The 2024 reform of the EU fiscal framework makes fiscal adjustment more country-specific and less procyclical. However, it does not eliminate two fundamental tail risks: following a large recession, too little fiscal flexibility can generate deflationary stagnation, while too much can undermine confidence in national debt stabilisation and generate stagflation. This column shows that a Eurobond-financed common fiscal capacity can mitigate both tail risks. Under this proposal, stabilisation of exceptional common shocks is shifted to the euro-area level while responsibility for national debt remains firmly national.
The EU has new fiscal rules. The reform that entered into force in April 2024 centres fiscal surveillance on country-specific medium-term plans and multi-year net expenditure paths. The new rules are designed to be less procyclical: cyclical revenue shortfalls do not require offsetting spending cuts, while cyclical unemployment spending is excluded from the monitored aggregate. The framework also clarifies when general or country-specific escape clauses can permit temporary deviations. Its aim is to steer between two extremes: rules so rigid that they amplify severe downturns and flexibility so broad that it undermines confidence in long-run debt sustainability.
The institutional challenge, however, goes beyond the design of national rules. Escape clauses can create valuable room for stabilisation, but the resulting deficits remain national debt and the framework does not determine how that debt will be stabilised once the crisis has passed. For highly indebted countries, the problem is therefore shifted forwards: whether the fiscal adjustment eventually required will remain economically and politically feasible.
Europe has developed important elements of common crisis support, but none fully resolves this problem by providing a predictable source of common fiscal resources when a large crisis hits the union. NextGenerationEU delivered genuine common resources — grants financed by EU borrowing and repaid through the EU budget rather than by recipient governments — but the Commission designed it as a temporary instrument tied to a single programme, so it cannot provide a predictable response to the next crisis. The European Stability Mechanism is permanent, with €500 billion of lending capacity raised against capital subscribed by euro-area members, and the proposed 2028–34 budget would add an extraordinary crisis instrument of up to almost €400 billion, backed by EU borrowing authorised only for that budget period. Both lend rather than transfer: the principal counts in full towards the borrowing state’s gross debt and remains its liability. For highly indebted countries, common lending eases financing conditions, but it does not remove the debt burden that constrains fiscal space.
The reform is a genuine attempt to make fiscal adjustment less procyclical while tailoring it to each country’s fiscal position and debt-sustainability constraints. But early assessments underline the remaining tension between flexibility and credibility. Hasekamp and Larch (2026) find that fiscal policy in 2024–26 remains frequently procyclical and that formal compliance with the rules need not signal a sound underlying fiscal position. Janeba and Larch (2025) stress that greater reliance on country-specific plans also increases discretion, making outcomes more dependent on governments’ willingness to comply and on consistent enforcement by the Commission and the Council. The fundamental tension therefore remains: too little room for stabilisation can deepen a severe recession, while too much flexibility can undermine confidence that national debts will ultimately be stabilised.
In recent research (Bianchi et al. 2026), we formalise and quantify this tension in an estimated two-country dynamic stochastic general equilibrium (DSGE) model of the euro area. In line with the current framework, fiscal policy remains national while monetary policy is conducted by a common central bank. The model is estimated using French and German data, with France representing euro area high-debt countries and Germany euro area lower-debt countries. We use the model to compare three policy regimes and examine how the same large common contractionary shock propagates under each of them.
The first scenario, Current Framework: Fiscal Discipline, represents the current fiscal framework operating as intended. The large recession allows temporary fiscal flexibility, but once the downturn has passed the high-debt country still undertakes the fiscal adjustment needed to put its debt back on a sustainable path. The blue solid lines in Figure 1 show the economy’s response under this regime when the lower bound binds: the central bank cannot provide enough monetary accommodation to offset the short-run contraction, leaving the high-debt country with especially limited room for stabilisation. The recession is therefore deep and deflationary; output falls sharply, and the debt-to-GDP ratio rises despite the fiscal adjustment. This is the first tail risk: preserving long-run fiscal sustainability when national fiscal space is scarce may lead to slow growth and persistent deflationary pressures, as markets anticipate the consequences of similarly severe downturns and lower inflation expectations today. The resulting combination of a deeper recession and a larger debt burden can, in turn, make the eventual fiscal adjustment increasingly difficult to sustain politically and economically.
