EU Strikes Deal to Curb Public Debt
New, more lenient rules will seek to reduce European government deficits and debt while encouraging investment in defense and tech
European Union governments have agreed on new rules to curb budget deficits and debt, drawing a line under years of freewheeling spending during the Covid-19 pandemic and the Ukraine war.
The agreement reached on Wednesday comes as rich nations face both rising borrowing costs due to higher interest rates and increased spending needs on items ranging from defense to the green transition and an aging population.
The deal, which comes after months of negotiations and still needs formal backing from governments and EU lawmakers, opens up a divergence between Europe and the larger U.S. economy, which is expected to run large budget deficits for years and has been growing faster.
The new rules are generally more lenient. They give countries more time to reduce budget deficits to the target 3% of gross domestic product, incentivize certain kinds of investments from a country’s budget gap, and encourage countries to reduce their public debt more gradually. They also give more space for governments to loosen fiscal policy temporarily during downturns.
The new rules will replace the fiscal framework that used to govern public spending and borrowing in the EU until it was suspended at the start of the pandemic. They aim to put budget deficits across the 27-nation bloc on a downward path, while leaving room for green investment. The deal walks a path between Northern European countries like Germany that are eager to keep debt in check and southern European nations such as Italy that would prefer more room for state investment.
At a news conference, Spanish economy minister Nadia Calviño said the deal sought to balance the need to rein in higher debt and deficits with ensuring investment in green and digital technologies and defense. The new rules “are more credible and will also be easier to apply,” Calviño said.
The effort to curb debt will likely reassure investors in European bond markets that public finances in the region are sustainable. But it could also weigh on economic growth at a time when Europe’s economy has been stagnant for a year. Officials expect the European Parliament to approve the rules early next year before they become binding in 2025.
“This agreement provides for fiscal rules that encourage reforms, with room for investments and tailored to the specific situation of the member state in question,” Dutch Finance Minister Sigrid Kaag said after the agreement was reached. They work counter-cyclically so that potential economic growth is not cut short.”
Across advanced economies, governments are still borrowing heavily four years after the start of the Covid-19 pandemic. However, a jump in long-term interest rates, as central banks battle high inflation, have made raising debt expensive, suggesting that countries might in future need to run smaller deficits than in the past.
Now, rich countries face massive new bills to finance the costly shift to green energy infrastructure and support aging populations. Together, those costs might add 3 percentage points of gross domestic product to annual government spending over the coming years, according to Capital Economics.
With rising spending needs but less room to borrow, many governments will find themselves considering tax increases. In Germany, the government this month announced a series of energy tax increases and spending cuts to plug a hole in next year’s budget, which had opened after the country’s top court ruled it couldn’t tap unused pandemic funds.
To safeguard investments required to address climate change and social problems and bolster Europe’s defense spending at a time of rising interest rates, the new rules allow for a transition period until 2027. For the next couple of years, governments tasked with reducing their deficits to 3% of GDP will be able to maintain higher investment spending levels by discounting the additional borrowing costs they face.
Europe conducted large scale fiscal stimulus to support workers and businesses during the pandemic and after the start of the Ukraine war. The measures included sweeping energy subsidies and supporting the wages of tens of millions of furloughed workers. EU governments were less lavish than the U.S., however, which ran double-digit budget deficits for two years—one reason for Europe’s slower economic recovery.
Government debt in the U.S. is expected to increase to 127% of GDP next year, about 40 percentage points higher than the ratio of 88% in the eurozone, according to IMF data.
The broad outlines of the European Union’s budget rules were laid down in 1993 as part of the Maastricht Treaty that paved the way for the euro. They stipulate that budget deficits should not exceed 3% of GDP and overall government debt should not exceed 60% of GDP. Those rules were suspended in 2020 to allow governments to respond to the pandemic, and again during the Ukraine war, to allow governments to support households during the surge in energy prices.
The U.S. is likely to run budget deficits of more than 7% of GDP over the next three years, while the combined deficits of eurozone governments will decline to 2.7% of GDP next year, according to the International Monetary Fund. Within the eurozone, deficits vary widely. In Greece, it is forecast to fall to 1.6% of GDP from 2.3% last year, while Ireland is forecast to have a budget surplus for the second straight year. Italy and France continue to have deficits of roughly 5% of GDP.
Governments that test the limits of their budgets, like the U.K., have been punished by investors. U.K. borrowing costs skyrocketed last year when then-Prime Minister Liz Truss announced a surprise package of large tax cuts. Truss was quickly replaced by Rishi Sunak, whose government has instead raised taxes in an effort to bring its debts down.
One of the toughest discussions over the new EU rules was how to replace a widely-disliked provision which demanded that countries with debt over 60% of their economic output had to reduce them by a set amount each year.
In the end, finance ministers agreed that the debt should be on a clear downward trend, but also that countries had to reduce their debt-to-GDP ratio by one percentage point a year if that ratio was over 90%. For countries with debt-to-GDP’s between 60% and 90%, the debt must fall by half a percentage point annually.
One significant criticism of the old fiscal rules was that rather than restrain day-to-day spending, they prompted governments to hold back on investment that boosts long-term growth. Enforcement by Brussels was also patchy, with bigger, more powerful countries like France repeatedly given more time to meet the goals.