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11. The longer-term fiscal challenges facing the European Union

Author:
Jeromin Zettelmeyer, Gregory Claeys, Zsolt Darvas, Lennard Welslau, and Stavros Zenios
Publication Date:
04-2023
Content Type:
Policy Brief
Institution:
Bruegel
Abstract:
The pandemic and subsequent price shocks triggered by Russia’s invasion of Ukraine, have increased longer-term fiscal pressures in the European Union through higher debt, higher expected real interest rates and higher public investment needs. This Policy Brief makes some simple quantitative assessments of those effects and discusses policy implications, with the following results. First, long-term increases in primary fiscal balances required to offset higher debt and higher expected real interest rates are in the range of 0.5 percent to 1.5 percent of GDP for most EU countries. However, because of pre-existing differences in fiscal space, not all countries will need to undertake that adjustment, while some countries may need to adjust by substantially more. Among the 21 EU countries for which we have data to undertake this analysis, 14 will need to adjust by more than they were planning to do by 2025. Second, the required additional fiscal adjustment looks manageable, although it is substantial in some cases. To achieve medium-term debt-reducing primary balances, several EU countries will need to raise primary balances by more than 2 percent of GDP above their 2025 target, but no country will need additional fiscal adjustment of more than 3 percent of GDP. Third, market data suggests that the future path of real interest rates is very uncertain. Compared to the period immediately preceding the pandemic, longer-term expected real interest rates have increased by about 2 percentage points but remain low on average, at about 1 percent in real terms. Future developments depend on whether the structural factors that led to low interest rates in the first place persist or unwind. While interest rates might decline again, fiscal policymakers should not make plans that assume such a decline. Fourth, public spending needs for additional defence and climate spending run well above 1 percent of GDP per year. These needs do not appear to have been incorporated into current fiscal baselines, and hence will come on top of the adjustment described above. To ensure that fiscal adjustment does not defeat its purpose by slowing growth, it is essential that it is conducted gradually. In countries that require such adjustment, it should start as soon as cyclical conditions allow.
Topic:
Governance, European Union, Finance, and Fiscal Policy
Political Geography:
Europe

12. How Europe should answer the US Inflation Reduction Act

Author:
David Kleimann, Niclas Poitiers, André Sapir, Simone Tagliapietra, Nicolas Veron, Reinhilde Veugelers, and Jeromin Zettelmeyer
Publication Date:
02-2023
Content Type:
Policy Brief
Institution:
Bruegel
Abstract:
The 2022 United States Inflation Reduction Act (IRA) is a significant and welcome climate law. It also includes trade-distortive subsidies, including local-content requirements prohibited under World Trade Organisation rules – the first time the US has done this and a blow to the international trading system that could trigger protectionism in other countries. The expected IRA green subsidies are of similar size to those available in the European Union, except in renewable energy production, where EU subsidies remain far larger. However, there are important qualitative differences. Some IRA subsidies discriminate against foreign producers while EU subsidies do not. IRA clean-tech subsidies are simpler and less fragmented, and they focus mainly on mass deployment of green technologies rather than innovation. The IRA will likely harm Europe through its competitiveness effect, while it will likely benefit climate transition in Europe and most of the rest of the world. However, the magnitude of both effects is very uncertain, partly because the IRA will induce substitution away from Chinese inputs. By forcing the reorganisation of supply chains, the IRA may make the EU and other economies more competitive relative to China. It may also initially slow the green transition. But in the longer run, this effect should be outweighed by the reduction in the cost of clean tech driven by the IRA. In responding to the IRA, the EU should not just seek to protect its competitiveness relative to the US but to pursue broader aims, including competitiveness in general, speedy decarbonisation and broad foreign policy and development policy goals. These aims imply that the EU should not impose local-content requirements of its own, should not loosen state-aid rules and should not mimic the IRA’s approach to manufacturing subsidies. Rather, it should focus on boosting its structural competitiveness, formulate a trade policy response that includes reform of the international subsidies regime, and develop an instrument for EU-level subsidies that focuses on early-stage development and increasing EU resilience to trade disruptions.
Topic:
Governance, European Union, Inflation, and Trade
Political Geography:
Europe

13. A quantitative evaluation of the European Commission’s fiscal governance proposal

Author:
Zsolt Darvas, Lennard Welslau, and Jeromin Zettelmeyer
Publication Date:
09-2023
Content Type:
Working Paper
Institution:
Bruegel
Abstract:
In the new European Union fiscal framework proposed by the European Commission in April 2023, medium-term fiscal adjustment requirements would be determined by country-by-country debt sustainability analysis (DSA), the 3 percent deficit ceiling and simple rules requiring minimum deficit and debt adjustments (‘safeguards’). These elements are controversial, with some EU countries (and ourselves) preferring a DSA-based approach, while others prefer to stick to simple rules. This paper evaluates the proposal by replicating the DSA methodology and computing fiscal adjustment implications for all EU countries with debt above 60 percent or deficits above 3 percent of GDP. We find that the proposed framework would require ambitious fiscal adjustment: on average, more than 2 percent of GDP over the medium term, in addition to the adjustment that is already planned for 2023-24. However, for most high-debt countries, these requirements are below those implied by the current framework. We also find that for most countries with debt above 60 percent of GDP, these adjustment requirements are driven by the DSA rather than the safeguards, but with significant exceptions. The main exception is France, for which the ‘debt safeguard’ – which requires debt to fall within four years – imposes much higher fiscal adjustment than the DSA. If the adjustment period were to be extended from four to seven years (as is possible under the framework for countries that submit growth-enhancing reform and investment plans), the safeguards would also be binding for several other countries. In addition, a requirement to reduce the deficit by at least half a percent per year if it exceeds 3 percent of GDP could become binding ex post, in response to output shocks, even if countries implement the fiscal adjustment required ex ante. Finally, we find that while the Commission’s DSA methodology is reasonable, it would benefit from review. This should be done by an independent expert group in consultation with the Commission, member states and other stakeholders, and endorsed by the Council. We recommend the endorsement of the Commission’s proposal after ambiguous aspects are clarified, the debt safeguard and other safeguards are removed or modified, the excessive deficit procedure is reformed to avoid procyclical adjustment, and a process for reviewing the DSA methodology is put in place.
Topic:
Governance, Regulation, Fiscal Policy, and European Commission
Political Geography:
Europe

