Reforming the EU’s fiscal framework

By Andreas Charalambous and Omiros Pissarides

The socioeconomic environment has been changing rapidly.  The risk of recession in the EU is increasingly becoming visible while inflation, although depicting signs of slowdown, remains at historically high levels and the sovereign debt interest rates exhibit an upward trend. A contrasting positive feature is unemployment, which remains at low levels.

Under such circumstances, and particularly in view of the gradual withdrawal of monetary support measures by the ECB, the importance of the fiscal policy is elevated. In this respect, the recently published fiscal governance reform proposals of the government of Germany attracted enormous interest.

The fiscal framework in the EU is governed by the Stability and Growth Pact, which is characterized by complicated and strict rules relating to the fiscal deficit and public debt. The implementation of the Pact has been suspended until 2023, with a view to enabling member countries to address the adverse repercussions of the pandemic and the war in Ukraine.

In a previous article, we had analysed the diverse policy positions observed in the EU. There are countries strongly supporting the preservation of the existing strict rules of the Pact but also countries which are in favour of radical changes in its underlying philosophy.

The government of the Federal Republic of Germany plays a central role in shaping EU policies. It currently consists of a coalition of three political parties, with different views concerning the fiscal framework. The liberal party supports reintroducing the strict provisions of the existing Pact, as a precondition for preserving macroeconomic stability and fighting rising inflation. The other two parties of the coalition (the Social Democrats and the Greens) favour substantial reforms, with a view to avoiding forcing member countries into social spending cuts and encouraging, in parallel, public investments.

The submitted proposals constitute a compromise, reflecting the consensual character of the German society.

In more concrete terms, the recommendations represent a first step towards a simplification of the framework, with the suggested abolition of the provision forcing a rapid adaptation of the public debt, in cases of divergence from the benchmark of 60% of GDP. This proposal is of particular significance for highly indebted countries, such as Italy, Greece and Cyprus. Furthermore, emphasis is attached on public expenditure control measures, as well as the favourable treatment of public investment.

During the next months, the discussion on the EU fiscal framework is expected to intensify, with the active participation of countries such as France and Italy. The latter favour further reaching reforms, for example the increase of the public debt to GDP benchmark, as well as the introduction of a clause, allowing the setting up of differentiated public debt targets, taking into account the specificities of each member country. It is highly likely that additional amendment proposals will be put on the table, for example the establishment of a permanent fiscal support facility at EU level, modelled on the recently established and temporary Resilience and Recovery Fund.

The objective of the debate should be to achieve an appropriate balance between the partially conflicting goals of financial sustainability and economic and social development.

Cyprus should participate actively in this debate, supporting additional flexibility and simplification of the framework, emphasis on long term sustainability, rather than inflexible fiscal rules, and the reinforcement of those provisions enabling member countries to undertake the necessary public investments in the future.

Andreas Charalambous is an economist and a former director in the Ministry of Finance.

Omiros Pissarides is the managing director of PricewaterhouseCoopers Investment Services.