In praise of the EU’s fiscal policy

Let’s face it, we all like to criticise the European Union. It is a slow-moving behemoth with a bloated bureaucracy. But not all is bad with the EU. Because it is such a large entity full of disparate interests, it had to resort to some rules that apply to all member states in order to keep them from engaging in policies that could endanger the entire union. One such example is the stability and growth pact.

This agreement amongst member states says that budget deficits must not exceed 3% of GDP and government debt must not exceed 60% of GDP. In emergency situations, these limits can be broken (and they obviously were during the last two years) but member states that violate these criteria must engage in stability programmes that bring these countries back into compliance within a reasonable time frame. Violations can be fined with a penalty up to 0.5% of GDP.

Now, people have criticised the stability and growth pact a lot over the years and my main problem with it is less the rules but the lack of enforcement of the rules if major EU economies like Germany or France violate them. But that is a criticism of the enforcement, not of the rule. Properly enforced, I think these rules are great. Some countries in Europe like Germany or Switzerland have even gone further and added a “debt brake” to their constitution, forcing governments to have a balanced budget over a cycle.

Now compare this stability and growth pact and the discussion around it with the situation in countries like the United States where no such rules exist. Modern Monetary Theory (MMT) has gained popularity in recent years because it stated that it is possible for a government to have much higher deficits than previously accepted without the threat of currency debasement and inflation. For those who need a short intro to MMT, I have provided one here. Just like Keynesian economics, MMT advocated for large fiscal stimulus during the pandemic to avert a major depression. And I think expanding deficits and engaging in massive fiscal stimulus in 2020 and 2021 was exactly the right thing to do. And no, current inflation is not the result of this fiscal stimulus. It is a result of supply chain disruptions on a global scale including energy shortages that are now filtering through the global economy. But if we continue  to engage in large fiscal stimulus measures now that the economy has recovered from the pandemic, I think we are making the mistake of ignoring history, as I have pointed out in a critical note on MMT here.

All the more worrisome that the New York times has published a major puff piece declaring victory for MMT. This article has been widely and rightfully criticised and I refer readers to two great pieces by Cullen Roche and Noah Smith. In essence, the proponents of MMT are making a similar mistake as politicians did when applying Keynesian economic theories in the 1970s. they are all for expanding spending in a crisis, but nobody seems to be willing to enact higher taxes or fiscal retrenchment when times get better.

And that is the problem with leaving fiscal policy to politicians. Politicians on the left will want to keep spending until – to paraphrase Margret Thatcher – they run out of other people’s money to spend. Politicians on the right will always try to starve the beast of national bureaucracy through spending cuts and tax cuts to the point where their austerity measures hurt the economy much more than the small gains in terms of debt sustainability. I think, both approaches are wrong. Too much austerity hurts the economy as does too much spending. What is needed is a golden middle.

And this is where fixed rules like the stability and growth pact come in. They anchor the discussion not around ideologies or the desire of politicians to please their voters, but around a sensible path that is guided by data not politics or ideology. For EU member states the political discussion of the next couple of years will be around questions whether the deficits or countries like Italy or Spain will be sustainable and how the debt levels of countries like France, Belgium or Italy can be brought back under control. Meanwhile, in the UK or the United States the outcome will likely be excessive austerity if conservative politicians are in power or excessive deficits if progressive politicians are in power. At least when it comes to this topic, I think the EU has the upper hand.