N.B.: This article is a guest post originally published in French on Alternatives Economiques: the positions taken are the responsibility of the authors and do not necessarily reflect those of Finance Watch.
The European Commission and EU governments are currently negotiating national budget trajectories for 2025 and beyond. As deemed appropriate by the Eurogroup in July, a restrictive fiscal stance is expected for the eurozone.
Seven countries, accounting for 55% of EU GDP—Belgium, France, Hungary, Italy, Malta, Poland, and Slovakia—are in excessive deficit. According to European fiscal rules, they will have to pursue a restrictive policy. Meanwhile, Germany, constrained by its own constitutional provisions, will at best maintain a neutral if not restrictive fiscal stance.
The grim scenario of the years of under-investment that followed the 2008-2009 crisis should not be repeated. Still today, inflation is close to its 2% target, economic indicators are stagnating or deteriorating, and several sources of uncertainty persist.
France must make 110 billion euros in budget savings, equivalent to over 3% of its GDP, over the next three to ten years. This figure has become a mantra in discussions. The debate continues to revolve around the speed and methods of adjustment, but not on the amount itself. Analysts, including those from the French Council of Economic Analysis, all echo this number.
The European Commission calculates the budgetary effort that Member States are expected to make using a mathematical model outlined in its May 2024 document on public debt sustainability. Economist Dani Rodrik reminded us in his essay, Can We Trust Economists?, that using mathematics and simplifying assumptions is not inherently problematic. However, anyone giving or receiving fiscal policy recommendations must ask themselves about the underlying assumptions.
Essentially, the exercise identifies the budget trajectory that will bring the public deficit below the 3% of GDP limit within a certain timeframe and guide debt toward the 60% limit. To clarify, the fiscal multiplier represents the ratio between the change in public spending and GDP. For example, a multiplier of 0.75 means that by reducing public spending by 1 point of GDP, GDP would shrink by 0.75 points of GDP. This means that the annual improvement in the fiscal balance and net spending (excluding new tax measures) will have to stay within a narrow corridor.
But let’s not dwell on the lack of foundation and opportunistic origin of these two figures, carved into the marble of the EU Treaty despite this poor assessment. Instead, let’s examine the assumptions at the heart of the model used by the European Commission.
A forecasting model based on very simplistic assumptions
One critical assumption concerns the projection of GDP. The gap between GDP growth and interest rates determines the dynamics of the debt ratio. To calculate long-term GDP, the Commission’s model is based on Robert Solow’s 1956 model, which itself relies on an empirical relationship between labour, investment, and growth, formalised by economists Charles Cobb and Paul Douglas in 1928. This model helps estimate a “potential” GDP that actual GDP will likely approach over time.
In practice, determining this long-term potential GDP depends on the projections of hours worked and the estimation of future productivity gains, which are based solely on past trends. This is a very reductive assumption, especially since it ignores the role of public policy (except those related to labour market reforms).
In the short and medium term, GDP is assumed to react within a year to changes in the budget balance. Since the Commission uses a budget multiplier of 0.75, it means that a 1% reduction in public spending is expected to shrink GDP by 0.75%. But automatic stabilisers, like social benefits and other public expenditures that rise during economic downturns, are assumed to close any gap between actual GDP and potential GDP caused by public spending cuts within three years.
The European Budgetary Committee, in its assessment of the new Stability Pact rules applicable from April 2024, concludes that in the absence of shocks other than moderate, demand shocks, compliance with the new rules will put fiscal stabilisation on ‘autopilot’ which should benefit all countries. But this reasoning will hold only if there are no supply shocks and if the model accurately reflects real interactions within the economic system.
Already, doubts surround the assumptions for the short and medium term. Estimates of fiscal multipliers are generally higher than the figure used by the Commission and vary between countries. Furthermore, the assumption that this impact will dissipate in just three years across all countries is debatable.
Finally, the rules are applied as though each country operates in isolation. But in a monetary union, adherence to restrictive budgetary trajectories has different impacts depending on whether it affects several large countries (whose economies are deeply interdependent), or just one. Recent research shows how the same policy leads to different budget balance and debt trajectories depending on these assumptions.
Essential Investments for the ecological transition are being neglected
Even more concerning is the assumption that the structure of the productive system remains stable in the long term. The European Commission’s model to project long-term GDP does not account for the direct impacts of climate change nor the policies and investments implemented for mitigation and adaptation. It not only ignores energy as a critical factor in production, but also overlooks other European objectives and challenges, such as deindustrialisation and digitalisation.
In fact, a strategy of massive investment in the reindustrialisation of Europe, as proposed in the Draghi report, would not be feasible under this model. A substantial increase in investment and accelerated productivity gains cannot be envisioned without an increase in public funding. But such funding could initially worsen the fiscal balance and debt ratio before private investments step in to take over.
A recent European Central Bank (ECB) working paper drawing on endogenous growth models where productivity gains accelerate with investment emphasises the importance of public intervention to achieve these gains.
There is an urgent need to revisit fiscal rules, both in France and at the European level. We must stop viewing this issue solely through the narrow lens of national public debt volumes. A broader perspective that considers the implications of these fiscal rules on investments is needed, particularly those necessary for ecological transition and economic growth. These rules should be reevaluated to better address urgent needs rather than just aiming to reduce debt levels.
The ecological transition urgently requires additional public funding in every country. These investments will yield returns, including reducing the risks and costs of climate change. Trade-offs must be possible between crucial investments for the security of our societies now and in the future, and a smaller improvement—or even short-term deterioration—of the fiscal balance. Otherwise, European economies risk being trapped in chronic under-investment.
At the European level, responsibilities are shared between Member States and EU institutions. In the short term, it is up to the European Commission and Finance Ministers to exercise good judgement and ensure that the first year of the application of new fiscal rules does not lead to a dangerous politics of austerity that is incompatible with the need for increased investments. In the long term, national governments and parliaments must, as the Draghi report suggests, lift their vetoes on joint borrowing to finance European public goods. Our government must have the courage to pursue this debate in Brussels.
This article was written by Ollivier Bodin (Co-founder of Greentervention) and Alain Grandjean (President of The Other Economy).
