The EU fiscal rules are one of if not the most important aspects of EU economic policymaking. Over the years, they have grown more complicated and difficult to understand. They have often been breached by member states and have proven inadequate at preventing the emergence of sovereign crises. With the world now much changed since the rules were originally formulated, not least due to Covid-19 and an impending climate catastrophe, it is unanimously agreed that they are in need of major reform. This policy study looks at how the rules may be reformed based on a number of guiding principles. One is that the rules should ensure the sustainability of public finances across member states and prevent sovereign debt stress. A second principle is that the fiscal rules should facilitate Europe’s public investment challenges in the coming years, especially in relation to climate change. Another principle is fairness – macroeconomic policy should not magnify inequalities within countries or inequality between countries. Finally, any reforms proposed should be politically feasible. This study shows that Europe’s highest-income countries were major users of public investment historically. The conditions faced by Europe in the post-war period necessitated very high levels of public investment, which countries met through major increases in public spending. All of Europe’s member states now once again require major increases in public and private investment, particularly to meet emissions targets. However, it is Europe’s less-well-off regions, such as new member states and southern European countries, that face the greatest challenges today. The fiscal rules in their current form cannot meet those challenges. As the rules have changed much since their introduction, the policy landscape continues to be fast-moving. The latest proposals represent significant improvement on the current framework. Reference to unobservable and poorly measured indicators, such as structural deficits and output, have very much been relegated to the background. The economically and politically unrealistic debt reduction rule has been removed. In its place, the Commission proposes to tailor debt-reduction paths to country-specific circumstances, for those member states deemed to be at risk. While an improvement, the original targets of a debt to GDP ratio of no more than 60% and a deficit no greater than 3% remain. As this study details, these values were arbitrarily chosen based on conditions that prevailed in the 1980s. Economies now suffer from secular stagnation and interest rates are to remain structurally low, notwithstanding recent inflationary pressures. We argue that the level of debt and the size of the annual deficit are limited measures of public financial sustainability, conceptually and empirically. They are poor measures of the cost of bearing debt, particularly in recent times – governments can essentially rollover debt continuously. We contend that interest payments to GDP or the burden of servicing debt offers a more useful metric of public financial sustainability. Empirical evidence is presented to this effect. The most sensible reform of the fiscal rules would, therefore, focus on the debt-servicing burden as the key indicator. Given political realities within the EU, such an overhaul is unlikely to be realised. We therefore suggest a number of less ambitious recommendations, which would be welcome, although not ideal. This includes raising the public debt target from 60% to 100%. The removal of said unobservables in the most recent proposal by the Commission – output gaps and structural balances – would be very much welcome. Similarly, the 1/20th debt-reduction target is unrealistic and its abolition is needed. Tailoring debt reduction to individual contexts and making allowances for green and other types of public investment is a positive move. But given the fact that countries with the highest debt, such as southern European countries, are often those with greatest investment needs, the recent reforms are likely to prove inadequate. The EU should build on the Next-Generation EU model and establish a permanent climate investment fund. Only then will the existential challenge of meeting emissions targets be insulated against political-economic pressures, namely, the limitations imposed by supranational rules and domestic distribution struggles.
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