Europe has a plan to avert a sovereign-debt crisis

In recent times, spending due to COVID pandemic and the war in Ukraine pushed debts even higher.

For decades, the European Union has been failing at one of its most fundamental tasks: ensuring that the finances of its member states don’t threaten the viability of the common currency. The longer the dysfunction persists, the greater the chance that rising government debts will trigger a new crisis.

After much delay, EU officials devised an ambitious plan to achieve better discipline. Months of discussion then followed. Europe’s leaders now need to get behind it. The proposal isn’t flawless, but it’s a vast improvement on the status quo.

For all its benefits, the common currency has a critical weakness: If a member state borrows beyond its means, it can disrupt other members’ economies and even undermine the entire union. To prevent this, the EU adopted fiscal rules known as the Stability and Growth Pact. Among other things, member states agreed to keep their budget deficits and sovereign debts below 3 percent and 60 percent of gross domestic product, respectively, and submit to fines if they failed.

It didn’t work. In 2003, Germany and France, Europe’s two largest economies, were among the first to violate the deficit limits. In the early 2010s, extreme debts in some member states — most notably Greece, where government obligations reached more than 180 percent of GDP — triggered a crisis that nearly broke up the euro area.

More recently, spending due to the pandemic and the war in Ukraine pushed debts even higher. Inflation has disguised the scale of the problem by boosting nominal GDP, hence restraining measured debt ratios — but the fiscal prospects are grim. As of the end of 2022, Italy’s obligations stood at about 145 percent of GDP, with no plausible prospect of getting back down to 60 percent at any point in the next couple decades.

The European Commission’s proposed overhaul introduces the needed flexibility, shifting the focus from current-year numbers to the sustainability of debts in the medium term. Where necessary, it requires each country to plan a path to lower debt after a several-year transition period. Failure to comply would trigger politically embarrassing consequences: The finance minister, for example, might have to appear before the European Parliament and offer an explanation.

The proposal isn’t foolproof. It relies on a needlessly opaque measure of adjusted public spending to judge progress toward sustainability. It gives too little weight to the role that national fiscal councils — independent from governments but locally accountable — could play in ensuring political buy-in. Enforcement mechanisms could be improved. Still, by setting credible, achievable goals, and by giving governments the opportunity to take ownership of their plans, the new framework would be a huge improvement over its predecessor.

Unfortunately, its future is still in doubt. The German government, for example, wants a hard rule requiring significant reductions in debt-to-GDP ratios exceeding 60 percent, even during transition periods. This would restore a key defect of the earlier system. Other governments are also voicing doubts and reservations.

The old rules are supposed to come back into effect at the end of this year. If Europe’s leaders can’t reach agreement by then, markets will wonder if they ever will — and the resulting increase in borrowing costs could precipitate the very euro crisis this effort is meant to avert. Europe’s governments should sign up without further delay.

Views are personal and do not represent the stand of this publication.

Credit: Bloomberg