Europe Is Fighting Over Its Fiscal Future

As the coronavirus is largely brought under control in Europe and battered economies finally start to rebound, a major political battle is looming over what a post-pandemic European Union should look like. 

A heated debate is getting underway within the bloc on whether the spending and debt restrictions on member states—suspended in March 2020 due to the COVID-19 crisis—should be brought back or substantially loosened for the long haul. At stake is a battle for Europe’s financial soul between fiscally conservative northern countries like Germany and the Netherlands and southern European countries like Spain, France, and Italy that have long demanded more spending flexibility.

“The stakes are quite high, mainly because we now have the real opportunity for a change to the rules in a way that we haven’t seen before,” said Claus Vistesen, chief eurozone economist at Pantheon Macroeconomics.

The north-south rift is a familiar one in European politics. It has led to deep resentment in the past, such as when painful austerity measures aimed at fiscal consolidation were imposed across the bloc in the aftermath of the 2008 financial crisis. It reared its head again last spring, when Germany and the Netherlands at first resisted emergency measures to jump-start European economies that were hammered by the pandemic and subsequent lockdowns. 

During the pandemic, as governments increased their borrowing to keep workers and businesses afloat, public debt skyrocketed across the union. By the first quarter of 2021, average EU public debt had grown by 14 percent compared to one year earlier. Germany’s debt topped 70 percent of its GDP while France’s reached 118 percent, Italy’s nearly 160 percent, and Greece’s an eye-watering 200 percent.

“The stakes are quite high, mainly because we now have the real opportunity for a change to the rules in a way that we haven’t seen before.”

The eurozone has long been premised—at least on paper—on a desire to keep member states’ fiscal houses in order. The EU’s stability and growth pact aims to cap countries’ annual budget deficits at 3 percent of their GDPs and their public debt at 60 percent of their GDPs. Countries with more debt are meant to reduce it by 5 percent of the excess every year.

The problem with that straitjacket approach is, if applied strictly, it can limit member states’ fiscal flexibility in times of crisis. Now, though, the fiscal doves are in the ascendant.

The EU economic affairs commissioner, Italian Paolo Gentiloni, is calling for loosening public spending restrictions for good. Even the much more hawkish Valdis Dombrovskis of Latvia, the EU trade commissioner, conceded earlier this month that the EU needs “a debt reduction path that is realistic for all member states,” code for a straitjacket with a lot more wiggle room. The European Commission is expected to start formulating reform proposals over the coming weeks and months.

But the so-called frugal countries are already pushing back. Ahead of the EU finance ministers’ meeting this month, eight fiscally conservative countries, including Austria, the Netherlands, and Sweden, reportedly signed a position paper arguing “reducing excessive debt ratios has to remain a common goal” and change should be limited to “simplifications” as well as “better application” of the rules. Germany, traditionally in the same camp but in a phase of political limbo ahead of a federal election this weekend, sat this round out and did not appear among the signatories.

Both hawks and doves have something to point to. High levels of debt have so far been sustainable due to very low interest rates. But hawks warn of the risks of a new debt crisis triggered by a rise in the cost of borrowing; the hike may happen when the European Central Bank as well as the U.S. Federal Reserve pump the brakes on monetary expansion amid fears economies could overheat and inflation could start rising in earnest. Earlier this month, the European Central Bank started slowing the pandemic stimulus—although it sought to reassure markets it will proceed cautiously, stressing the eurozone is “not out of the woods” yet.

But if the old rules are brought back in 2023, as currently planned, applying them to bloated post-pandemic budgets would entail even more draconian austerity measures than after the 2008 financial crisis, when premature fiscal tightening undermined growth for years. 

“At that time, Europe declared victory too soon, and we paid the price for that,” said EU Commission President Ursula von der Leyen in her State of the Union address last week. “We will not repeat the same mistake.”

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The outcome of the battle over fiscal flexibility may also depend on political dynamics between some member states. Those calling for Europe to loosen its belt are hoping to gain credibility from the presence among their ranks of Mario Draghi, a highly respected former head of the European Central Bank who was appointed Italy’s prime minister in February this year. 

