Research Economics

Debt and Spending in Europe After the Pandemic

, by Fabio Todesco
When the COVID crisis is over, returning to the rules of the Stability and Growth Pact would be problematic. With a new paper Francesco Giavazzi, two scholars and an Economic Counselor at the Elysee suggest another way

A reform of the current European fiscal framework, proposed in a paper by Francesco Giavazzi (Bocconi), Veronica Guerrieri (Chicago Booth), Guido Lorenzoni (Northwestern), and Charles-Henri Weymuller (Economic Counselor at the Elysee), could sustain a coherent European strategy to foster durable growth and sustainable public finances when the COVID emergency is over.

The paper has been discussed in a Financial Times op-ed signed by Emmanuel Macron and Mario Draghi.

Following the activation of the general escape clause, the fiscal constraints imposed to EU Member States by the Stability and Growth Pact have been suspended, in order to face the extraordinary, exogenous, and common shock of the COVID-19 pandemic, until the end of 2022. Returning to a strict implementation of the pre-pandemic European fiscal framework in 2023, though, "would require excessive fiscal adjustments, especially for countries with high legacy debt, and would allow limited space for spending on desirable public investment projects and on expenses that contribute to European public goods," Professor Giavazzi and his co-authors write.

"The rules we propose would preserve a primary objective of debt sustainability, but, at the same time, allow for a stronger pro-growth stance, which in the long term contributes to sustainability itself," Professor Giavazzi says.

The two-pronged reform includes:

  1. transferring the portion of national debts accumulated during the pandemic from the balance sheet of the European Central Bank to a European Debt Management Agency;
  2. a revision of the existing fiscal rules based on a medium-term debt anchor with a speed of adjustment that depends on the share of spending devoted to public investment, to European public goods, and to fight recessions.

"A debt assumption plan would consist of a gradual transfer of a portion of national public debts to a European Debt Management Agency. The Agency would receive contributions from national governments to cover future interest payments. The debt would clearly not be eliminated. However, the fact that it will be intermediated by the European Agency will produce a reduction in the debt burden, given that the Agency will be able to issue debt at more favorable conditions than highly indebted countries," the authors write.

According to the plan, the debt assumption would take place over a period of five years, with the Agency acquiring an amount of debt-as a fraction of GDP-equal to 1/5 of the target acquisition each year.

In the case of Italy, for example, the COVID debt accumulated is 19% of GDP. So, the Agency would acquire debt equal to 3.8% of GDP in each year from 2022 to 2026. In the years after the fifth, the Agency would acquire Italian debt so as to keep its debt at 19% of Italian GDP.

Coming to the fiscal rules, the authors propose to set a medium-term debt-to-GDP ratio target which could be achieved using a single instrument: a spending rule that defines a ceiling for the growth rate of primary expenditure net of interest payments, automatic stabilizers, and "spending-for-the-future" items. The authors label as "spending-for-the-future" certain categories of public spending the EU needs to promote, such as public investment that is beneficial for the long-run growth prospects of the country and expenditures that contribute to European public goods that benefit future generations.

As "spending-for-the-future" contributes to national debt anyway, though, the plan also provides a mechanism that changes the speed of future debt adjustments in function of the investments made in the past. Simply put: COVID spending and "spending-for-the-future" would allow for a slower adjustment path towards the debt-to-GDP ratio target.

"The rule is designed to incentivize desirable forms of spending and to promote European cooperation on these objectives, while the debt assumption plan is a natural complement to the new rules, as it gives highly indebted countries a better starting point in their debt-reduction effort," Professor Giavazzi says.

Francesco Giavazzi, Veronica Guerrieri, Guido Lorenzoni, and Charles-Henri Weymuller, "Revising the European Fiscal Framework."