Luke Bartholomew

Hello and welcome to Macro Bytes the economics and politics podcast series from abrdn. My name is Luke Bartholomew, and today we will be talking about some important changes in the European fiscal rules. Now whilst this might sound like a somewhat dry and technical topic, there are I think some quite important changes coming down the path both in terms of the macroeconomics, fiscal rules around how fiscal policy is used to support the economy, debt and deficit levels and the level of interest rates and also around the microeconomics of fiscal policy- how companies are supported and regulated and how competition policy is implemented. All of this we think does have significant implications for various different markets and sectors of the economy. So, I'm delighted to be joined by Lizzy Galbraith, Political Economist at abrdn and Paul Diggle of course co-host of this podcast, to discuss this important topic. So let us start with the question of European fiscal rules as they relate to macro policy. And Lizzy, there's been some new proposals from the EU around how these fiscal rules will change. So do you want to run us through what their proposals are in that respect?

Lizzy Galbraith

Yeah, so the European Commission has been working on a plan to update fiscal rules for about a year now and it's got to the point where it has published some broad proposals for member states to consider. It's worth pointing out before I jump into those that the current fiscal rules have actually been suspended now since 2020, in recognition of the COVID pandemic, and then the invasion of Ukraine, essentially making the member states spending completely unviable when it comes to maintaining those rules. So previously, when we did have active fiscal rules, every member state’s government deficit couldn't exceed more than 3% of its GDP, and its debt wasn't supposed to exceed more than 60% of its GDP. And when there was an overshoot of the debt-to-GDP ratio, the gap was supposed to close by 1/20 per year. At the moment, because as I said, of COVID and then the invasion of Ukraine, a lot of member states are exceeding those rules. So, you have 15 member states currently exceeding the deficit rule, and 14 exceeding the debt rule. So, the Commission is trying to work out a new framework that is a bit more realistic, given the position that most member states now find themselves in. There are three main components to what the Commission has put forward, the first being more national ownership of debt reduction plans, so the member states will propose their own fiscal plans that have to put debt and the government deficit down on a credible path to below the 60% and 3% targets. But the key point is that it wouldn't be imposed by the EU governments would essentially get to decide how they meet those targets, or how they put spending on a path to meet those targets. Second, is simplification of the fiscal rules. So, the only fiscal indicator that the EU would use to judge spending going forward would be primary expenditure, net of interest, unemployment spending, and discretionary spending. And thirdly, crucially, for some of the more fiscally hawkish states is an enhanced enforcement regime to make sure that member states actually stick to these rules, which hasn't always been the case under the previous system.

Luke Bartholomew

As you say, there will be new enhancement and enforcement mechanisms to sort of perhaps buy off some of the more frugal fiscally hawkish steaks, but do you think that will be enough to see these proposals passed? Or are we still seeing resistance from certain countries, even with those new mechanisms in place?

Lizzy Galbraith

The short answer is no. It's not enough. Principally, Germany is still pretty opposed to these proposals and it's German opposition that's really slowing this process down and making the reform process drag on a bit. So, Germany really is opposed to the idea that this is sort of a bespoke fiscal framework for each member state, so they think it sort of goes too far the other way away from the old framework. And they want to see a bit more continuity between the fiscal rules that each member state would have to adhere to. So, we've had a little bit of progress today, on the day of recording, so the finance ministers from the member states are actually meeting today and Germany has signalled that it's maybe something that they're now willing to actually discuss, whereas previously Germany was opposing the proposals and not really being willing to engage in the reform process, which was jamming things up a bit. We've now got to the point where the Germans seem more willing to talk about what it is that they might want in exchange for agreeing to a future framework, although very little in the way of sort of meaningful progress towards substantive change yet. But certainly, the way forward will be that the Commission is going to have to compromise on a little bit of this flexibility, and probably some more concrete enforcement as well to make sure that the more hawkish states remain on board going forwards as well.

Luke Bartholomew

So Paul, assuming that these reforms do get passed, at some point, in one form or another over the next year or so, what are the concrete differences we think it would make to European fiscal policies as actually implemented by the various different member states?

