Version française sur le site d’alter éco ici

(Translation of an article published in French in Alternatives Economiques)

By Ollivier Bodin and Alain Grandjean

The European Commission and EU governments are currently negotiating national budget trajectories for 2025 and beyond. As deemed appropriate by the Eurogroup in July, a restrictive fiscal stance is expected for the eurozone. 

Seven countries, accounting for 55% of EU GDP, are in excessive deficit and, according to European fiscal rules, will have to pursue a restrictive policy^[1]. France just anounced its intention to save 60 billion euros (2% of GDP) in 2025. For its part, the fiscal stance of Germany, constrained by its own constitutional provisions, will at best be neutral, if not restrictive. 

Will we experience a repeat of the black scenario of the years of under-investment that followed the 2008-2009 crisis, even though inflation is close to its 2% target, economic indicators are stagnating or deteriorating and several sources of uncertainty persist? 

A model based on very simplistic assumption

The Commission calculates the budgetary cuts that the Member States are expected to make on the basis of a mathematical model described in its working document of March 2024 (Debt Sustainability report). Dani Rodrik reminded us in his essay ‘ Can we trust economists? that using mathematics and simplifying assumptions is not in itself a problem. But anyone making or receiving fiscal policy recommendations must ask themselves what the underlying assumptions are.

Essentially, the exercise consists of identifying the budget trajectory that will bring the public deficit below the 3% of GDP limit in a given period of time, and bring the debt closer to the 60% limit^[2]. The annual improvement in the balance and in spending net of new tax measures will have to fall within a narrow corridor. 

Let’s not dwell at length on the lack of foundation and the opportunistic origin of these two figures, carved into the marble of the EU Treaty in defiance of common sense. Let’s look at the assumptions at the heart of the model used by the Commission.

One critical assumption concerns the GDP projection. The gap between GDP growth and the interest rate determines the dynamics of the debt ratio. To determine long-term GDP, the Commission’s model is based on economist Robert Solow’s model (1956), which is itself based on an empirical relationship between labour, investment and growth formalised by economists Charles Cobb and Paul Douglas (the Cobb-Douglas relationship, 1928). This model makes it possible to determine a ‘potential’ GDP towards which actual GDP will tend to converge^[3]. In practice, the determination of this long-term potential GDP is fundamentally based on a projection of hours worked and an estimate of future productivity gains. And these projections are based solely on past trends. This is a very simplistic assumption, which in particular ignores the role of public policy excepted labour market reforms.

For the short and medium term, GDP is assumed to react within the year to changes in the budget balance (the Commission assumes a budget multiplier of 0.75 for all countries^[4]), but automatic stabilisers^[5] are assumed to eliminate the gap between GDP and potential GDP caused by the fall in public spending within a maximum of three years.

The conclusion drawn by the European Budget Committee (EBC) in its assessment of the new rules of the Stability Pactapplicable from April 2024 is that, in the absence of major shocks and provided they are only demand shocks, compliance with the new rules will put fiscal stabilisation on ‘autopilot’, which would benefit all countries. But this reasoning will only hold in reality in the absence of possible supply shocks and if the model accurately reflects the real interactions within the economic system.

There are already doubts about the assumptions for the short and medium term. Estimates of fiscal multipliers are generally higher than the figure used by the Commission and differ from one country to another. Secondly, the assumption that this impact will dissipate in just three years in all countries is questionable. Finally, the rules are applied as if each country were isolated. In a monetary union, compliance with restrictive fiscal trajectories will have a different impact depending on whether it concerns several ‘large’ countries whose economies are highly interdependent or a single country. A recent article has clearly shown the extent to which, for the same policy, fiscal balance and debt trajectories depend on these three assumptions.

Investments crucial to the ecological transition forgotten

Even more significant is the assumption that the structure of the productive system is stable over the long term. The model takes no account of the direct impact of climate change, nor of the policies and investments implemented to mitigate and adapt to it. It ignores energy as an essential ingredient of production. Nor does it take into account other European objectives and challenges, such as reindustrialisation and digitalisation.

 In fact, a strategy of massive investment in the reindustrialisation of Europe as proposed by the Draghi report would not be possible under this model. A massive increase in investment and an acceleration in productivity gains cannot be envisaged without an increase in public funding. However, this financing could initially lead to a deterioration in the budget balance and debt ratio before private investment takes over. A recent ECB working paper, based on endogenous growth models in which productivity gains accelerate with investment, stresses the importance of public intervention to achieve these gains.

There is therefore an urgent need to revisit the fiscal rules, both at national level and at European level. We need to stop looking at this issue solely through the prism of the volume of national public debt.The ecological transition urgently requires additional public funding in every country. This funding will have a return, including in terms of reducing the risks and costs of climate change. Unless we want to trap European economies in chronic underinvestment, it must be possible to make trade-offs between investments that are crucial for the security of our societies now and in the future, on the one hand, and a smaller improvement in the budget balance, or even its deterioration in the short term, on the other.

At European level, responsibilities are shared between the Member States and the EU institutions. In the immediate term, it is up to the European Commission and the Finance Ministers to show discernment in order to avoid the first year of application of the new fiscal rules being that of a dangerously pro-cyclical austerity policy incompatible with the need for a strong recovery in investment. For the longer term, national governments and parliaments will have to lift their vetoes on common loans to finance European public goods, as the Draghi report has invited them to do. Our government must have the courage to open the debate.

^[1] Belgium, France, Hungary, Italy, Malta, Poland and Slovakia. 

^[2] According to the European Union’s Stability and Growth Pact adopted in 1997.

^[3] Economists make a distinction between actual GDP (that which is actually measured) and potential GDP (which would be the GDP resulting from a ‘normal’ economic situation). Put another way, potential GDP is that which would result from full employment of the factors of production (labour and capital). 

^[4] The fiscal multiplier is the ratio between the change in public spending and GDP. A multiplier of 0.75 means that by reducing public spending by 1 point of GDP, GDP would shrink by 0.75 points of GDP, all other things being equal.

^[5] Social benefits and other public spending increase mechanically in the event of an economic crisis and support activity.