In March, EU finance ministers will gather in Brussels to try and strike a deal on EU fiscal rules. Fiscal rules are a notoriously sensitive subject, with ideas around public debt shaped by the history of individual countries.
With the suspension of the Stability and Growth Pact to be lifted before the end of the year, policymakers accept that the old rules will not set the European Union on a course for sustainable growth, but they are struggling to agree on what will.
For example, while everyone seems to agree with the European Commission’s proposal to move from a one-size-fits-all approach towards more country-specific debt reduction pathways, some EU member states are sceptical about how this would work in practice.
The best option – backed by several prominent economists including Olivier Blanchard, former chief economist of the International Monetary Fund – is to build these pathways on country-specific debt sustainability analyses.
A debt sustainability analysis is like a stress test for public finance – it considers future economic scenarios and applies shocks to key drivers of debt sustainability to help gauge the possibility for countries to expand debt financing of public spending and investment.
This quickly brings us to another point of contention – the impact of public debt on future generations. When public debt is discussed, it is too often described as a burden on future generations, as an inherently bad thing.
But this is not necessarily the case.
Quality investments in public infrastructure and R&D have an important multiplier effect, boosting economic growth and employment. Quality, green public spending can help us reach our sustainability goals and should be excluded from the calculation of deficit and expenditure ceilings.
High-quality and future-oriented public investment and spending will benefit multiple generations.
Financing such projects via debt is a legitimate way to spread their cost among those who will experience the benefits. Investment costs will weigh less on the shoulders of future generations than the cost of failing to tackle the challenges facing Europe.
When it comes to European fiscal rules, the core argument for not drifting too far from the status quo is fear of how financial markets react to high public debt levels.
But when we dare to ask questions, to peel back the layers of financial jargon, this does not reflect reality.
As illustrated in the below graph, credit rating agencies like Moody’s care less about the debt-to-GDP of a country and more about the size, complexity, strength and growth of its economy.
Financial markets pay little attention to arbitrary fiscal thresholds. Countries with a debt-to-GDP ratio above 60% can still have a good credit rating. For example, in 2020 the United States had the highest possible Moody’s credit rating (Aaa), and France the third highest (Aa2). By contrast, Ukraine had in 2020 – prior to the war – a very low credit rating (B3 – “speculative” scale).
Debt-to-GDP is not a good indicator for assessing the debt sustainability of a country – it is merely an easy, but misleading, political target. Other indicators are needed, which is why the EU must move towards country-specific debt pathways based on debt sustainability analysis.
The European Union finds itself wedged between economic powerhouses taking ambitious steps to increase competitiveness in a very uncertain time. Uncharted territory can present new challenges, but it can also present new opportunities.
If our finance ministers do not rise to the occasion this March, Europe will be left behind.