Just when we forgot for a moment about the fiscal belt-tightening, it may be brewing again. Not so long ago we were still recovering from the effects of the 2007/08 financial crisis and the deep recession of 2009. Fiscal responsibility has emerged as a key issue and the EU has highlighted it as an indispensable part of any stabilization. We have been accustomed for years to hearing about wasteful Greeks, Italians, Spaniards, and Croats – about their inflated public debts and unsustainable budget deficits. Today the situation is even worse, but no one is upset about it. At least not yet. Why is that so?
The Past
The basic fiscal rules in force are derived from the Maastricht Treaty and the Stability and Growth Pact. The permitted values are 3% of GDP for budget deficits and 60% of GDP for public debt levels. The persons directly involved claim that these benchmarks were set arbitrarily and corresponded to the then average of the 12 countries involved. In this sense, they could not provide any special insight into the level of debt that poses a challenge to growth in all imaginable conditions. Incidentally, that average for debt would be around 100% today. Does that make a difference?
The basic idea was clear – closer economic integrations (and above all, a common currency) imply the need for a certain degree of fiscal harmonization. According to everything we know about optimal currency areas, the coexistence of wasteful and conservative budgets under the same currency is simply undesirable. But basic benchmarks that are formulated as ratios to GDP cannot work well in deep recessions – because GDP can fall sharply. The crisis was not in mind when the EU decided to use such fiscal benchmarks. We thus welcomed the horrific year 2009 with the wrong type of indicator. For example, if you manage to reduce your public debt by 2% but your GDP falls by 3%, your public debt as a ratio of GDP will inevitably grow – even though public debt itself has been reduced. By banal but relentless mathematical logic. What good is this indicator to us if we know that GDP can plummet in recessions (in Greece, for example, it fell by 27% in the eight years after 2008)?
Yet it is precisely this erroneous logic that has been applied after the global financial crisis and the European debt crisis. The European periphery suffered the most, as it was exposed to bail-out mechanisms with conditionality. The Balance of Payments Mechanism (BoP), used outside the euro area, has been applied to Hungary, Romania and Latvia (with an effective duration of 2008-2011). The temporary European Financial Stability Facility (EFSF) and the European Financial Stabilisation Mechanism (EFSM) were applied to Portugal and Ireland (2010-2015) and then replaced by the permanent European Stability Mechanism (ESM) (Spain, Greece, 2013-2018). The approved amounts of funds were often quite significant, but they also implied the obligation to comply to the accompanying austerity measures. At the EU-wide level, the first reaction in 2009 was panic, and the focus was on the alleged fiscal stimulus, but already in 2010 there was a turnaround and the idea of fiscal responsibility gained traction. Its importance rose primarily through better opportunities to implement existing rules by the way of a number of institutional innovations: first six pack and two pack reforms, with the formation of the European Semester and combining alignment with the EU Strategy, with anticipation of future instabilities, with additional opportunities offered first by Euro+ pact and then and the Fiscal Pact.
Of the two versions of Europe’s response to the crisis – spending or saving, the latter clearly quickly prevailed. This prompted a deepening crisis on the periphery, a wave of social unrest and populist responses, and the creation of an additional gap between “thrifty” (primarily Germany, Austria, the Netherlands) and “wasteful” (primarily southern European) member states. The implementation of austerity measures in the context of the crisis has become a typical European solution, followed by a variety of criticisms. Solid arguments against it were offered by Keynesian-minded economists, including Nobel laureates Joseph Stiglitz and Paul Krugman. Savings in the crisis are contributing to the worsening fall in GDP, and thus to the growing unsustainability of the remaining debt – it is a self-defeating maneuver. Failure to respect such a link between savings and GDP was a fundamental reason why growth projections in the context of austerity measures were regularly over-optimistic. The second set of arguments stems from a synthesis of comparative institutionalism and growth. According to Peter Hall and David Soskice, fiscal policy can also be understood as institutionally specific, so the periphery cannot simply be blamed for wastefulness. This is a deeper problem – their unfortunate growth models may be institutionally dependent on borrowing. In both versions, it was detrimental to the periphery to imitate Germany in the crisis, and the new European fiscal architecture is doing exactly that – forcing the periphery to imitate German solutions.
