The German government’s new position paper on European fiscal rules, initiated by Green State Secretary Sven Giegold (serving under Green Economy and Climate Minister Robert Habeck), must be understood in both a German domestic and a European context. While it does little to move domestic fiscal and energy policy forward, and its European reform ideas stem from a domestic political compromise that is less than desirable on an operational level, it could nonetheless advance the debate at the European level.
Weak Domestic Agenda
On a domestic level, the paper reflects a desire of the Greens to rein in Free Democrat (FDP) Finance Minister Christian Lindner, whom they see as increasingly pushing the boundaries of the coalition agreement among the Greens, FDP, and Social Democrats. Despite this objective, the proposal does not go far in addressing domestic issues – in particular, Lindner’s pledge to restore Germany’s debt brake in 2023 – a set of constitutional provisions that were temporarily lifted during the pandemic and aim to curb structural deficits by limiting new government debt.
It also fails to clarify how more ambitious investments can be made to meet Germany’s medium-term climate goals and short-term energy independence needs. In that sense, the government remains in profound denial about the extent of the economic and energy transformation necessary and the impact it will have on domestic and fiscal policy. The Greens are now paying the price of the weak settlement in the coalition negotiations, which effectively limited green investments to some 60 billion euros via a dedicated fund.
Moving the European Conversation
In the European context, the paper offers more opportunity for action. It comes amid a two-year debate over reforming economic governance, characterized by the absence of proposals, consensus, and compromise. The German paper could therefore be useful in moving this conversation forward.
Despite high expectations that France would make European economic governance an integral part of its agenda during its six-month presidency of the EU, French President Emmanuel Macron wavered on leading the fight, as the war in Ukraine dwarfed most other issues in the first half of the year.
Nevertheless, Macron and Italian Prime Minister and former European Central Bank (ECB) head Mario Draghi had already launched a debate in a joint Financial Times opinion piece published in December 2021. Although the article was vague on substance, it signaled a desire to address the topic ahead of the March 2022 Versailles Summit. Unfortunately, although they were meant to hammer out a new consensus, leaders at the summit barely touched on the issue. The joint opinion piece did, however, initiate some meaningful Franco-Italian work on the evolution of rules and broader economic governance, which was met with outrage in Berlin given how it could marginalize German views and rock the coalition agreement’s compromise.
The joint paper was written by Italian economist Francesco Giavazzi (for Mario Draghi) and Charles-Henri Weymuller (for Emmanuel Macron). It was both ambitious and original, separated into two parts: one on rules, one on debt management.
The debt management section proposed a European debt agency that would buy out a portion of the ECB’s outstanding government debt with a view to relieving its balance sheet. The French Treasury found this potentially destabilizing for European sovereign debt markets, for it could create two categories of European government debt. The Treasury effectively stopped the Franco-Italian effort – to the great satisfaction of the new German government.
Instead, the French Treasury came out with a tentative compromise in a paper released in February 2022 arguing for:
- An expenditure rule alongside previous proposals by the European fiscal board or the IMF (2018) instead of a structural adjustment measure prone to revision and measurement issues;
- Lifting the 1/20th debt reduction rule and introducing country specific targets (although not specified); and
- Expanding public investments either by a green golden rule, which would discount green investments, or by a dedicated European fund.
All in all, the French proposals were not particularly ambitious but at least came close to the European intellectual consensus.
The Germans Weigh In
On the heels of these proposals, the new German paper reflects a greater openness to reform than Germany has shown before, when it essentially rejected the very need for reform. This shift gives the German paper some importance, but the path the government offers is fairly narrow and potentially ineffective without serious amendments.
The German government essentially argues for:
- Suspending the 1/20th debt-reduction rule.
- Simplifying the rules by introducing an expenditure benchmark – but without abolishing the existing minimum required structural adjustment in current rules. (This compromise between the introduction of an expenditure benchmark and the persistence of a structural adjustment will certainly prove hard to operationalize.)
- Extending the investment flexibility clause introduced in 2015 by the European Commission. This remains relatively vague because it explicitly rules out a green golden rule but could potentially enable an extension of European programs like the Commission’s Recovery and Resilience Facility.
- Finally, the paper calls for a clearer and stricter framework for enacting the general exemption clause, which allows for suspending the stability and growth pact when the economic situation warrants. This would severely constrain the Commission’s current discretion and would certainly open a difficult negotiation about the appropriate metric/trigger to invoke the general exemption clause.
All in all, the German proposal is an internal political compromise that doesn’t amount to a complete and operational reform proposal. It is however a good basis for discussion.
Time for EU Institutions to Act
Now that Berlin has signaled its openness to negotiate, European institutions should seize the opportunity to put their own ideas on the table. To be fair, the ECB has surprisingly put out the most solid work and offered concrete suggestions, and the European Fiscal Board has been a trailblazer.
Indeed, since ECB Chief Economist Philip Lane gave a speech in November 2021 outlining how fiscal rules should take into account the distance to the ECB’s inflation target, the ECB (2022) has developed its own proposal and simulation – the embryo of a framework for fiscal/monetary policy cooperation.
The ECB’s proposal and simulations laid out two objectives of a prospective reform:
- Simplify the framework and take into account the prevailing macroeconomic context, as well as enhance considerations that balance sustainability and stabilization.
- Reflect increasing investment needs related, among other things, to the green transition.
The ECB’s proposal essentially builds on:
- An inflation-adjusted expenditure growth-rule linked to a debt anchor.
- A standard increase in net public investment from the 0.1 percent of GDP observed in 2019 to 0.7 percent (the 2000-2007 average), which is also the low end of what is deemed required for Europe to meet its emissions reduction targets.
- A suspension of the 1/20th debt reduction to be replaced by a 1/30th debt reduction ceiling as inspired by the ESM proposal, which would effectively reduce the maximum nominal adjustment to 3 percent per year.
On that basis, the ECB finds that the recommended adjustment would ensure both better stabilization and better debt reduction than the current framework. For low debt countries, the rule would create fiscal space allowing a return to implementation of the existing SGP framework. Such fiscal space would support increasing public investment needs. In addition, taking the ECB’s 2 percent inflation target into account in the spending rule would enhance the counter-cyclicality of the SGP framework. For high debt countries, it would reduce the maximum adjustment to something more economically sensible and politically sustainable.
This could eventually be further adjusted by introducing country-specific debt targets. On the whole, and maybe most importantly, the framework would enable a much greater level of fiscal/monetary policy coordination without subordinating fiscal policy to the ECB’s monetary policy. It would instead be calibrated in real terms while government budgets are usually designed in nominal terms. The envisaged framework would create fiscal space in times when inflation is below target and vice versa. This should be at the heart of the European Commission’s proposal, and it could arguably be a politically realistic compromise.
These discussions are, however, unlikely to deliver a new framework immediately. In the meantime, the European Commission will play an important role in managing expectations for fiscal policy. Extending the suspension of the SGP in 2023 is important, especially as the German government has – oddly – committed to it despite adverse economic circumstances. The draft budgetary plans to be released by October 15 and the Commission’s assessment will drive policy in 2023, but a draft communication/legislative proposal on medium-term reforms could play an even bigger role in setting out medium-term fiscal paths.