Paul Diggle

Thanks Luke. I think because the starting point is an existing set of rules that are suspended, the change a new set of rules would make is relatively small at first, you know because you're starting from a point where there are no rules. I mean, if anything, the new set of rules would be stricter than the complete absence of fiscal rules that we have at the moment, although we are obviously coming off an extraordinary economic period with COVID, then the Russian invasion of Ukraine and the energy shocks. So actually, it's kind of a tightening up of the fiscal framework relative to right now. But we are in an unusual period at the moment. Longer-term then, comparing the new rules to the old rules, I think there are two really important differences. The first is that the design of the old rules which everyone criticised certain aspects of that design, they encouraged a procyclicality in fiscal policy, in particular, during macroeconomic downturns. Almost by design, fiscal policy would take on contractionary qualities, because you would see a deterioration in your deficit, in your debt to GDP ratio during a downturn. That is kind of normal. In fact, it may be desirable, in some respects, they're called the automatic stabilisers of fiscal policy. The new rules, I think, don't have that same degree of potentially macroeconomically damaging procyclicality into a downturn. And that's because you're making primary expenditure i.e. spending net of interest payments, net of unemployment, spending net of discretionary spending, you're making that the really important macro-fiscal variable. So you're kind of taking out the cycle or put another way, giving member states room giving their financial ministry is room to combat downturns with a degree of fiscal stimulus. And that's probably from an economist’s perspective, from a growth perspective, probably a helpful change. And then the other really important change is that by introducing this bilateral element that Lizzie was talking about, you know, a plan that is designed together by a member state’s finance ministry, and by the Commission, I think you're reducing the scope for fiscal conflict risk, if I can use that term. You know, this very frequent problem we've seen in Europe, where member states, and it's often the usual suspects, it might be Italy, it might be Greece, it might be other highly-indebted states come into conflict with the Commission over the fiscal rules or over their fiscal path. And that has all sorts of ructions into domestic politics and European-wide politics. You're basically toning down that conflict risk as well, so in this sense, perhaps you're encouraging a degree of growth and European cohesion by having a somewhat more bilateral flexible fiscal framework.

Luke Bartholomew

So let me draw out there then what seems to me to be a bit of a tension between what Lizzy was saying around the difficulties of implementing these proposals about the need for enhanced enforcement mechanisms, the difficulty of bringing Germany on board with these fiscal reforms to use a phrase that you use, Paul generally seems very much the ‘usual suspects’ in that respect when it comes to resisting changes in European fiscal policy, compared to your point that actually maybe this is a mechanism that can allow for greater harmony and reducing the risk of fiscal ructions. So, what really is the right way of framing this in terms of what it means for European solidarity and the way in which countries relate to each other over fiscal policy?

Paul Diggle

I think the right framing is its progress as it usually occurs in Europe, which is via fits and starts, spurred on by shocks and even crisis and with a lot of tooing and froing and negotiating and compromising along the way. And I think it's yet again, another kind of example of that how policymaking gets done at the supra-European level. And in a sense, how else would it get done in a union of so many countries? So, yep you do have kind of usual ‘holdouts’, to use that term, but Lizzy’s pointed to progress already even marginal progress today, and I think it's our full expectation that a deal on the fiscal framework along the sort of lines of the Commission's plan is done with some concessions, perhaps to Germany, between now and then. And it is progress because it is probably a better-designed fiscal framework. There were plenty of problems with the old one. But yeah, this is what policymaking in Europe looks like. We get to look inside the sausage factory, and there are plenty of negotiations along the way.

Luke Bartholomew

So, I should probably point out that the day that we are recording this on, that we've referred to several times, is the 14th of February. So perhaps there is some sort of Valentine's love between the European countries as they work to resolve some of these issues. But Paul, bringing together some of the points that you were making about perhaps a reduced procyclicality in fiscal policy going forward. And then also the possibility of lower tension between member states and perhaps a bit more flexibility around how they conduct fiscal policy, maybe reducing some of the tension that they have with the European institutions as a whole. What impact do you think those might have on interest rates and risk premia in European markets?

