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An IMF proposal – IMF Blog

By Vitor Gaspar, Alfred Kammer and Ceyla Pazarbasioglu

High debt and rising interest rates give priority to improving governance to anchor fiscal policy in EU member states.

Given the central role of fiscal policy in addressing both recent crises and future challenges, the call to reform fiscal governance in Europe resonates as never before.

Fiscal policy provides essential support when households and businesses are hit by large shocks, such as the pandemic, or when monetary policy is constrained. However, this requires sound public finances. High debt and rising interest rates are making it harder for governments to meet today’s multiple priorities, including tackling extreme increases in the cost of living and tackling the climate emergency.

In this context, the European Union needs revised fiscal rules that provide the necessary flexibility for bold and swift policies when needed, but without jeopardizing the sustainability of public finances. It is essential to avoid debt crises which could have significant destabilizing effects and put the EU itself in danger. This will require building larger budget reserves in normal times.

A new IMF document proposes reforms to the EU budgetary framework to help manage the enormous political challenges.

The overhaul should be economically sound and politically acceptable, building on lessons learned from several past attempts to improve fiscal rules. It will be essential to balance respect for the sovereignty of national budgetary policies while strengthening the incentives to adopt sound policies for the EU.

The proposal is built around three pillars: revamping the numerical fiscal rules to explicitly take into account the fiscal risks that countries face while having a clear medium-term orientation; strengthen national budgetary institutions to improve national debate and ownership of policies; and the creation of an EU fund to help countries better manage economic downturns and provide essential public goods.

Ambitious reforms needed

The existing rules have had some success, including raising public awareness that budget deficits must be less than 3% of gross domestic product, which strengthens government accountability. But they did not prevent an undesirable accumulation of public debt and fiscal sustainability risks among some members.

As we have seen with the European sovereign debt crisis, these risks have threatened the stability of the monetary union in the past and continue to create vulnerabilities today. This despite many efforts to refine digital rules and strengthen central oversight over the years.

To some extent, weak national institutions, political pressures and large negative shocks have led to poor compliance. Combined with the limitations of the framework’s design, which sets ceilings on deficits in bad times without providing sufficient incentives to build up reserves in good times, this has led to the build-up of fiscal imbalances. The framework has also done poorly in stabilizing production and lacks the tools to deliver common public goods to member countries.

In response to the pandemic, in March 2020 the European Commission triggered the General Escape Clause – which allows for a temporary derogation from EU fiscal rules – allowing member countries to react with greater strength and flexibility. But rising deficits have pushed debt levels even higher above the the Maastricht Treaty reference value of 60% of GDP in many countries, which poses additional difficulties in returning to the existing rules.

The IMF proposal is based on three interconnected pillars:

  • Risk-based fiscal rules at EU level: While the current 3% deficit and 60% debt benchmarks remain, the speed and ambition of fiscal adjustments would be linked to the degree of fiscal risks. These are identified by a debt sustainability analysis using a common methodology, developed by a new independent European Fiscal Council, or EFC, in consultation with other key stakeholders. Countries with higher fiscal risks are expected to converge towards a zero or positive overall fiscal balance over the next three to five years. Countries with lower fiscal risks and debt below 60% would have more flexibility but still need to factor risks into their plans. The framework would encourage the building of fiscal buffers allowing for significant flexibility to respond to adverse shocks and conduct countercyclical policy.
  • National fiscal institutions strengthened: All EU countries should adopt medium-term budgetary frameworks and set multiannual annual expenditure ceilings consistent with their overall balance over the period. Independent national fiscal councils would play a greater role in strengthening checks and balances at the country level, including by establishing or approving macroeconomic projections, assessing fiscal risks, and ensuring the consistency of spending ceilings and fiscal plans. The European Commission would continue to play its key oversight role and the EFC would serve as a central node for a network of national fiscal councils, helping to promote good practice and providing an independent voice both on debt risks and on the frame execution.
  • A well-designed EU fiscal capacity: This would be established to fulfill two key roles: enhancing macroeconomic stabilisation, particularly when monetary policy operates at the effective lower bound, and enabling the provision of common public goods at EU level, such as climate change and energy security infrastructure. Their implementation has become more urgent due to the green transition and common security concerns. A dedicated climate investment fund is an important part of the proposal.

The proposal should be seen as a set of interrelated elements aimed at promoting effective reform. This requires a mutually reinforcing relationship between EU rules and national implementation, in particular greater national ownership of rules and better alignment between national frameworks and EU rules. The first can only be achieved by balancing the needs of member countries while protecting them from negative spillovers from other parts of the union. This argues for a risk-based approach, the first pillar of the IMF proposal. The latter requires a stronger role for our second pillar: significantly improved national frameworks, including strengthening the capacity and mandates of independent fiscal institutions.

In a context of extraordinary economic uncertainty and upcoming budgetary challenges, the reform of the EU’s budgetary framework cannot wait. The extension of the general escape clause until 2023 provides a window of opportunity to do just that; further delays would force countries to revert to the old rules with all their problems. The opportunity should not be wasted.