Europe’s policymakers risk crashing its recovery

Mujtaba Rahman is the head of Eurasia Group’s Europe practice and the author of POLITICO’s Beyond the Bubble column. He tweets at @Mij_Europe.

COVID-19 has been good for the EU.

Unlike any other region in the world, Europe is now both more cohesive and resilient as a result of the crisis. But these precious gains risk being lost if the economic recovery isn’t sensibly managed. As policymakers begin to negotiate the bloc’s fiscal rules, there are worrying signs ahead.

Two reasons explain the EU’s greater resilience after COVID. The most important is the creation of the recovery fund — a vehicle set up at the height of the crisis to enable large-scale Europe-wide borrowing on capital markets, which is then transferred to member countries hit worst by the pandemic. By facilitating their economic recovery, without increasing their debts, the fund has made the eurozone more robust and will set a precedent for how the EU manages external shocks in the future.

The recovery fund has also made it harder for populism to prosper. It’s hard to rail against €180 billion — close to 10.5 percent of gross domestic product (GDP), in Italy’s case — explaining why Matteo Salvini’s nationalistic far-right League party duly entered into a reform-oriented coalition led by Prime Minister Mario Draghi.

There are other reasons why populists had a bad crisis. The simplistic country-first solutions peddled by the likes of Salvini and France’s Marine Le Pen in recent years became much more implausible in a pandemic, which is global by nature. Countries where populists managed to turn voters against immigration also found that immigrants tend to work in essential frontline roles. With growing deference to scientists, anti-expert sentiment across the Continent also receded, and the EU’s vaccination effort is now a resounding success — with 70 percent of adults fully vaccinated. 

However, these achievements risk coming apart if EU countries mismanage the recovery. Key to that will be whether — and how — the EU’s fiscal rulebook, known as the Stability and Growth Pact, is reformed. 

The pact dictates that the deficits and debt levels of EU countries should not exceed 3 percent and 60 percent of GDP, respectively, and must fall quickly if they do. But during the pandemic it was suspended under a provision known as “the general escape clause.” The pact is due to come back into force in 2023, and if the rules don’t change, the EU’s national governments will be forced into unprecedented tightening, having implemented unprecedented fiscal support throughout their lockdowns.  

A public “reflection” of the rules, involving expert stakeholders, academics and think tanks, will be kicked off by the Commission later this month. There’s little doubt as to the conclusions that will emerge: They will suggest that the emphasis of fiscal policy should shift away from austerity toward growth and that more attention should be paid to incentivizing public investment in Europe’s green and digital transitions. 

Sensible as these suggestions may be, substantive negotiations between member countries and EU institutions will only begin once a new German government is in place. Based on events in Berlin, this could be early next year. 

However, the Commission needs to provide a clear direction for national governments on what the EU’s fiscal objectives for 2023 will be. The deadline for that is next April, when EU countries submit their so-called Stability and Convergence Programs, previewing their budgets for the fall. 

Assuming a coalition is in place in Germany by the end of the year, that leaves roughly four months to build consensus on what the EU’s forward-looking fiscal rules should be. It is this truncated time frame that fiscal hawks are opportunistically trying to exploit. 

Opposing substantial change will be Valdis Dombrovskis, executive vice president of all things economy. Dombrovskis remains keen to put countries with unrelenting hight deficits and high debts — including France, Italy, Spain, Greece and Belgium — into an “excessive deficit procedure.”   

Other senior voices in the Commission are also looking for a more orthodox implementation of the Stability and Growth Pact and worry the Commission is seen to always err on the side of leniency. Indeed, even those who favor reform are not pushing for a further suspension of the rules in 2023.  

Facing Dombrovskis are the European Central Bank, the European Fiscal Board, a majority of the College of European Commissioners and, importantly, Commission President Ursula von der Leyen. She wants a “new set of rules for the medium term,” says one senior EU official with knowledge of her thinking, “especially to facilitate the green transition.” 

While Northern Europe will likely oppose big reforms, Berlin’s position is less clear and will ultimately depend on the nature of the new government. The risk is that an inexperienced chancellor who is consumed by coalition management will be more cautious and less ambitious in Europe.  

In light of these signals, French Finance Minister Bruno le Maire has been downplaying expectations of a deal under France’s presidency in the first six months of next year. Still, the best-case scenario for reformers would be for the French presidency to take up concrete legislative proposals on Europe’s new fiscal rules early next year. The Stability and Growth Pact’s deficit and debt levels are defined in the Maastricht Treaty, but the pace at which debt levels must be reduced each year is not.  

That gives space for a new, simpler framework that would also exclude investments in high-quality public goods from EU deficit calculations and amend the debt rule that stipulates member countries with debt ratios above 60 percent reduce their excess debt-to-GDP levels by 1/20th every year. 

Some in Brussels and Paris would also like more decentralized fiscal governance, allowing EU capitals to design their own adjustment path, with the Commission playing referee and drawing up the consequences if national efforts should fail. 

If there is no consensus over these issues by March, the Commission would instead be forced to issue a communiqué — interpretive guidance for member countries pointing to where Brussels believes the fiscal framework will end up. The purpose would be to give governments enough latitude to interpret the rules more flexibly — on the basis of where they are heading, as opposed to what they say today. 

It is in this scenario that Northern European fiscal hawks will pounce — pushing for member countries to default to the old rules while the new ones are renegotiated. This could result in a large number of excessive deficit procedures. As another senior Commission official says, “Some people argue you can decouple the reflection and our annual fiscal cycle. So you could open EDP’s and then see how the review plays out.” The official continues, “Momentum might vanish if we discuss for too long without tabling legislation.”

Most officials in Brussels believe the Stability and Growth Pact won’t be fully reapplied in a mechanical fashion in 2023 and that the “brakes won’t be whacked on full throttle.” The idea of putting France into an excessive deficit procedure on the heels of Emmanuel Macron’s presidential election, for one thing, is extremely unlikely.  

But that outcome remains far from clear. Hanging in the balance is the EU’s recovery — and the credibility of its net-zero transition.