It’s Politics, Stupid

I quickly want to come back to the issue of fiscal rules and of the Commission’s proposal for reforming the Stability and Growth Pact. In my previous post I discussed how the proposal does not do enough for public investment. Yet, this is not what most commentators have been focusing on.

The proposal foresees an important role for the Commission. First, it goes without saying, it is central in the sanctioning process, the Excessive Deficit Procedure, that is mostly the same as in today’s framework. But on two crucial aspects of the reformed Pact, if it had to see the light, the Commission acquires new competencies (and the power that goes with them).

The first is in setting the stage for the countries’ debt reduction plans. The Commission is in fact supposed to define the scenarios with which debt sustainability risks are determined, using a tool developed in recent years by the World Bank and IMF, the Dynamic Debt Analysis, or DSA). The tool is well tested but, as it is obvious, the different scenarios heavily depend on the parameters (growth, interest rates, etc) that are fed to it. The second expanded role that the Commission has is in negotiating with the governments the country-specific debt reduction paths and expenditure targets.

This centrality of the Commission, however, has been almost unanimously criticised. Opponents of austerity fear that discretion will allow draconian  policies to be imposed, thus reviving the austerity catastrophic experiment of the 2010s. At the other side of the spectrum, the fiscal hawks of the so-called “frugal” countries do not trust the Commission in its role of watchdog of public finances, and have criticized it several times for being too permissive with the “Club-Med” countries. They are therefore afraid that too timid debt-reduction paths will be agreed with profligate governments of the South.

Here is an unpopular opinion: both teams are right, and it is very good this way. As far as I am concerned, I always believed that the fiscal policy of deeply integrated countries should never be a technocratic endeavor but, on the contrary, be the result of a political process of coordination, in which more or less hawkish outcomes stem from bargaining between different positions, economic and political contingencies and, last but not least, compromises between the needs of individual countries and the attainment of common goals. No rule can deliver this. In 2002, the then President of the Commission Romano Prodi was violently attacked when he defined the Stability Pact “stupid, like all decisions which are rigid.” But in fact he was perfectly right, and as we finally manage to abandon the flawed view that all countries should implement the same policies (one-size-fits-all), then no rule can be put in place unless it leaves space (a lot of it!) to discretion, negotiation, case-by-case assessments.

In short, how much and how to use fiscal policy must emerge from the capacity of governments and policy makers to persuade their partners of the pertinence of their policy stance. Those opposing excessive fiscal discipline should reach their goals by winning the hearts and minds of those favoring it (and vice-versa), not by pushing  for mechanical (“stupid”) rules that embed their views. As a side note, we already have, in the European framework, a seat for discretionary assessments and choices. The European Semester was created for coordinating and monitoring fiscal policies, to then quickly become, in the austerity frenzy of the time, just a tool for the latter. It would be time to go back to the letter of the Law and finally make the European Semester the place for dialogue and coordination among member states and the Commission.

There should not be a discussion on whether fiscal policy in European countries should be determined leaving space to discretion. The discussion should be about who should have the discretionary power. Some argue for example that an almighty Commission might create an imbalance in the delicate tripartite decision structure of the EU, and that it would be better to give a role (for example in debt sustainability assessments) to a reformed European Fiscal Board. There are pros and cons of such a strategy, but that is the discussion that we must have.

Whatever your views on the desirability and on the extent of fiscal policy in managing the European economies, blaming the Commission proposal because it leaves too much space to discretion does not make any sense. Fiscal policy is politics, stupid.

A Plea for a European Public Investment Agency

The European Commission has introduced a legislative proposal for the reform of European fiscal rules with the aim to have the new rules approved by member states and the European Parliament by the end of the year, and to be in force by 2024. If this timeline is not met, the old Stability and (lack of) Growth Pact (SGP), adopted in 1997 and discredited during the sovereign debt crisis, will be reintroduced.

The Stability Pact, together with the  Fiscal Compact hastily adopted in 2012 in the belief (oh, how erroneous! ) that it was necessary to impose austerity in order to get out of the sovereign debt crisis, impose annual targets in terms of structural (i.e. cyclically-adjusted) deficit to ensure that public debt falls steadily towards the level of 60% set by the Maastricht Treaty (a level that is totally arbitrary, incidentally).  From the outset, many of us criticised the Stability Pact, because the emphasis on annual targets pushes countries to adopt pro-cyclical policies: in the event of a crisis  and a fall in GDP, to stay on the path of debt reduction, fiscal restraint is needed; this has nevertheless a negative impact on growth, triggering a vicious circle. Moreover, the Pact imposes the same objectives on everyone (one size fits all is used). Last but not least, the current rule does not distinguish between current expenditure and investment spending, ending up penalizing the latter which, politically, is less problematic to cut.

To address these issues, the European Commission reform proposal replaces annual targets with multi-year debt reduction programs agreed upon by member countries and the Commission. Although very imperfect, the proposal represents a very clear improvement on the existing rule, on two grounds..

