L’AGEFI - European fiscal policy crossroad

Translation of an article published by L'AGEFI on 23 November 2023
By Michala MARCUSSEN, Group Chief Economist

The EU Commission’s Annual Sustainable Growth Survey 2024 highlights that despite recent years’ major crises and considerable present uncertainties, the European economy has remained resilient with unemployment at historic low levels. Much of this resilience can be attributed to policy support, and not least at the European level. With the general escape clause due to be reactivated at the end of 2023, Europe now stands at a new policy crossroad and the choices made today will be key for Europe’s sustainable growth prospects.

The European Commission’s newly published assessment of the member states draft budgetary plans for 2024 concluded that the overall fiscal stance will tighten in 2024, as member states phase out past support measures, and notably on energy. Ensuring public debt sustainability will entail further fiscal consolidation beyond 2024, and the Commission has warned that that several member states (Belgium, Croatia, Finland and France) risk falling foul of their medium-term budgetary objectives. The medium to long term pathway will also be determined by the EU’s new fiscal rules, currently under discussion. These rules need to be flexible enough to allow fiscal policy to adjust to the economic situation and foster growth-enhancing structural reform, and, at the same time, strict enough to ensure sustainable public debt trajectories.

Even with fiscal consolidation, public investment is set to remain a bright spot in 2024 and not least thanks to the Recovery and Resilience Facility (RRF) of the Next Generation EU and other EU measures. The economy should also enjoy some support from lower inflation, creating room for at least some easing of monetary policy. The RRF was, however, designed as a temporary facility and there is still no consensus to create a permanent large-scale common facility. Such an instrument would bring several benefits, supporting public investment and structural reforms, and building credibility with financial markets thus limiting the risks of sovereign bond spread widening.

The list of open questions on future public investment for the euro area was further challenged when the German Constitutional Count on 15 November ruled against a €60bn transfer (of unspent pandemic funds) to the Climate and Transformation Fund. Since then, the German government has reportedly closed off other funds on the advice of their own lawyers. The initial concern is twofold. First that the German economy will as a result face further fiscal policy headwinds at a time when the economy is already stalling. Second, that Germany will fail to deliver sufficient public investment to ensure the necessary green and digital transformation of its economy. Our concern falls primarily on the latter, as this is key for Europe’s largest economy’s growth potential.

A further question at the European level is what the present developments in Germany may entail in terms of the capacity to develop a permanent European capacity to support public investment and thus also green and digital transformations.

With concerns mounting on the ability of the public sector to support investment, calls to further Europe’s Capital Markets Union (CMU) have recently intensified. While the development of CMU should indeed be a top priority, it cannot compensate for a potential lack of public investment and poor economic policy. Quite to the contrary, history shows that private risk sharing only works when supported by public risk sharing. This is what creates a positive spiral of private investment and economic growth. A good illustration is the ECB’s Transmission Protection Instrument (TPI). Introduced in 2022, the mere existence of this instrument has been very important in cementing the credibility of the euro area in its ability to fight against unwarranted sovereign bond spread widening. At the same time, the TPI is conditioned on the respect of the European fiscal rules. It’s thus quite easy to understand why a well-functioning CMU, also requires good fiscal rules, structural reforms and public investment capacity.

Concern today, however, is that Europe may see a return to counter-productive fiscal austerity, rendering efforts to pursue structural reform more difficult, thus weighing on both short and medium-term growth prospects and with the risk of adding a vicious loop of sovereign bond spread widening. The importance of the European policy choices made over the coming weeks and months thus cannot be understated.