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The European Commission is in the final stages of drafting a legislative proposal, to be published by the end of April, on reforming the economic governance of the European Union. The proposal will follow on from a plan, published in November (European Commission, 2022), that set out the main lines of the Commission’s thinking and gave EU countries a chance to respond.
The stakes for the new proposal are very high. If the Commission ignores the criticisms of EU countries, the reform will not pass before the 2024 European elections. This would leave the fiscal governance of the EU in an extended state of limbo. But if the Commission accommodates EU countries too much, the reform will lose the intellectual strengths of the original plan and may morph into something resembling the present system – a Frankenstein’s monster of overlapping rules and procedures.
Most criticism relates to the Commission’s plan to replace numerical rules, focused on mandatory minimum reductions of debt or deficits, by a structured process – debt sustainability analysis (DSA) – which takes a broad view of the determinants of debt risks. DSAs look at current debt and deficit levels, but also try to project them into the future, making assumptions about economic growth, current and expected future interest rates, primary balances, implicit liabilities and the maturity structure of the debt stock. DSAs attempt to assess whether debt as a share of GDP is likely to come down or explode, and how fiscal plans and uncertainty about the drivers of the debt influence the chance that debt might be on a rising path. The greater this chance, the stronger the case for fiscal adjustment and/or growth-enhancing reform.
There are three main reasons for using DSAs in the EU fiscal framework, as we have argued previously (Blanchard et al, 2021).
First, using all relevant information to assess debt sustainability makes a lot more sense than relying on a few ‘magic numbers’ that generally will either fail to pick up debt risks or sound a false alarm.
Second, the main weakness of the current system has been poor implementation. Some of this reflects the unavoidable tension between the EU, represented by the European Commission, and governments that do not internalise the risks of unrestrained deficits for other member states. But some of the reluctance to abide by the rules also reflects their poor design. EU countries are much more likely to undertake fiscal tightening if it is not dictated by a seemingly arbitrary rule, but can be justified based on their specific economic circumstances. This is precisely what the DSA-based approach seeks to do.
Third, though DSAs are far from flawless, we know from experience that using them makes for far better discussions of debt sustainability. The main flaw of DSAs is that their results are only as good as the assumptions they are based on. But these assumptions can be made transparent, and the consequences of different assumptions are easy to illustrate. The International Monetary Fund, for example, uses DSAs to assess debt risks in the context of IMF surveillance, to decide whether countries qualify for loans, and to establish what debt relief is needed when countries cannot pay. All these applications involve discussions or even conflicts of interest: between different departments within the IMF, between the IMF and its members, and between creditors and debtor countries. DSAs make these debates more rational and transparent...
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