Strengthening Europe’s Financial Stability

A European Union that enjoys strategic autonomy needs to have a finical system that supports this autonomy. Therefore, financial stability is essential as it is a vital precondition for economic success in the modern world. After all, the EU can only be a forceful and autonomous international actor if we keep our own house in order. In that sense, a stable and reliable currency is crucial. The Euro has been such a stable and reliable currency over the past years: we have witnessed low inflation rates and fairly stable exchange rates against other major currencies. This has allowed the Euro to become one of the world’s reserve currencies. While over the past couple of years, the Single Currency has become an overall success story, the outlook for the future looks somewhat gloomier.

Over the past couple of years, public debt ratios in the Eurozone have surged. The economic implications of an unprecedented pandemic and the necessity to launch a forceful fiscal response have worsened an already dire situation. With average public debt levels in the Eurozone reaching 100% of GDP, there might be a risk of another debt crisis.

While debt-servicing costs in the Eurozone are still low and have in fact fallen over the past couple of years, the only reason this is the case, is the European Central Bank’s ultra-accommodative monetary policy that has artificially depressed financing costs for many Member States. In light of the current inflationary pressures, it is likely that the ECB’s ultra-accommodative monetary policy cannot go on indefinitely. After all, it is not the ECB’s mandate to ensure smooth financing conditions for indebted Member States, but to ensure price stability and thereby pave the way for an efficient allocation of scare resources. Therefore, a change in the ECB’s monetary policy is not only necessary, but also desirable.

Nonetheless, such a shift in monetary policy might come with side-effects: A U-turn in terms of monetary policy might cause Member States’ refinancing costs to rise thus putting a question mark on the long-term sustainability of Member States’ public finances. In the medium-term the order of the day therefore has to be to conduct a more responsible fiscal policy.

A key cornerstone of a path towards fiscal responsibility will be the reform of the Stability and Growth Pact (SGP). Looking on the experiences of the past couple of years, one can identify some shortcomings that require adjustments. When it comes to the EU’s fiscal rules, there is value in simplicity.

Instead of going for a specific rule for every conceivable situation, the SGP needs to focus on a few core principles that are easily understood by everyone involved. Such a streamlined process also implies to refrain from introducing new exemptions (e.g. preferential treatment for sustainable investments).

Currently, the analysis underpinning the SGP relies heavily on metrics that either have to be estimated (such as the output gap or potential GDP growth rate), cannot be entirely influenced by policymakers (such as the annual deficit as a percentage of the GDP) or are prone to frequent revisions (GDP growth). As result, the process often looks more like art than like an exact science.

This causes the decision making to be somewhat opaque and prone to manipulation. Building on the proposals by the European Fiscal Board, we should therefore move towards a system that focusses on variables that are easily observable and under full control by policy makers. Expenditure growth could therefore serve as the central variable. If the expenditure grows slower than a country’s gross domestic product, that Member State should gradually grow out of its debts.

One of the key shortcomings of the EU’s fiscal framework is poor enforcement. Despite the fact that there were numerous violations of the reference values – sometimes justified, sometimes less so – the European Commission has never proposed meaningful sanctions. An effective enforcement of the fiscal rules requires a capable and impartial referee though.

A Commission that considers itself to be first and foremost a political actor, cannot credibly take that role. Therefore, a comprehensive review of the SGP must not stop at the rules itself, but also look at the institutional framework.

For the fiscal rules to be credible, they must be applied in a fair, objective and equal manner to all Member States. During the past years, the European Fiscal Board has built up a considerable expertise and has proven that it can provide fair and independent fiscal analysis. Therefore, the important task of fiscal surveillance should be progressively entrusted to the EFB, which needs complete political independence for that purpose.

To ensure political accountability, the final decision in relation to possible sanctions should remain at the level of EU finance ministers.

If the reform proposals outlined above were implemented, this would reverse the trend of steadily increasing public debt levels thus making EU governments less dependent on inflation-prone central bank interventions and the whims of financial markets. This would arguably be of great benefit to the resilience of the European Union and would also increase its strategic autonomy.