If constrained by EU rules, fiscal policymakers will cut or postpone public investment. This seemingly obvious point came up regularly in the policy debate around the latest reform of the EU fiscal framework. This column argues that the reality is more complex. Governments lamenting a stifling effect of fiscal rules on public investment are often those that have a poor compliance record and, as a result, high debt. They tend to deviate from rules not to increase public investment but to raise other expenditure items.
During the long and difficult debate preceding the latest reform of the EU’s fiscal governance framework, two camps clashed over what fiscal rules do to public investment. One side insisted on the seemingly obvious notion that legal constraints on fiscal policy will inevitably hold back public investment needed to address old and new policy challenges. Others upheld the equally obvious but less popular view that compliance with EU fiscal rules creates the fiscal space for public investment. To put it more vividly: is public investment the victim of fiscal rules or simply an orphan of politics? Drawing on the latest update of the European Fiscal Board Secretariat’s Compliance Tracker, our analysis supports the latter.
Let’s start with some facts. Governments do not have to balance their budgets every year; they can and do raise debt ideally on the grounds that future generations will benefit from today’s spending decisions, notably when new debt is incurred to finance public investment. In the EU, national governments may also expect help from other parts of the Union through commonly agreed spending programmes.
However – and this is equally plain – in the long run public finances need to be sustainable and fiscal policymakers, like all economic actors, face trade-offs, especially although not exclusively when debt levels are already high. Fiscal rules, such as the EU’s Stability and Growth Pact (SGP), encompass arrangements intent on keeping public finances on a sustainable path. Short of more radical and painful solutions such as a debt restructuring or monetising government debt, fiscal rules are ultimately meant to remind policymakers that choices need to be made before tail events impose them.
Governments face trade-offs with or without fiscal rules
From a bird’s-eye view, one trade-off stands out in the composition of government budgets: social spending versus public investment. In the euro area, national governments currently spend around 30% of GDP on social objectives, 1 up by close to 2 percentage points compared to the mid-1990s. In the same period, when government gross debt increased by nearly 20% of GDP, public investment – measured as general government gross fixed capital formation – fluctuated between on average 2¾% and 3¾% of GDP. In a nutshell, euro area governments incurred a substantial amount of new debt, to be shouldered by future generations, mainly to pursue social policy objectives.
To be clear, social policy is an essential ambition of all advanced societies. Depending on the prevailing political ideology, it can absorb a larger or lower share of total government expenditure. Those who see public investment as a victim of fiscal rules tend to blank out policy trade-offs. They implicitly assume that social or other types of current expenditure are a given. If one buys this argument, any fiscal rule, if followed, must inevitably weigh on public investment. However, theory and data tell a different story. Governments don’t have unlimited pockets and when bond yields increase on the back of growing debt-to-GDP ratios something must give, rules or not. Which type of expenditure will then be cut is a political choice, and governments may – for good or other reasons – have a preference for keeping social spending untouched.
In a new study, we take a closer look at the interplay between public investment and EU fiscal rules (Larch and van der Wielen 2024). Compared to the existing literature, we present two important extensions. First, we cover a longer time period (1998–2023), which encompasses the full history of SGP implementation and a particularly pronounced and telling economic cycle – the one around the global financial crisis of 2008/09. Second, we explicitly account for compliance with EU fiscal rules as opposed to their mere presence. Compliance is crucial because having rules in place does not necessarily mean governments follow them all the time – on the contrary. This transpires very clearly from the Compliance Tracker of the EFB Secretariat, which was recently updated to include 2023, the last complete annual surveillance cycle in the EU. The tracker documents stark cross-country differences in the capacity or proclivity to meet the constraints on budgetary aggregates implied the EU rules.
While our study draws on inferential, multivariate statistical methods, our main findings can be illustrated with a simple set of graphs. In essence, social expenditure and public investment tend to follow a largely specular path. In the boom years prior to the global economic and financial crisis, social spending declined both as a share of GDP and total government expenditure, and the additional budgetary leeway was inter alia used to increase public investment (Figures 1 and 2). Countries with higher levels of debt typically recorded lower shares of public investment and higher shares of social expenditure (Figure 3 and 4).
Expenditure paths reversed quickly after the crisis. Most, if not all, euro and non-euro area countries saw their social expenditure rise on the back of growing unemployment and new support measures. At the same time, public investment was cut or grew less. Of particular note, between 2008 and 2019 there was a clear negative correlation between the change in social expenditure on the one hand and public investment on the other: countries with a larger increase in social expenditure recorded higher cuts in public investment (Figure 6).
The role of fiscal space, including the one played by fiscal rule compliance, emerges very clearly from our regression analysis. For purely illustrative purposes, in this short piece we limit ourselves to a simple analysis of variance that checks for significant differences in means across groups (Table1). 2 Countries that entered the crisis with higher levels of government debt spent less on public investment to start with and afforded significantly lower increases in total expenditure in the wake of the crisis including the subsequent recovery. Moreover, additional spending was mostly used to support social objectives, with low-debt countries also recording a higher average increase in public investment. A similar although somewhat nuanced result emerges when differentiating countries by their degree of compliance with EU fiscal rules: higher compliance in the years prior to the crisis is associated with higher total spending growth after, in particular social spending. There are no significant differences in public investment growth.
Notes: GFCF – general government gross-fixed capital formation (public investment). Compliance: relative share between 0 and 1.
Source: European Commission
Table 1 Analysis of variance: Capital and social expenditure by government debt levels and compliance, EU as a whole
Source: European Commission and authors’ calculations
Policy conclusions
Our results do not corroborate the narrative whereby fiscal rules stifle public investment. On the contrary, they confirm and extend the literature on ‘social dominance’ (e.g. Delgado et al. 2020) as well as earlier studies pointing to the dominant effect of fiscal space (e.g. Bacchiocchi et al. 2011).
Regardless of fiscal rules, whenever the opportunity or need arises, policymakers increase or protect social spending. Fiscal rules are arrangements aimed to prevent fiscal policymakers from actually testing the limits of sustainability. In practice, it is difficult if not impossible to know where those limits are, and fiscal rules can be understood as prudent lines placed at a hopefully sufficient distance from the cliff. Countries that stay behind or on those lines will typically have enough space to react to downturns or to new challenges. By contrast, those who consistently deviate from agreed rules will sooner or later trigger concerns in financial markets and face more or less urgent consolidation needs. 3
Those who still insist that public investment is held back by EU fiscal rules either reject the notion that governments face constraints (which would go against core principles of economics and the history of economic systems) or deliberately accept brinkmanship. Ironically, the idea that EU rules stifle public investment typically comes from countries with high government debt, that is, countries with a time-tested history of not following commonly agreed rules and on average lower public investment. In times of crisis, when markets reassess sovereign risks and request higher interest rates to buy their debt, the same countries typically trust in the willingness of the EU to extend help, which in the Union as a whole can only be secured if another part follows the rules, thereby signalling financial markets their capacity to honour new debt going forward.
As long as the political preference prevails, reforms of fiscal rules are unlikely to spur higher public investment while still delivering sustainable public finances. Binding floors of public investment for national governments would be a more promising avenue. To ensure their effectiveness, such floors need to be backed by EU spending programmes. For instance, if an EU member state went below the agreed floor for public investment, disbursement of EU funds allocated to the country would be made conditional on identifying new national investment projects. The EU’s Recovery and Resilience Facility embodies this type of mechanism and should ideally be extended.
Source : VOXeu