Paul Diggle

Yeah, I think it has two very concrete investment implications or implications for interest rates, which is, I think you should, at the margin, raise the risk-free rate but reduce the risk premia or the spread between European sovereigns in their bond market. So, it should raise the risk-free rate because, in a sense, a more well-designed fiscal framework, a more flexible framework that responds to shocks allows a degree of fiscal easing into downturns should actually help your long-term growth rate and to the extent that's reflected in your risk-free equilibrium interest rate, it should mean a higher risk-free rate. On the other hand, I think it lowers the spread between sovereigns because that spread partly embodies default risk, even you know, the very small probability of exit risk of redenomination risk in the eurozone, much of which stems from differences in fiscal policy and fiscal flare-ups, leading to heightened political rhetoric around exit and so on. I mean, none of which is ever particularly likely, but some tiny risk of it has to be factored into asset prices. And that I think helps explain why there are spreads in the eurozone between member states. And if you're therefore reducing that risk by having a more well-designed fiscal framework, you actually I think, should see some should spread compression. Now, obviously, a lot of other things drive both the risk-free rate and the spreads - all sorts of aspects of long-term growth, inflation, policymaking and politics, but this one, I think, does help anchor those variables in the longer-term and means, as I say, higher risk-free lower spreads.

Luke Bartholomew

Okay, so that is the macroeconomic side of the changes in fiscal policy and what we think they mean for some important market variables. But as I said, there are also some quite important changes in sort of the microeconomics as it were of fiscal policy in Europe. And in particular, the Inflation Reduction Act in the US, which we've talked about on this podcast before, seems to have precipitated among the EU and European countries, the sense that they need to update and reform their own rules about state aid and competition. So, Lizzy, maybe a good place to start is just by explaining why it is that Europe does feel that it needs to respond in some way to the inflation Reduction Act in the US. And perhaps not only that, it feels it needs to respond, but also that it feels rather aggrieved by how the US went about passing the Inflation Reduction Act. So why is it that Europe does have these bad feelings around the policy?

Lizzy Galbraith

Yeah, I mean, there's definitely an element to which part of the EU's upset over the Inflation Reduction Act is caused by the fact that it just wasn't really notified in advance and it's quite upset that the US didn't feel that it should be kind of involved in decision making of such as sort of a large scale on global industrial policy. They didn't feel like it was a kind of a way that allies should be treated, I guess. So, there is a little bit of a bruised ego element to this, particularly among some of the larger EU countries. Emmanuel Macron has been particularly vocal on his feelings toward the Inflation Reduction Act and I think that's, in part, because France is obviously a very big manufacturer of things like cars that the Inflation Reduction Act seeks to target, but also that it wasn't necessarily the type of relationship that maybe some of the bigger European leaders thought they had with Joe Biden and policymakers in the US. But on a more practical level, what the Inflation Reduction Act does is essentially provide nearly $370 billion worth of tax breaks and subsidies by 2032 to boost green technology and energy security in the US. And the principal concern among European leaders, particularly in France and Germany is that that is going to harm their own manufacturing base, that companies are going to, leave Europe or curtail investment in Europe to take advantage of those tax breaks that they might be able to get in the US for the same manufacturing goods. So, there's, there's been quite a bit of debate in Europe about how to how to respond to the Inflation Reduction Act to essentially protect their manufacturing base, make sure that they're still going to be sort of a big global player in some of these industries going forwards.

Luke Bartholomew

And specifically, what are some of those proposals? And I suppose also, I mean, is there a sense in which those proposals run counter to some of Europe's previous thinking around state aid and the way in which individual nation-states should respond to these questions?