1. The annual numerical targets are replaced by multi-annual (4-year) debt reduction programs. The adoption of a medium-term perspective, is the only reasonable one when it comes to the sustainability of public finances. It is good that we have finally realised the absurdity of annual targets
2. Debt-reduction plans are formulated (in terms of expenditure targets) by member countries in agreement with the Commission, on the basis of scenarios for the evolution of public finances. High-debt countries obviously need to make greater efforts, especially if the most likely scenarios are high interest rates and low growth, and therefore more risks to future sustainability. Abandoning the one-size-fits-all and top-down approach is important for democratic legitimacy and credibility of implementation.

Against these very significant improvements, the amended rule would remain seriously problematic for two reasons. The first is that overall the focus is still on debt reduction. Too much Stability and not enough growth, like with the old SGP, at the risk of obtaining neither (ever heard of self-defeating austerity?) This is even trues since, to accommodate strong German pressures the Commission has introduced safeguards to ensure that debt remains strongly anchored to a downward path. This excessive weight on debt reduction might be tempered by the increased politicization of the process, a feature of the Commission proposal that has been criticized but that on the contrary I find quite appealing. I will come back to that in a future post.

The second reason why the Commission proposal (a significant improvement, let me state it again) falls short of my expectations is the lack of specific provisions for protecting public investment. The only concession that is made is that “Member States will benefit from a more gradual fiscal adjustment path if they commit in their plans to a set of reforms and investment that comply with specific and transparent criteria”. This is what I would like to address in this post.

With my colleagues Floriana Cerniglia (Catholic University Milano) and Andy Watt (IMK Berlin), we have been editors for some years of a series of yearly European Public Investment Outlook involving dozens of European researchers. Volume after volume, the message that comes out of this series is that in OECD countries public investment has been sacrificed on the altar of fiscal discipline since the 1980s. In Europe the downward trend is particularly marked and  has further accelerated with the austerity programs of the 2010s. The result is a chronic shortage of public capital, both tangible and intangible (social capital) which today seriously limits the growth potantial of all European countries, even those that are apparently healthier. As an example, the German colleagues who worked on the chapters on Germany estimated the  amount needed over the next decade to fill the German infrastructure gap at around 45 billion per year, not to mention the additional investment needs made necessary by an aging population and by the ecological and digital transition. Italy is no exception: Cerniglia and her co-authors report  an estimate by which between 2008 and 2018 about 200 billion were lost along the way compared to the scenario in which public investment had continued at the (not excellent) previous rates. This figure is sobering: the entire allocation of the Italian NRRP (191 billion), which should project us into the ecological and digital transition, will not even be able to bridge the gap that has opened up in the last ten years.

Looking ahead, the numbers get even more impressive. The Commission has estimated that the  European Union would need €520 billion in additional investment each year to meet the Green Deal’s 55% emissions cut target before the end of the decade.  Although the Commission believes that a significant part of this investment should come from the private sector, the figure gives a measure of the colossal effort that lies before us.

A team from the New Economics Foundation (NEF), took the figure given by the Commission as a basis for simulations in which it also considered the needs related to social investment (education, health, etc.) and the digital transition. These simulations lead, in a report also published last week, to conclude that only nine European countries would have the fiscal space to implement such large investment programs, were they to respect the existing rule or even the one amended by the Commission proposal. Italy is obviously not one of them, but neither are France nor Germany. The assumption of the NEF report may be questioned, of course, but the overall picture they draw is quite clear, and highlights a  fundamental incompatibility between the huge investment needs of the coming years and a system of European rules that, even in the reformed version, remain too oriented towards debt reduction as a self standing objective. The intransigent position of the German government has even prompted a usually cautious and moderate economist like Olivier Blanchard, former chief economist of the IMF, to ask rhetorically  whether it is preferable to preserve the earth with a slightly higher debt or to go towards climate catastrophe with  sound public finances

Many, including myself have for years called for a reform of European rules that would allow governments to invest outside the constraints of the budget. Such a “golden rule” would make it possible to finance the ecological transition while preserving the stability of public finances. In the past year it has at times seemed that such a proposal might have a chance of being discussed. Today the mood has changed. We should consider ourselves lucky if the Commission’s proposal is not twisted in an even more restrictive way by the negotiations with the Member States. In the coming years, therefore, it will be necessary to accept a continued state of chronically insufficient national public investment.

What to do then?  If we do not want to fail in the objective of ecological transition, there  is only  one way: to work on the quick creation of a European Investment Agency able not only to finance national governments’ investment (as in the proposal for a Sovereign Fund for Industrial Policy, buried in the Brussels’ mist); but also to design and implement genuinely European investment projects. The governance of such an Agency should be designed very carefully: fiscal policy has an inherently political dimension that requires accountability in front of voters.  In our non federal system this accountability lies with national governments, which should therefore be involved in European public investment choices. Some form of control by the Parliament and the Council in determining (or at least validating) investment projects would certainly make the work of the European Investment Agency more cumbersome. But this seems inevitable to ensure the democratic legitimacy of spending programmes (and their financing) at the European level.