EU needs radical fiscal reforms, IMF report says

The European Union should carry out radical reforms to its fiscal rules, a report published by the International Monetary Fund on September 5 suggests.

The proposed framework would combine the creation of common fiscal tools with the reinforcement of debt sustainability at the national level. The IMF’s proposal crucially involves the creation of a common fiscal capacity. It aims to foster macroeconomic stability when monetary policy is operating at the lower bound and the resources to provide public goods across the EU.

Some observers say the lack of this common buffer explains the repeated bouts of instability that eurozone sovereign debt markets have experienced. These have prompted the European Central Bank to carry out massive purchases of sovereign bonds to tame yields over the past decade.

While this coincided with below-target inflation up until last year, ECB interventions seemed sustainable. However, with year-on-year inflation reaching 9.1% in August, it has become much harder for the ECB to justify these accommodative practices.

The IMF says the reform is especially pressing because of urgent demands for greater use of public resources. “High debt and rising interest rates are making it harder for governments to address today’s multiple priorities, including tackling extreme increases in the cost of living and addressing the climate emergency,” says the report.

The report’s authors are Vitor Gaspar, director of the fund’s fiscal affairs department, Alfred Kammer, European department director, and Ceyla Pazarbasioglu, director of the strategy, policy and review department. They acknowledge current rules have made the public accept the importance of fiscal limits.

EU law currently requires that budget deficits should not be over 3% of GDP, and total public debt 60% of GDP. But the IMF report notes that there has only been “poor compliance” with this, due to “weak national institutions, political pressures and large negative shocks”.

The EU framework has “design limitations” like ceilings on deficits during economic downturns, while failing to provide incentives to create buffers in periods of expansion.

Due to the unprecedented economic shock unleashed by the Covid-19 pandemic, the European Commission suspended the implementation of these rules in a bid to provide governments with more fiscal room. This escape clause will remain active through 2023, which offers an opportunity to reform the rules that “should not be wasted”, add Gaspar, Kammer, and Pazarbasioglu.

The report stresses the need for flexible rules to allow bold and swift policies when needed. However, this must not endanger debt sustainability, it says.

“It is critical to avoid debt crises that could have large destabilizing effects and put the EU itself at risk,” say the authors. “This will require building greater fiscal buffers in normal times.”

Creditor countries such as Germany, the Netherlands and Austria have traditionally opposed the mutualisation of sovereign debt and the issuance of Eurobonds. They have argued it would expose their taxpayers to risks from high-debt eurozone economies, and have resisted fiscal transfers and criticised ECB sovereign bond purchases.

Three-pillar proposal

The IMF report suggests three main actions. The EU should modify the speed at which fiscal goals are attained. It should also create a new European Fiscal Council to co-ordinate the rules’ implementations with national fiscal councils, and also introduce a cross-border fiscal capacity.

“While the current 3 percent deficit and 60 percent debt reference values remain, the speed and ambition of fiscal adjustments would be linked to the degree of fiscal risks,” says the report. These risks would be assessed employing a shared methodology developed by the European Fiscal Council. Countries at higher risk would need to record a balanced or surplus budget deficit over a period of three to five years.

In contrast, countries at lower risk and debt below 60% of GDP would have more flexibility to reach that fiscal position.

Furthermore, all EU countries would need to create medium-term fiscal frameworks, as well as establish multi-year annual spending caps consistent with their overall fiscal targets.

“Independent national fiscal councils would play a stronger role to strengthen checks and balances at the country level, including making or endorsing macroeconomic projections, assessing fiscal risks, and ensuring the consistency of the expenditure ceilings and fiscal plans,” say the authors.

The European Commission would be the framework’s arbiter, aiming to foster the adoption of best practices across the region.

The new fiscal common capacity would safeguard macroeconomic stability and finance the provision of public goods, such as action against climate change and energy security, the report says. “Delivering these 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 authors say.