Updating the EU’s fiscal rules (Part 1)
How improving the EU’s potential output methodology can mitigate the risk of deepening recessions
The COVID crisis and the implications of the current war in the Ukraine for the European economy have highlighted the need for economic stabilisation, for which countercyclical fiscal policy is an important tool. During the COVID crisis, large stimulus packages around the world helped cushioning the negative effects of the economic recession. The EU has declared the NextGenerationEU fund a non-permanent measure for this extraordinary crisis, which was only made possible through a deactivation of the fiscal rules in the Stability and Growth Pact. While the Stability and Growth Pact intends for the structural budget balance rule to enable countercyclical fiscal policy, this paper shows that, due to procyclical estimations and revisions in the underlying methodology, it is often a-cyclical or even procyclical in practice.
An expenditure rule based on potential output growth, which is discussed as a potential remedy, relies on the same estimation methodology and is therefore prone to the same issues, albeit to a lower extent. Thus, this paper presents technical improvements to the estimation methodology that reduce its procyclicality and its proneness to revisions. Moreover, these improvements can generally increase Member States’ fiscal space. While the political feasibility of these technical improvements seems higher than for other reform proposals, they are not sufficient to resolve all fiscal rules’ underlying problems.
