extent of any fiscal adjustment needed following the COVID-19 pandemic’s dramatic increase in government debt will be determined by the fiscal rules. Their reform is much discussed, and mooted proposals could drastically reduce the pressure to consolidate over the long term. However, regardless of whether and how the rules are reformed, the above points will hold over the medium term.

Recovery and Resilience Plans should focus on high-quality investments

These clarifications would also help the governance of RRPs. Once we accept that their primary function is not immediate recovery, the focus can shift to ensuring quality investments. For some member states, the funding could more than double their investment rate, creating significant risks of waste. Quality is critical in determining an investment’s long-term impact on growth, and previous investment-led stimuli have illustrated the dangers of misdirected spending.

Europe’s structural challenges make this particularly important. A well-targeted, long-term investment is critical for restructuring the economy to adapt to digitalisation and combat climate change. It is necessary for setting us on a higher sustainable growth path, following a decade (or even longer) of disappointing underperformance. It would be a tragedy if this opportunity was wasted by rushing the RRPs.

The European Parliament has rightfully emphasised the need to monitor the implementation closely. Nonetheless, concerns have been raised that political and economic pressures will mean there will be little real control over the RRPs. However, if the Semester makes clear that member states will have the fiscal policy space to support immediate recovery and stabilisation, the Commission’s ability to exercise effective oversight will be strengthened. Even if confidence-building and political reasons require headline approval in early 2021, over the next few years, the Commission should make full use of its ability to monitor milestones, withhold final commitments until further details are provided, request changes, and hold back payments due to poor implementation.

Europe has already suffered once this decade for tightening fiscal policy too early. Although there is no impetus for the large, pro-cyclical tightening experienced between 2011 and 2013, there is a real risk that we stumble into a 2011-lite, particularly if there are persistent misapprehensions over the RRF’s purpose. The European Semester over 2021 and 2022 must reflect this – and the sooner, the better. This should hopefully also mitigate the risk that the RRF is squandered in the face of Europe’s deep-seated structural challenges.

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

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