Pandemic Sets Stage for Euro-Area Showdown Over Debt Rules

(Bloomberg) -- The European Union’s three-decade-old strategy for keeping its debt in check has been shattered for good by the pandemic, and that threatens to open up battle lines over what should replace it.

The Stability and Growth Pact requires countries to aim for budget deficits of less than 3% and debt burdens below 60% of gross domestic product. The European Commission expects those figures to be more than 6% and 100% for the euro area this year, and by cutting its growth forecast on Thursday signaled the bloc may be even further off its goal than that.

The SGP was suspended when the coronavirus hit, and few believe it can ever return in the same form. It was already set to be rewritten before the pandemic started, with the rules frequently breached and little evidence that it was contributing to either stability or growth. Officials say talks will likely resume in the second half of this year.

“What was clear before the pandemic has become even more obvious now: the fiscal rules in Europe need a substantial overhaul,” said Christian Odendahl, chief economist of the Center for European Reform.

Yet political distrust is likely to be a key hurdle to reaching agreement on what comes next. Politicians in countries such as Germany and the Netherlands have long called for debt burdens to be reduced, and railed against southern nations such as Italy and Spain that they see as spendthrift and dependent on the help of others.

Their targets argue that austerity measures in the name of debt reduction have crushed their economies in the past -- Greek unemployment surged to almost 30% last decade as it endeavored to meet the terms of an international bailout -- and would do so again.

Such divisions also came to the fore during negotiations on the EU’s 750 billion-euro ($911 billion) recovery fund, when the so-called Frugal Four -- the Netherlands, Austria, Denmark and Sweden -- pushed for the project to be based solely on loans and not on grants. Portuguese Prime Minister Antonio Costa at one point questioned the Dutch commitment to the EU, before a compromise was eventually found.

“Minds need to be made up,” Thomas Wieser, a former euro-area official wrote in an article for the Bruegel think tank this month. “The fundamental economic and political issue confronting EU countries is how to manage support for the recovery and longer-term debt sustainability risks at the same time.”

A key factor now is that rock-bottom interest rates have changed the notion of how much debt is sustainable. Italy, where the debt burden is approaching 160% of GDP, can issue 10-year bonds at an interest rate of around 0.5%, less than half the cost of a year ago. French 10-year bond yields are negative, meaning the government is effectively paid by investors to borrow.

What Bloomberg Economics Says...

“The Group of Seven governments piled on about $7 trillion of debt in 2020. Just as staggering: the real cost of servicing the new issuance is negative and will remain so until 2030 if yield curves don’t shift. But, here’s the rub: they often do.”

-Jamie Rush, Maeva Cousin, Tom Orlik. To read the report, click here.

The discussion on changing the SGP was about to restart last year, but was put on hold and the rules suspended as the virus-induced recession engulfed the continent.

Olivier Blanchard, a former chief economist at the International Monetary Fund, co-authored a paper last year arguing that writing down fiscal rules that cater for every possible scenario is a fool’s errand. That paper called for discarding concrete limits and applying greater judgment in deciding when to rein in member states.

The European Fiscal Board, an advisory body to the EU, has proposed sticking with the current targets but giving nations with high debt burdens more time to reduce them. That idea wouldn’t even require drastic legal changes, it said.

A key problem is that the current spending limits are enshrined in the EU Treaties, meaning getting rid of them risks tortuous negotiations that could unleash other demands by member states.

A consensus is reachable. The EU’s recovery fund has already overcome one longstanding taboo on debt in that it’ll be financed by jointly backed bonds. The fund was designed to partly address the limited fiscal space some nations would face in trying to help their economies rebound.

“For now, we have to live with small steps,” said Odendahl. “If these small steps, such as a slower fiscal transition out of the pandemic to support the recovery, turn out to be economically useful without undermining debt sustainability, then the fiscal hawks may be more open to a broader rethink.”

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