Encouraging growth through a paradigm change

Vision Paper by Francesco Grillo and Claudia De Sessa expanding Francesco's column published on the Italian newspapers Il Messaggero and Il Gazzettino del Nord Est

Scan of the paper edition

"The stability pact is stupid, but necessary. We would need a smarter tool, but no one has the authority to change it”.

In October 2002, it was the President of the European Commission – back then at its apogee - that spoke these words which became some of the most famous quotes in recent European history. The European Union was about to celebrate its latest and most impressive “enlargement” (going from fifteen to twenty-five members) and the signature of a true a constitution in Rome, all the while twelve of its members had already given up their national currency, sealing the irreversible process that had been the dream of three exiles in Ventotene. It was Romano Prodi himself that reminded us that such a construction was made frail by a pact that had no alternatives. Twenty years and three great economic and financial crises later, it is now time to complete this great project. It is History that gives us that authority, putting us in front of a crossroad.

The stupidity of the pact undersigned in 1997 (and then reformed in 2005 and 2011) was that, paradoxically, it revealed itself to be rather incompatible with the goals it was meant to achieve. The effects of the limited growth objectives, in which every country is not meant to go over a certain (3%) ratio between deficit and GDP are evident: during “bad” years of GDP contraction (meaning the worsening of the denominator), the pact pressures countries to reduce their public spending. This can transform short term recessions in a long-term depression. Conversely, during “good years”, the increase in the growth rate disincentivizes members to reduce pre-existing debts, in a moment where they could more easily be re-absorbed.

The graph presented in this article summarizes the result of this strategy: in 2019 – the year before the pandemic and of the interruption of the pact – in 15 out of 19 EURO countries the ratio between public debt and PIL worsened compared to the year 2000, when the pact entered into force. Moreover, more than half of them were not respecting the objective of progressively lowering that ratio under 60%. Paradoxically, the nine countries that remained out of the Eurozone fared better in terms of containing public spending. 

Graph - Public debt to GDP ratio (Eurozone countries, %, 2000 and 2019)

Source: Vision on Eurostat data

The graph presents an analysis that needs to be further refined, considering that 8 out of 19 countries joined the Euro after 2000 but that in any case, the effects on public finance of joining the Euro already manifest themselves before the official undertaking, as countries already need to meet the requirements in order to be granted admission¹ . The magnitude is, however, clear: EUROSTAT data highlights, paradoxically, how the nine countries that were out of the Eurozone fared better in terms of containing public spending.

However, as Prodi pointed out, EURO did need a pact. The groundbreaking experiment of having a central bank among countries that retained fiscal sovereignty was however, bound to be unstable (and it was criticized by all Nobel prizes for Economics such as Milton Friedman and Paul Krugman, although for opposite reasons). The temptation for a single government to overspend (to gain popularity), pressuring the central bank to monetize its debt and thus burdening its partners is real. It is so real that Klaus Regling, the CEO of the European Stability Mechanism, is right in defending the pact he negotiated on behalf of Germany. In 2005 and 2011, the terms of the deal were indeed made stricter and adapted to each different country. However, the rules concerning the stability goal setting are still left to a “code of conduct”² that employs algorithms so complex that the Ministry of Economics needs to devote entire scientific articles to their interpretation³.

This begs the question: how can we make the pact – that has been put on hold for one year and a half and that will be reactivated soon - smarter? A pact more capable of directing governments towards a sustainable growth that will not put financial or ecological burdens on next generations? More transparent towards citizens that need to necessarily be part of any growth project?

One option could be subverting the logic of the stability and growth pact. While the old pact states that countries need to acquire flexibility margins in order to be able to face crises or to make one-time investments, a new pact could upscale to the European level the responsibility of buffering shocks – such as the pandemic – and, progressively, of realizing strategic investments to increase the long-term growth potential of member states (especially those that are lagging behind).

According to this logic, the European level would not only be tasked with emergency funding in times of crisis (such as with the SURE instrument that aims at lowering the effects of the pandemic on the job market) but also with the management of buffers aimed at reaching citizens hit by sudden shocks. Not only, it could also acquire the direct responsibility of managing both physical (high speed trains and metros) and digital infrastructures (such as the Cloud) in order to equalize the level of development of member states.

This would require making the Next Generation EU permanent, but also changing its goals and management mechanisms, with the Commission at its head.

A step towards integration that we can nowadays dare to take. This of course presupposes a change in the organization of the Commission, its budget, its decision-making process and the way it remains accountable to citizens.

The vision for the future entails taking a step back, looking at the reasons that first brought Delor’s genius mind to attempt a European political integration through a monetary union. A monetary union without fiscal unity is not sustainable and, exactly for this reason, it can only survive if governments give up the last bit of power that divides us from full integration. To do so, we could start by taking to the European level the responsibility of handling crises and guiding modernization dynamics that go beyond nation states that belong to the past.

One thing is certain though. The cleavage – as the Belgians define it, meaning a deep, multilayered difference that is hard to overcome – between countries that fear risk sharing and those who suggest that fiscal unity will help them overcome current economic struggles and become more virtuous, has been a red lining through the majority of recent European political conflicts. This is because a lack of fiscal unity implies a lack of trust, of solidarity which therefore translates in a deepening of differences between member states. Recent events, such as Poland’s Constitutional Tribunal’s ruling undermining EU law’s primacy, have just further showed how frail the European project is, how still very incomplete. If a half-built house can withstand the test of time in normal times, it cannot resist the earthquake of COVID-19, of globalization and of shifting global equilibriums. One possible route to more towards increased risk sharing is relying on initiatives that have already been in discussion, such as European Deposit Insurance Scheme and develop complementary tools that would buffer the risks of a full-fledged fiscal union. A risk-free option is, however, impossible and in the end it will be up to politicians to truly take the step needed to commit to a true European Union. 

1 - See also Mileusnic, Marin. "Steps towards a European Fiscal Union: Has the revised Stability and Growth Pact delivered so far?." Journal of Contemporary European Research 17.3 (2021): 409-430. 

2- Revised Specifications on the implementation of the Stability and Growth Pact and Guidelines on the format and content of Stability and Convergence Programmes (Code of Conduct of the Stability and Growth Pact) che è stato rivisto il 27 Maggio 2017 da ECOFIN  .

3 - Biraschi, Paolo, et al. "The new medium-term budgetary objectives and the problem of fiscal sustainability after the crisis." Government of the Italian Republic (Italy), Ministry of Economy and Finance, Department of the Treasury Working Paper 8 (2010).