Lizzy Galbraith

Yeah, there's a really interesting tension within the EU over their response, principally, because quite a big pillar of this is going to be about relaxing state aid, but Europe's in a unique position relative to some of these other countries in that it needs to protect the single market at the same time. And that's where a lot of this debate is going to be going forwards. So, Europe's response is called the Green Deal Industrial Plan and there are four main pillars to it. Part of it is about regulatory reform. So essentially protecting the integrity of the single market by just making it quite hard for external companies to sell their goods in the EU by introducing very high regulatory barriers that maybe other manufacturing countries don't have. Another one of these pillars is around funding, which is a bit more contentious among EU member states, particularly around whether or not to borrow to support the industrial plan. And then there are two smaller elements as well which are around increasing skills and shoring up supply chains to make sure that the EU is sourcing raw materials from a diverse range of countries and making sure that it doesn't repeat what happened with commodities and Russia you know making it very dependent on a single source for some of these key goods that it needs to support future growth. The real contention here is essentially around the tension between the relaxation of state aid rules and funding to support smaller member states that maybe can't take as much advantage of relaxed state aid rules. So bigger countries, Germany and France in particular, will be able to benefit quite strongly from relaxed state-aid rules. Smaller countries want funding to help them take advantage of those relaxed state aid rules because they don't have the same fiscal firepower. And the early compromise that we've got here between the member states is that they're going to relax the state aid rules a bit because they don't want to deliver the level of funding that would be necessary for them to relax the state aid rules more and deliver an even more comprehensive response. And this is principally down to Germany's opposition to more borrowing. So, what we're getting from the EU is a pretty, a pretty limited initial response to the Inflation Reduction Act. But one that does give individual member states more flexibility to invigorate their own industrial base, and more freedom to dictate their own industrial policy going forwards. And it's likely that we're going to see the debate over whether more funding should be delivered sort of rumble on over the next few years as well. So, it's unlikely that we've seen the end of of Europe’s sort of debate over how to respond to the Inflation Reduction Act.

Luke Bartholomew

Thanks, Lizzie. So, Paul, perhaps as a final thought then, we've talked a lot on this podcast before about deglobalization, offshoring of production, possibility or trade wars running across various different axes and across different countries, the importance of industrial policy around the green transition. So, in the context of all those kind of big picture themes, what is the right way do you think of framing what's going on around the IRA, the Inflation Reduction Act and Europe's response to it?

Paul Diggle

Well, I think it's rightly seen as embodying some of those key themes, Luke. So, the first would be the changing nature of globalisation. And in particular, the growing focus on securing strategic industries, and ensuring the security and resilience of the supply chains around those key strategic industries. And I think the key point here is that green technology and all of the technologies involved in the energy transition are precisely one of those strategic industries. And the US with its Inflation Reduction Act, the EU with its response, is doing what it can, using the power of the state, to encourage those industries domestically. I think that's what the IRA is. I think that is what relaxing the state aid rules in Europe are as well. That's the key point number one. The second one, I think is that conflict in the global trade arena doesn't just happen on the familiar US-China axis. It can also to a lesser extent, and with perhaps bigger guard rails. occur on the US-EU axis as well. I think that the EU’s peaked response to the IRA tells you that it's seen in Europe as being a potential overstepping of how the global trading system should work. Now, obviously, Europe's responses Lizzie's articulated have been measured. But you know, early on there was kind of perhaps loose talk of a growing subsidy war between the US and the EU. So that's the second one. And the third key takeaway for me is that onshoring reshoring, securing strategic industry is knowing that you have the security of supply chains, for you know, whether it be things evolved in military production, but also in green production. They are obviously unwinding some of the gains from trade that occurred during the hyper globalisation period of the 90s and early 2000s. And there's obviously a vast economic literature on gains from trade, you know, having very long complicated supply chains delivers efficiencies. That's why those things developed. You're kind of trading off that you're losing those efficiencies, but what you're gaining on the other hand might be resilience and security of supply - issues that we know can be threatened during global pandemics or wars when the fact that you're reliant on certain external suppliers for key goods can become a real problem. So, you're trading off I think, efficiency and resilience. Or put another way, you might be trading off, the expected outcome in any single year for growth might be lower. But because you're perhaps reducing some tail risks, your vulnerability to shocks, your expected outcome over a whole range of years could be higher, because you don't suffer the very negative outcomes during big negative economic shocks because you've built in this degree of resilience. So, I think it's an important evolution - we had previously had gains from trade - now we have the focus on resilience and securing strategic industries.

Luke Bartholomew

Thanks, Paul. Well with that very philosophical, anti-fragile style point there we will leave it for this week. Please do join us next time when we will be discussing monetary policy in Japan in the light of the new governor. But in the meantime, all that remains is for me, to remind you all to please do subscribe, and reviewer us on your podcast platform of choice, to thank Lizzy and Paul for their excellent contributions, and to thank you for listening. So, thanks very much and speak again soon.

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