It’s the moment of truth for EU fiscal reform

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Mujtaba Rahmanis the head of Eurasia Group’s Europe practice. He tweets at @Mij_Europe

The moment of truth is almost upon us, as we will soon learn whether the European Union will be able to agree to a new, more sensible set of fiscal rules.  

Doom and gloom have surrounded the prospect of a deal on this matter for some time, and Germany’s opposition to the European Commission’s proposed far-reaching changes has been the biggest reason for pessimism. It’s possible, however, that the tide may finally be turning. 

0-09/" target="_blank" rel="noreferrer noopener">A two-day retreat between the French and German governments last month in Hamburg has been key in unleashing some of the positive momentum that can currently be found behind negotiations. Senior French and German officials said the bilateral between President Emmanuel Macron and Chancellor Olaf Scholz was a particularly “huge atmospheric success”  — which, given the current state of the two countries’ relationship, is important. 

According to those present in Hamburg, both sides made a commitment to reach a deal on economic governance and electricity market reform — two of the biggest outstanding issues. And in keeping with this commitment, after months of deadlock, an agreement on the latter was finally reached earlier this month

Overall, the Commission’s aim is to migrate the Stability and Growth Pact’s uniform set of fiscal adjustment requirements into more bespoke, bilaterally negotiated fiscal adjustment plans unique to each member country, based on a debt sustainability analysis.  

Countries would then have either 4 years to reduce their debt-to-GDP ratios, or 7 years if they also undertake reforms and investments that promote the EU’s strategic priorities. 

But for much of this year, Germany remained highly anxious about whether such an approach would ensure sufficient debt reduction. 

It considered the Commission’s original goal — to simply ensure debt is lower at the end of time frame without committing to a specific number — to be too unambitious, while high-deficit, high-debt members like France, Italy and Belgium found it too onerous.  

Thus, several counterproposals have been put forward — by the Spanish Presidency of the Council, for example — aiming to achieve an average 1 percent of GDP debt reduction per year, but over a longer time horizon instead, say 14 or 17 years. And currently, this option commands greater support.

 As these would be the minimum ex ante commitments member countries would sign up to, though, senior EU officials believe they should also be enough to win the support of both the German Chancellery and Christian Lindner’s finance ministry. 

However, with such an agreement on debt finally coming into view, Germany and other frugal member countries have currently opened a “second front” of debate relating to fiscal deficits. And Germany is now demanding member countries effectively achieve a fiscal deficit of 1 percent of GDP by constraining the growth in countries’ public spending (to below the growth potential of their economy).  

Yet, this is being strongly contested by many members — and France in particular. They argue Germany’s push on deficits has no economic rationale. As one senior French official said: “We need sustainable debts, not the lowest debt possible.”  

Part of the problem here is that Berlin simply doesn’t trust the Commission to administer the new rules. And Germany is growing alarmed about the direction of Italy’s economic and fiscal policy under Prime Minister Giorgia Meloni’s government.  

Also, Lindner remains committed to balanced budgets in Germany — the infamous schwarze Null, or black zero — and he believes this should also apply across the EU. 

Meanwhile, there are still other matters to be ironed out. For example, which reforms will member countries have to undertake, so they can win additional time to implement their debt reduction plans? And which categories of investment spending can be accounted for differently when computing fiscal deficits? However, the debate over the appropriate level of deficit reduction is now the key issue, and if a deal stumbles, this will likely be the reason why. 

So, negotiators are now racing against the clock to try and secure an agreement by the EU finance ministers meeting on December 8 — a deadline that may well slip into the new year. Then, once there’s an agreement among member countries, this would pave the way for trialogues with the European Parliament, resulting in — negotiators hope — a revised and final legal text before the break for next year’s elections in early June.  

Even though the new rules won’t apply until 2025 — and even then, they won’t fully apply to countries with deficits above 3 percent of GDP and that are in a so-called Excessive Deficit Procedure — this newfound momentum is welcome. 

A no deal outcome would lead to another wave of concern about the state of Franco-German relations and, more broadly, the EU’s ability to get its fiscal house in order. Absent a deal, fiscal policy between Brussels and member countries would also need to be negotiated on an annual basis, and both the process for doing so as well as its outcomes would be highly opaque — and uncertain — which, in turn, could spook the markets.  

Moreover, in the past, whenever lackluster growth forced governments to implement austerity, the tendency was to slash public investment, which is politically easier to cut than current spending but undermines the long-term growth potential of economies.

This is why the logic of this reform — modeled on the flagship EU recovery and resilience facility — is so important. And if it goes through, it will likely result in more sensible deficit and debt reduction, higher public investment and also reform — all things the EU economy could desperately use.