Home » Growth beyond stability. Heimberger (WIIW) discusses the Pact reform

Growth beyond stability. Heimberger (WIIW) discusses the Pact reform

Growth beyond stability. Heimberger (Wiiw) on the reform of the Pact
As the German Finance Minister lands in Rome, the EU’s fiscal structure is in the spotlight yet again. We reached out to an European economist who believes it’s time to draw the right lessons from the financial crisis and avoid suffocating growth when it’s most needed. Here’s how – and why – the EU should reform its fiscal rules, and where Germany fits in the process

A self-professed “friendly hawk” has landed in Rome. Christian Lindner, leader of the German Liberal Democrats and Finance Minister in the newly formed federal government, flew in for a high-level meeting with members of the Italian executive.

His visit follows that of Foreign Minister Annalena Baerbock and signals that Rome and Berlin are upping their cooperation efforts. Mr Lindner, long regarded in Italy as an austerity-touting fiscal conservative, is now embracing laxer tones – as is his government, led by Chancellor Olaf Scholz.

The German Finance Minister will meet his counterpart Daniele Franco. The officials will surely touch base on the key matters concerning the European Union. Among them, the debate about rewriting its fiscal rules has been gaining traction – a matter in which the direction of the new German government will have a disproportionate impact.

To make sense of what’s to come, Decode39 reached out to Philipp Heimberger, PhD. An Austrian economist at the Vienna Institute for International Economic Studies (WIIW) and an attentive watcher of the EU’s fiscal dynamics, he took stock of the past years and mapped out a way forward.

Mr Heimberger, do you see Berlin converging on Paris’ and Rome’s line on the EU budget rules?

The tone struck by German policymakers in the new government may be somewhat friendlier. However, one should not mistake this for a fundamental shift in the German position on European fiscal policy and EU fiscal rules.

Mr Lindner himself says that he remains a “friendly hawk”, which is to say he’ll continue to emphasise budget discipline and repeat his position that the EU’s fiscal rules have proven flexible. This line is also consistent with the wording of [his government’s] Coalition Treaty.

Now, however, there is arguably more openness for pragmatic compromise – as long as it’s still possible to sell it to the political home base in Germany that holds hawkish positions.

Who would be capable of changing the balance in Europe?

[French President] Macron and [Italian PM] Draghi will work together to reform the EU’s fiscal rules. They wrote a joint op-ed in the Financial Times about the necessity of reform, which was already urgent before the pandemic started. Chiefly, they pointed to the need to incentivise more (green) public investment.

Both are political heavyweights making the case for fiscal reform – but there are still uncertainties. For instance, given other EU policy issues and the elections he needs to win this year, how high up will the fiscal rules really be on Mr Macron’s priority list?

Anyways, the recent developments in Italy – with Mr Mattarella re-elected for president, while Mr Draghi stays on as PM – certainly weigh on the EU fiscal rules debate. The Italian PM does have a lot of European weight in Frankfurt and Brussels; we’ll see how he wants to use it.

How do you believe Germany will act?

If Germany were to join France and Italy on this issue, it would be a major game-changer. But a natural alliance remains unlikely, given that the government’s interests are different. Rome and Paris have much higher public debt-to-GDP ratios; they would face much more difficulty in meeting the requirements of a little-reformed EU fiscal regulation framework.

Nonetheless, Germany’s new government also has a more ambitious investment agenda than in the past, especially when it comes to infrastructure and climate investment. Those investment plans must be consistent with the fiscal rules at the domestic level (its “debt brake”) and at the EU level.

The German Coalition Treaty foresees an evaluation of important technical details in the domestic constitutional “debt brake”, with potential for pragmatic reform, and does not include any red lines on reforming the EU’s fiscal rules.

Still, we should not be over-optimistic about Germany’s role. Chiefly, Mr Lindner’s party has a lot to lose if they are perceived to give in too much to demands for fiscal flexibilisation, as they campaigned hard on the need for budgetary discipline and obeying the existing rules.

Rewriting the European rules would entail reforming the Maastricht Treaty. Do you rule that out? Or do you believe it can be bypassed by re-interpreting the current text?

