John FitzGerald: Success of pandemic measures shows merit of discretion in EU fiscal rules

The fiscal rules agreed by the EU 25 years ago were designed to ensure that no member of the euro zone would become insolvent, endangering the new currency and fellow members. These rules limited government borrowing to 3 per cent of GDP, and government debt to 60 per cent of GDP.

The original objective was to have a one-size-fits-all set of fiscal policy guidelines, minimising the need for discretionary action by the EU Commission. However, the financial crisis of 2008 showed the weaknesses of the system, and its failure to avert threats to euro zone stability.

In the run-up to the financial crisis, Ireland looked like it was following the EU fiscal rules, but that compliance was built on sand, as government revenues melted away in the property crash. The then government had been applying the accelerator to the economy where the brake would have been more appropriate but, because this dangerous driving was consistent with the fiscal rules, the EU Commission could not shout “stop”. Neither did the fiscal rules prevent major problems emerging in Spain, Greece and Portugal.

In the aftermath of the crash, a rigid insistence on tight fiscal discipline made recovery harder than it needed to be. When Ireland and others faced massive fiscal problems, and had to slam on the brakes and deflate their economies, there should have been a fiscal expansion by the rest of the EU to stabilise demand within the wider European economy. Instead, in the absence of EU requirements for supportive action, the countries with strong finances also deflated their economies, resulting in even more damage to the weaker EU economies.

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German finance minister Christian Lindner’s stance seems fixated with debt, and ignores the wider role fiscal policy plays in managing our economies

Given their shortcomings, the fiscal rules have already been modified a number of times. The EU Commission is proposing further changes this year. Its latest proposals call for countries to develop medium-term plans to meet the debt and borrowing guidelines, with the EU Commission to adjudicate on these plans on a country-by-country basis.

This emphasis on exercise of judgment by the Commission improves on the pure rules-based approach. But it hasn’t pleased German finance minister Christian Lindner, who wrote in the Financial Times last week in favour of maintaining strict rules. His stance seems fixated with debt, and ignores the wider role fiscal policy plays in managing our economies.

[ EU reform of fiscal rules hits resistance among big capitals ]

Reflecting this German concern, the draft EU guidelines still focus purely on indebtedness, and don’t address the role of fiscal policy in protecting the EU economy from the vagaries of the economic cycle.

Rules suspended

This is a step back from how the pandemic shock was managed. Then, the fiscal rules were immediately suspended. All member states replaced the massive fall in private sector demand with huge government fiscal stimulus. The outcome was that the EU economy made a very rapid recovery. The pandemic has left few scars on the EU economy. The limited increase in debt levels incurred are fully sustainable, being financed by long-term borrowing at very low interest rates.

Given Ireland’s exceptional corporation tax revenue, the updated EU fiscal rules will have little relevance to us. We need to have our own rules to protect ourselves from unwise government action

The big success of this countercyclical fiscal action occurred despite the fiscal rules, not because of them. So it’s appropriate that the EU Commission should have more discretion in interpreting the fiscal rules, otherwise the proposed reforms seriously lack ambition. The lessons of the slow recovery from the financial crash and the success of the pandemic interventions show that any new rules should incorporate co-ordinated countercyclical fiscal policy.

Given Ireland’s exceptional corporation tax revenue, the updated EU fiscal rules will have little relevance to us. We need to have our own rules to protect ourselves from unwise government action, and framed in terms of an appropriate measure of national income rather than GDP.

[ The Irish Times view on the debate on EU budget rules: battle lines are drawn ]

The Government’s expenditure rule, set in 2021, allows a 5 per cent increase in public expenditure each year, in line with rising national income. This rule was adjusted to partially reflect the higher inflation of the past year. However, when inflation returns to the 2 per cent target, the 5 per cent expenditure rule should be reinstated.

In addition, it is also appropriate that the Government should stimulate the economy in times of exceptionally low growth, as in the pandemic and, symmetrically, it should take money out of the economy when it is at full employment, as it is today. The Irish Fiscal Advisory Council (IFAC) as independent arbiter has an important role to play in advising Government on the appropriate fiscal stance.

In the last two elections, IFAC helped frame the economic room to manoeuvre or “fiscal space” as parties developed their manifestos. With bumper, but unreliable, revenues, this framing will be even more important in the run-up to the next election.