Fiscal Mythology Unmasked

12 July 2021


Debunking eight tales about European public debt and fiscal rules.

Europe faces serious environmental, economic and social challenges that require a rethink on public intervention. Not free to do as they wish, European governments devise fiscal and socio-economic policies constrained by a self-imposed maze of economic governance rules. Those rules are built on a series of debatable conceptions about public debt and the role played by the state.

This paper debunks eight often-espoused conceptions:

  1. DEBT OVERLOAD: The public debate overly relies on arbitrary debt-to-GDP thresholds to gauge debt sustainability, overlooking true explanatory factors like evolution of government revenue, interest rate, debt composition, differential between interest and growth rates as well as the building up of fiscal risks. Interest payment-to-public revenue (flow-to-flow) seems a more meaningful proxy indicator of debt sustainability than debt-to-GDP (stock-to-flow).
  2. INFLATION: A growing concern centres on inflation possibly returning, driving up interest rates, which would render debt unsustainable. Meanwhile, analysis shows a situation where this risk is not the most pressing one as inflation and interest rates are driven by structural factors unlikely to change in the near future.
  3. FUTURE BURDEN: Public debt often gets framed as an unfair burden on future generations. The “intergenerational equity” story overplays the liability trope around debt while overlooking some fundamental arguments such as the presence of funding gaps that, if unbridged, will leave future generations worse off.
  4. CROWDING OUT EFFECT: Public investment often gets brushed off under the argument that it would crowd out more productive private investment. In fact, this portrait overlooks some core elements. As Europe finds itself awash in savings and liquidity as well as unused economic resources, more public investment can instead “crowd-in” private investment to meet societal aims like a robust economy, cleaner environment, and a well-trained workforce.
  5. SPENDTHRIFTS: EU countries with comparatively high stocks of government debt to fellow Member States often get accused of living “beyond their means”. A closer look shows a more nuanced picture where these countries mostly hold legacy debts from tackling unexpected previous crises, not from supposed constant reckless spending.
  6. BUDGET SURPLUS ANALOGY: Building on the household analogy, public budget surplus is often presented as a necessity to repay debts and build “fiscal space”. This debate reveals two main flaws: First, running continuous public budget surpluses is the fiscally irresponsible course of action under certain circumstances. Second, intra-EU trade imbalances continue to hamper the prospects for every Member State to run concomitant budget surpluses.
  7. FENCED IN RULES: EU fiscal rules are presented as a package of sound limits designed to eschew the deficit bias of politicians. Meanwhile, the chosen fiscal limits lack economic justification: while the 60% debt-to-GDP limit was only a rough average of the then 12 EU countries, the 3% deficit limit is the economically unjustified heritage of its prior usage in France. Whilst the “debt-to-GDP” ratio itself suffers important conceptual flaws – such as non-commensurability and time-inconsistency – debt sustainability requires more than reaching a specific threshold.
  8. AMPLE WRIGGLE ROOM: European fiscal rules usually get depicted as flexible enough. In fact, flexibility is sparse and the rules dampen growth and employment while holding back Europe from reaching its environmental and social goals. Reforms must aim to improve quality of spending, take context better into account and prioritise long-term social and environmental sustainability over arbitrary fiscal constraints.

Read the report