Treaty reform is unrealistic. Given the current political constellations, the 60% debt limit and the 3% deficit limit are unlikely to be revised. But there is still a lot that could be done in terms of reform without Treaty changes.

The European Commission could use its interpretive powers to enhance flexibility further. Secondary legislation – such as details in the preventive and corrective arms of the Stability and Growth Pact – could be changed. There is a lot of technical fine print where countries like Italy could gain a great deal of fiscal space.

For instance, the fiscal adjustment path could be made less severe by making debt reduction rules less strict. And there could be more generous exemptions when there’s slack in the economy (and the labour market continues to show potential for recovery). One could also think of a big investment bonus when the government undertakes important climate-related public investment.

What’s your take on the current EU fiscal architecture?

The current fiscal rules are characterised by a pro-cyclical bias, which was particularly pronounced during the fiscal austerity years, from 2010 onwards. Applying them in several member countries, including Italy, has contributed to unnecessarily deepening and prolonging economic downturns. This led to needless social hardship and unintended political consequences; political polarisation has increased in the aftermath of the financial crisis, against the background of excessively tight fiscal policies.

EU fiscal rules often demand government spending cuts and tax increases from crisis-ridden countries at the wrong time. These measures stifle the economy and thus also counteract a reduction of crisis-related increases in public debt-to-GDP ratios via higher economic growth.

So, how would you ensure sustainable growth?

At this stage, member States do not agree on what they want to achieve with reforming the EU’s fiscal rules. That’s where we must first strive for more clarity.

The main focus of reforming the fiscal rules should be eliminating the pro-cyclical bias. The technical details are of high political relevance: cyclically-adjusted fiscal variables — which are based on the idea of correcting headline fiscal balances for the effect of the business cycle on government revenues and spending — are currently crucial for medium-term budgetary objectives of member countries.

Biases in estimating these cyclically-adjusted fiscal variables have promoted counterproductive pro-cyclical fiscal policies. Whatever the final reforms look like in detail, we urgently need to solve the underlying technical problems, which imply a tendency to revise member countries’ fiscal space downwards in times of economic stress.

And then?

The second major objective in reforming the EU’s fiscal rules should be allowing more public investment. This is essential for governments to stabilise the economy in the short- and medium-run. And it is vital for successfully addressing significant long-term challenges such as climate change and digitalisation.

Unfortunately, the current fiscal rules do not distinguish between investment and non-investment spending adequately. Therefore, they have also failed to shield public investment from being cut in times of economic stress. Public investment has fallen drastically over the last decade in many European countries, as governments can quickly cancel investment projects or put them on the back burner as austerity pressures mount.

Did you draw any fiscal lessons from the pandemic period?

The pandemic has shown how important fiscal policy is in stabilising the economy. Running massive fiscal deficits in 2020 (and to a smaller extent in 2021) was very successful. The European economy has so far weathered the pandemic-induced crisis much better than the previous financial crisis.

A major reason for this is that fiscal policy was allowed to respond more forcefully – both at the domestic and European levels. Italy’s economy, like others, would have contracted much more had we not deactivated the EU’s fiscal rules to allow governments to spend big by issuing government bonds.

Fiscal sustainability has improved because deficits were run purposefully. Today public debt-to-GDP ratios would be even higher if fiscal policy had not been used to prevent the collapse of the private sector, especially in the early stages of the pandemic. Next Generation EU was also an important step in stabilising expectations and financial markets, and providing spending impulses for the coming years.

Nonetheless, policymakers could repeat the mistakes they did in the aftermath of the financial crisis – where premature and excessive fiscal consolidation from 2010 onwards undermined the economic recovery. We cannot allow this again; it would push Italy along with other countries into economic and political troubles and tear the Eurozone apart in the foreseeable future.

All EU countries need to consider the adverse domino effects. Including Germany and the so-called “frugals”, such as Austria and the Netherlands, which are export-dependent and strongly linked to other member countries due to their industrial structures. Against this background, Germany and others also have an interest in agreeing on sufficiently reforming the EU’s fiscal rules.

Picture: Twitter profile of the German Ministry of Finance

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