The second scenario, Current Framework: Conflict, shows a situation in which fiscal flexibility allows debt in the high-debt country to rise to the point where its commitment to future debt stabilisation is called into question, while the low-debt country remains committed to fiscal discipline. The ECB initially continues to defend price stability, creating a conflict over how debt will eventually be stabilised: inflation versus taxation. The red dashed lines show the resulting vicious circle. Fiscal concerns generate inflationary pressure; the ECB responds by tightening monetary policy; higher rates deepen the recession and worsen debt dynamics, which in turn intensify inflationary pressures. This stepping-on-a-rake scenario may therefore give rise to a stagflationary tail risk.1 Importantly, one high-debt member is enough to expose the entire monetary union to this risk because all members share the same monetary policy.
The third scenario introduces a more pervasive institutional reform, with a centralised fiscal capacity created by issuing Eurobonds. Common debt finances area-wide stabilisation, while national governments continue to stabilise their own debts under existing fiscal rules. There is therefore no need to suspend national rules or invoke escape clauses, thereby avoiding uncertainty about their reinstatement and sparing already strained national budgets from bearing the stabilisation burden. In normal times, Eurobonds are backed by future primary surpluses financed through member-state contributions, so an independent EU taxing power is not essential. In exceptionally severe recessions that can push the economy to the zero lower bound, however, the centralised monetary and fiscal authorities can coordinate to stabilise the resulting increase in debt. The increase in spending in response to the adverse shock is unfunded, meaning that it is not matched by equivalent future taxes or spending cuts. Instead, the ECB accommodates the moderate reflation needed to stabilise this crisis debt while remaining active against inflation arising from other shocks.
The black dashed lines show that this arrangement substantially cushions the fall in output, limits the increase in national debt, and generates enough moderate reflation to help the economy escape the zero lower bound. The key difference is that the additional fiscal space is created at the union level rather than by relaxing national fiscal discipline. This allows the euro area to respond forcefully when national fiscal space is scarce, without forcing highly indebted countries to bear the full stabilisation burden on their own balance sheets after the recession. At the same time, because national governments remain responsible for their own debts, the framework avoids creating pressure for the ECB to eventually accommodate the liabilities of an individual member state. In this way, Eurobonds address both the deflationary and stagflationary tail risks and successfully separate short-run stabilisation from long-run fiscal sustainability.
Figure 1 Propagation of a large common contractionary shock under three model regimes
The graphical analysis above highlights the two tail risks: a deflationary tail when national fiscal space is too limited to stabilise severe recessions, and a stagflationary tail when excessive fiscal flexibility undermines the credibility of debt stabilisation and eventually pressures monetary policy to accommodate. In Bianchi et al. (2026), we use stochastic simulations of the same estimated two-country model to quantify whether — and by how much — an area-wide fiscal capacity backed by Eurobonds mitigates these risks.
Relative to the fiscal-discipline benchmark, introducing Eurobonds reduces the frequency of the zero lower bound from 25.6% to 13.1%, lowers euro-area output volatility from 13.5% to 6.4%, and roughly halves negative output skewness. Average output moves much closer to steady state, while inflation volatility falls slightly rather than rising. The gains extend to both high- and low-debt countries, reflecting stronger stabilisation and smaller cross-border spillovers.
These results illustrate the value of separating short-run stabilisation from long-run fiscal sustainability. A common fiscal capacity reduces the deflationary tail by providing stabilisation when national fiscal space is scarce, without adding to already high national debt. At the same time, because national governments remain responsible for their own liabilities, it limits the risk that fiscal stress in high-debt members ultimately requires ECB accommodation and generates a stagflationary tail for the union.
At the onset of a large area-wide crisis, should the euro area rely on escape clauses that temporarily relax national fiscal rules, or on a centralised fiscal capacity financed by a common asset — Eurobonds? Our results point to the second approach. Apart from replacing escape-clause flexibility for exceptional common shocks, the proposal fits squarely within the new EU fiscal framework: country-specific medium-term plans, expenditure paths, and national responsibility for debt sustainability remain unchanged. What changes is where crisis stabilisation takes place. Rather than placing the burden on national budgets, Eurobonds create fiscal space at the euro-area level.
The proposal is deliberately narrow. Eurobonds could also be issued in normal times to finance large common European programmes and, in that case, be fully backed by future fiscal contributions. Whether Europe chooses to use them for such purposes is immaterial to the mechanism studied here. What matters is that, in exceptional area-wide recessions, a common fiscal capacity separates short-run stabilisation from long-run fiscal sustainability, while responsibility for national debt remains firmly national.
Source : VOXeu
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