Zsolt Darvas: Fundamental reform of EU fiscal rules is needed irrespective of the pandemic

“A fundamental reform of EU fiscal rules is needed irrespective of the pandemic and the fiscal situation of EU countries in the years to come, and the reason is that current rules suffer from major shortcomings. The current rules are overly complex, unpredictable, relies on unobserved variables (output gap and structural balance) that are difficult to estimate, prone to errors, lack proper enforcement mechanisms and credibility,” Zsolt Darvas tells Athens Digest.

The Bruegel’s senior fellow sees the RRF as a great opportunity for Greece, given that only “three countries will get more than 10% of their annual GDP: Greece, Bulgaria, Croatia.” Although in the past, as he stresses, “Greece was unable to exploit the benefits of EU integration (…) the strong reform momentum currently observable in Greece raises the hope that NGEU will have some lasting impact as well.”

Interview with John Papageorgiou

 

There is a lot of talk about the fiscal challenges in the post pandemic era. Given the decisions the EU institutions have made, which is the basic scenario that we should follow regarding the revision of the EU fiscal rules?

Darvas: Budget deficits and public debts have indeed increased significantly due to the pandemic, but such an increase is not a reason for an EU fiscal rule reform. A rule should not be reformed when it is difficult to meet (that would completely undermine the credibility of the rule), but when the rule is bad. A fundamental reform of EU fiscal rules is needed irrespective of the pandemic and the fiscal situation of EU countries in the years to come, and the reason is that current rules suffer from major shortcomings. The current rules are overly complex, unpredictable, relies on unobserved variables (output gap and structural balance) that are difficult to estimate, prone to errors, lack proper enforcement mechanisms and credibility. The suspension of fiscal rules due to the pandemic presents an excellent opportunity to discuss the reform. However, while a major reform would be highly desirable, I give a low probability that this will actually happen. It was rather difficult to discuss the previous round of reforms in the early 2010s which suggests that reaching a consensus now would be difficult. Many countries put the current rules to their national constitution, which make a fundamental change hard to implement. Instead of a major reform, I expect some marginal changes, such as exempting some climate-related investments from the rules and relaxing the pace of fiscal consolidation after rules are reinstated.

 

In which ways political developments such as the upcoming elections in Germany and France may affect the plan for financial recovery or the discussions on the new EU fiscal framework?

Darvas: Fiscal rule reform is not a topic of the German election campaign and I do not expect any change in this after the elections, whatever its outcome is going to be. Let me add that the German national fiscal rule, which is enshrined in the German constitution, is even tighter than European fiscal rules. Some French politicians seem to be more in favour of a reform, as well as Italian politicians, but a consensus cannot be achieved if Germany and some of the so-called frugal countries, like Austria and the Netherlands, are against a major reform.

 

Unquestioningly, Next Generation EU is an important tool for the recovery of the member states economy as it comes additional to the EU budget and as many say complementary to the ECB policy. Is it enough? And under which terms?

Darvas: Already the Franco-German proposal for a recovery fund in mid-May 2020 had a positive impact, as well as the approval of NGEU by the European Council in July 2020. The approval shows that when Europe is in deep trouble, European politicians can come together and agree on meaningful measures. Irrespective of any pay-out from NGEU, this announcement effect already improved market sentiment and boosted the credibility and sustainability of the euro, and thus lowered the borrowing costs of member states with higher debt, along with bold European Central Bank measures. The overall amount of grants form NGEU is about 2.4% of annual GDP which will be paid out over the 6-year period of 2021-2026, which is not that large. But three countries will get more than 10% of their annual GDP: Greece, Bulgaria, Croatia, most other central Europeans get about 6-10% of annual GDP, while Italy and Spain get about 5% of their annual GDP. For Greece, Bulgaria and Croatia these amounts are huge, while these are sizeable for central and southern Europe. Yet the credibility brough by NGEU helps national borrowing by lowered interest costs, which also supports the recovery.

Greece seems to have high hopes from the implementation of its national RRF plan. Why can we be optimistic about its proper implementation, and do you think that the Commission’s projection of a 0.8 percent yearly growth only due to the plan is achievable?

Darvas: More public spending increases GDP by definition, so indeed higher GDP is expected while NGEU money is coming to Greece in 2021-2026. This will boost employment as well, contribute to better infrastructure, support the green and digital transitions and thus projections for higher GDP in 2021-2026 are justified. Beyond money, a crucial growth driver is structural reform: it is easier to implement reforms when GDP and employment are growing. The main issues are whether money will be spent on worthwhile projects and in a cost-efficient way, and whether improved infrastructure and structural reforms will boost growth after the end of NGEU in 2026. We will know the answer a decade from now, yet the strong reform momentum currently observable in Greece raises the hope that NGEU will have some lasting impact as well.

This year Greece celebrates 40 years in the EU. You are well familiar with the developments in the country especially during the past difficult decade. In your opinion, which are the basic benefits out of this, are there lessons that should be learned, and are there new challenges for the country in the foreseeable future?

Darvas: EU membership, along with economic and policy integration with other EU countries, offer a framework for better economic prospects. But this is an opportunity, not a guarantee. Greece received huge amounts of EU funds in the past four decades and access to the European single market should have fostered competition, innovation and faster growth. Yet various studies cannot identify a positive growth impact from EU membership in the past for decades. This suggests that Greece was unable to exploit the benefits of EU integration. The reasons are well known: inefficient, overly bureaucratic and often corrupt public administration coupled with irresponsible fiscal policy and business-unfriendly regulation. While there were major mistakes in the design of the rescue packages for Greece in 2010, a correction of unsustainable economic, fiscal and external positions was inevitable and would have happened even with a better design of the rescue packages. Let’s keep fingers crossed that the current reform momentum will result in a better use of the EU framework in the subsequent decades.
I’d like to add that importantly, the EU is not only an economic cooperation of member states. It promotes widely shared values and results in a stronger voice in the world than what EU member countries could achieve on their own.