“When Mario Draghi speaks at the European Council, even the frugals have to listen,” said Marc Lazar, a professor of political sociology and history at the Paris Institute of Political Studies.

France seems to have noticed, and Paris, a longtime advocate for reform of the budget rules it keeps breaking, will potentially have a crucial role early next year when it holds the rotating presidency of the European Council. A recent diplomatic rapprochement between Paris and Rome is partly motivated by France’s wish to build a stronger, more coordinated front ahead of the looming showdown in Brussels, Lazar said.

Two years ago, when a populist coalition led Italy, bilateral relations hit rock bottom. A top Italian government official even met with some “yellow vest” protesters in the French capital just as the movement against economic inequality was at its peak and often-violent street rallies rocked France on a weekly basis. But relations have considerably warmed up since. The thaw began under a new center-left coalition that took power in Italy in late 2019 and has accelerated under Draghi. The two governments are currently working on a bilateral cooperation treaty, expected to be signed later this year.

The partnership has already borne fruit at the EU level. In 2020, France and Italy’s joint efforts overcame the reluctance of Germany and other frugal states and delivered a $880 billion stimulus package to help economic recovery during the pandemic, the first time the European Union raised large amounts of common debt on capital markets, with more solid economies essentially guaranteeing the weaker ones.

The question is whether the Franco-Italian condominium will continue to change the way the EU works. The political futures of both Draghi and French President Emmanuel Macron are uncertain. France will hold presidential elections next year, and Italians will return to the polls in 2023 at the latest. A lot will also depend on the outcome of the German elections later this week, with the Social Democrats and especially the Greens considered more accommodating on spending and public debt than the Conservative Party. The Social Democratic Party is currently ahead in the polls, with the Conservatives a close second, but it may take months of negotiations before parties agree on a government coalition and key ministerial roles following the vote. But even if German conservatives are turned out of office, Germany will likely continue to be cautious about any major reform of EU budget rules. Berlin saw the huge recovery fund put together in 2020 as “an exceptional answer to an exceptional situation,” according to the Montaigne Institute. 

For France, whose alliance with Germany is the cornerstone of its foreign policy and the driving force of the European Union, a direct confrontation over budget rules is hardly welcome. “The France-Germany relationship is a marriage,” Lazar said. Every now and again, “France remembers it has this beautiful mistress, Italy. But its goal is only to try and spice up what it considers the most fundamental relationship, the one with Germany.”

Even with Draghi at the helm, it’s unclear how much influence Italy can bring to bear at the upcoming negotiations. “Draghi is universally respected in Europe and beyond,” said Ferdinando Nelli Feroci, a former Italian European commissioner. But Italy’s credibility in Brussels will ultimately depend on how it spends the huge check it got as part of the recovery fund. Italy, hit early and hard by the pandemic, is getting the largest share of the pie—and the scrutiny. “We will be on the watch list,” Nelli Feroci said, who is now president of the International Affairs Institute in Rome.

It’s unlikely either the deficit or debt limits, both enshrined in the Maastricht Treaty, can be fundamentally rewritten in the short term. An easier target would be to soften the requirement to shave off excess debt every year. But countries looking for flexibility have other options. The emergency suspension of budget restrictions sets a precedent for the future as does the idea of centralized borrowing to give struggling member states access to cheaper money, said Gregory Claeys, a senior fellow at Bruegel, a think tank. Another possibility is to move spending meant to fight climate change off the books so it wouldn’t count against debt and deficit limits. Such a “green pact” would help Europe meet its ambitious climate targets while also allowing it to pursue cautious budget consolidation.

“From a political perspective, even among the frugal countries there is some appetite” for that, Claeys said.

Unlike in past years—thanks in part to EU joint debt issuance and the European Central Bank’s huge bond-purchasing program—there aren’t clear-cut haves and have nots in Europe right now, at least as far as the bond market is concerned. Since the pandemic began, the “spread” between German 10-year bonds (considered the gold standard) and Italian bonds has actually shrunk. That’s a sign that speculators don’t see blood in the water, which is potentially opening the door for reform.

“To some extent, the budget discipline rules will come back,” Vistesen said. “But the new rules will be much looser than before.”