The Present
It is significant that some conclusions were drawn from bad experiences, so in 2015-2017 changes in fiscal rules that emphasize flexibility timidly appeared. However, perhaps more important is the fact that the new crisis is palpably different from the past. The past crisis was basically an asymmetric shock of epic proportions – Germany lost only three years of real growth, while Italy and Greece never returned to the old levels of GDP (the Croatian case is similar: our GDP exceeded the level from 2008 only in 2019). The crisis that began in 2020 is both a health and economic crisis, and its development is connected to the measures taken to deal with the pandemic. Today’s situation is different because the asymmetry is smaller and interests coincide. They prompted a different reaction at the EU level, one that is far more oriented towards more spending, i.e. fiscal stimulus. A more visible way of fiscal expansion is activity at the EU level – a temporary instrument, the Next Generation EU (NGEU), has attracted considerable political and media attention in our country as well. Ten billion euros, of which more than 6 billion in grants, represent a significant opportunity for the Croatian economy. However, although this is a large short-term increase in the EU’s overall fiscal capacity, it is in fact extremely small compared to Member States’ fiscal spending. Far more important to understanding the changing fiscal policy was the activation of the general escape clause of the Stability and Growth Pact in March 2020. An essential part of fiscal architecture has thus been temporarily halted. Until the end of 2022, we can pretend that it is not even there. Starting in 2023, a wave of fiscal consolidations may begin, with all the side effects, but we can blissfully ignore them for now.
The Future
The new year is at the door. Next year should be good and easy for us. But as things stand now, 2023 could easily be a year of austerity measures. How many dissatisfied citizens will take to the streets or leave the country? It depends on the rules being discussed today. Consultations on the redesign of fiscal rules in the EU have been launched in October 2021, and this topic is becoming more and more common. Mario Draghi (a key figure in the last crisis and now Italy’s prime minister) has repeatedly stressed the need for more flexible rules. Macron agrees, and in Germany the new Scholz government is necessarily prone to political compromises and sends ambiguous messages. There is agreeimentwith the need for reform, but its understanding of the specific direction of reform can be significantly different from Italian or French conceptions. By the way, these three economies account for 55% of the GDP of the entire EU, dominating the post-Brexit phase of EU development. Various versions of the solution are possible. Let’s look at the three basic options:
1. The rules remain the same or only cosmetically changed. We should expect a strong recovery to continue, without grave problems. The wave of austerity measures that will be launched in 2023 will take place in circumstances of good growth. This growth will be somewhat dampened by the fiscal consolidations, but as long as it does not cause a recession and high unemployment, the political effects will also be moderate. But there are a number of possible exogenous shocks that could ruin our expectations – from trade wars to hot wars and a worsening epidemiological situation. If the old situation is repeated (austerity measures combined with already weak growth), we can have a return to the old way with protests, intensification of already developed populist tendencies, and even a return of tendencies towards the crumbling of EU membership.
2. The rules relax dramatically and permanently. This solution is not ideal as it encourages unhealthy fiscal tendencies, and they can be a burden for growth. Moving the public debt limit to 120 or 150% of GDP would be pointless.
3. The rules become more flexible, with particular caution towards the different demands of national economies in asymmetric shocks. This could be a winning combination. It could allow the common monetary policy in the eurozone (which simultaneously responds to the needs of Germany and Greece) to be complemented by active anti-crisis policies at the national level. At the same time, we would retain the obligation to put our houses in order after the immediate crises have passed.
The third and best option would be the most demanding, and this unfortunately reduces its likelihood. In all versions of reforms, not only technical solutions are at stake, but the whole next phase of our economic integration, with all its human and social consequences.