By Vaibhav Tandon

The economic debate in this election year has centered on the costs of proposed policies.  Politicians have been trying to put the cart before the horse, as they make plans to spend money before being certain that the money will be available.

The debate on this front has been particularly active in Europe, where rules on national budgets underpin the monetary union.  Tensions over how those rules should be applied have simmered frequently since they were first adopted, but they may be on the verge of boiling over.

The first Stability and Growth Pact (SGP) was adopted in 1997. It established caps on annual government deficits and aggregate public debt for countries using the euro.  The Pact has been updated and amended several times, most recently late last year.  We expressed concern about the most recent edition in this January commentary.

The reformed rulebook retains the two goals of maintaining public debt below 60% of gross domestic product (GDP) and deficits below 3% of GDP.  However, it allows a slow but steady pace of deficit and debt reduction over four to seven years, with the longer option available if a country undertakes reforms and investments that are in line with the bloc’s strategic priorities.

The SGP calls for the European Commission (EC) to enforce the standard.  The vehicle through which this is achieved is called an Excessive Deficit Procedure (EDP), which initiates a timetable for countries to get their fiscal positions back within guidelines.

The EC can also levy penalties if a country fails to take corrective action.  This step has never been taken, given the potential for adverse political and economic reactions.

It didn’t take long for the new pact to be put to the test.  The EC recently took the first step towards placing seven countries into an EDP.  Among the seven was France, which drew a lot of attention because of the sheer size of its economy, deficit and debt. 

The EC decided to exempt Spain from the disciplinary step, despite the country exceeding the fiscal limits.  Deficits and debt there are to follow a downward trajectory, as per a recent European Commission forecast, which allowed some lenience.

For France, the announcement couldn’t come at a worse time.  President Emmanuel Macron’s gamble to call snap elections has backfired, pushing the country into a period of uncertainty.  The deeply divided government that will soon be seated has sparked renewed concern about the sustainability of French public finances. 

Public debt in France is projected by the EC to rise from 110% of GDP in 2023 to almost 114% of GDP next year.  In May, global ratings agency S&P downgraded the country’s credit score for the first time since 2013, amid the deteriorating budget position.

The new French assembly will struggle to pass economic and fiscal measures, leading to fiscal slippage relative to prevailing guidance.  Attempts to form a so-called “Rainbow Coalition” of several parties will require significant compromises, mostly on fiscal consolidation. 

Macron is facing calls to roll back the 2023 pension reforms, increase spending on public services, cap the prices of essential goods, and raise the minimum wage.  Proposed increases in taxes for high earners will not be enough to offset the potential increase in expenditures. 

A newly formed government will be tasked not only with implementing the 2024 budget, but it will also have to present a 2025 budget by October to the European Commission.  The outgoing government guided towards reducing the deficit from 5.5% of GDP in 2023 to 5.1% of GDP this year and 4.1% next year, which were necessary to reassure financial markets.

Some would argue that a slower pace of deficit reduction will reduce the drag on growth in France, but it is also worth stressing that an expansionary fiscal policy will raise concerns of sustainability of public debt.  This would cause financial conditions to tighten, thereby weighing on growth. Already, the spread of French bond yields to German bond yields has widened considerably.

The exact size of required fiscal correction for France will be known by the fall when the government prepares next year’s budgets.  A deficit reduction of at least 0.5% of GDP is mandated by the new European fiscal policy.  

Financial market volatility has not raised an alarm at the European Central Bank (ECB) yet.  But a failure to enact the required fiscal measures will render countries in EDP ineligible for the ECB’s emergency bond-buying program – the Transmission Protection Instrument.  This would hinder the central bank’s ability to intervene and prevent further widening of spreads. 

A major dilemma for European governments is that fiscal space is constrained, growth needs a push and the continent is threatened by war on its Eastern border.  Security, energy transition, and technology all require investment.  But there is also no politically easy way to find the fiscal space to address the challenges that Europe faces without triggering financial stability risks. 

The initiation of EDPs will not help Europe unite to confront the economic and geopolitical challenges of the day.  Unfortunately, a mechanism intended to foster growth and stability may produce the opposite outcomes.