14. Completing Europe’s banking union: economic requirements and legal conditions

Author:
Thorsten Beck, Jan Pieter Krahnen, Philippe Martin, Franz Mayer, Jean Pisani-Ferry, Tobias Tröger, Beatrice di Mauro, Nicolas Veron, and Jeromin Zettelmeyer
Publication Date:
11-2022
Content Type:
Policy Brief
Institution:
Bruegel
Abstract:
The European Union’s banking union project started in mid-2012 in response to the euro-area crisis, with the goal of breaking the bank-sovereign vicious circle. The objective was also to restore private liability in banking and to move towards an integrated supranational market for banking services. For all the progress achieved in the past decade, particularly in banking supervision, these aims have not yet been accomplished. This Policy Contribution analyses the deficiencies of the current framework and identifies possible responses, in line with three levels of reform ambition. We label these ‘incremental’ (broadening the scope for private-sector burden-sharing in future cases of bank failures), ‘real’ (effectively breaking the bank-sovereign vicious circle), and ‘cosmic’ (a single, seamlessly integrated banking market). European policymakers should set their sights on the second level, which we view as achievable within the current decade, requiring new EU legislation but no change to the European treaties.
Topic:
Regulation, Economy, Crisis Management, European Central Bank, and Banking
Political Geography:
Europe

15. An assessment of Europe’s options for addressing the crisis in energy markets

Author:
Conall Heussaff, Simone Tagliapietra, Georg Zachmann, and Jeromin Zettelmeyer
Publication Date:
09-2022
Content Type:
Policy Brief
Institution:
Bruegel
Abstract:
Since Russia’s invasion of Ukraine, wholesale prices for electricity and gas in the European Union have risen five to fifteen-fold, with severe impacts for households and businesses. The crisis is also creating liquidity problems for energy companies, with contagion risks for the financial sector. In response, European governments have taken a range of actions. Some have introduced measures at retail level, while others have introduced windfall-profit taxes on energy companies. Some countries have provided emergency liquidity to energy companies facing soaring collateral costs. Some energy companies have even been nationalised. Emergency-intervention proposals should be evaluated against three principles. First, energy supply must meet demand at prices that do not cause major damage to the European economy. Second, the most vulnerable consumers must be protected. Third, measures should be consistent with the case for investment in a sustainable energy system, in order to safeguard Europe’s ability to decouple structurally from fossil-fuel imports. Gas price caps have been proposed as an emergency measure in different forms: a cap on Russian gas only, a cap on gas used in electricity generation, a cap on all wholesale gas. All entail significant risks. The first might lead to a full stop of Russian gas into the EU. The second might increase gas demand from the electricity sector. The third might raise gas demand and also undermine Europe’s ability to attract much-needed gas supplies. Instead of capping gas prices, the EU should engage collectively with external gas suppliers and negotiate new long-term contracts with provisions to limit price volatility. A September 2022 European Commission proposal involving electricity demand reduction, a revenue cap on inframarginal generation, solidarity payments from fossil-fuel companies and consumer support measures, is broadly positive, notably because it emphasises demand reduction. However, it is not sufficient. A more comprehensive plan needs to ensure that all countries bring forward every available supply-side flexibility, make real efforts to reduce gas and electricity demand, keep their energy markets open and pool demand to get a better deal from external gas suppliers. In the longer term, measures to split the markets for energy generated from renewables and fossil fuels should be examined.
Topic:
Markets, European Union, Energy Sector, and Green Economy
Political Geography:
Europe

16. Redesigning EU fiscal rules: From rules to standards

Author:
Olivier Blanchard, Alvaro Leandro, and Jeromin Zettelmeyer
Publication Date:
02-2021
Content Type:
Working Paper
Institution:
Peterson Institute for International Economics (PIIE)
Abstract:
The European Union’s fiscal rules have been suspended until at least the end of 2021. When they are reinstated, they will need to be modified, if only because of the high levels of debt. Proposals have been made—and more are to come—suggesting various changes and simplifications. Blanchard, Leandro, and Zettelmeyer take a step back and discuss how one should think about debt sustainability in the current and likely future EU economic environment. They argue that, given the complexity of the answer, it is an illusion to think that EU fiscal rules can be simple. But it is also an illusion to think that they can ever be complex enough to accommodate most relevant contingencies. Instead, the authors propose abandoning fiscal rules in favor of fiscal standards, i.e., qualitative prescriptions that leave room for judgment together with a process to decide whether the standards are met. Central to this process would be country-specific assessments using stochastic debt sustainability analysis, led by national independent fiscal councils and/or the European Commission. Disputes between member states and the European Commission on application of the standards should preferably be adjudicated by an independent institution, such as the European Court of Justice (or a specialized chamber), rather than by the Council of the European Union.
Topic:
European Union, Fiscal Policy, and Deficit
Political Geography:
Europe

17. Creating a Euro Area Safe Asset without Mutualizing Risk (Much)

Author:
Alvaro Leandro and Jeromin Zettelmeyer
Publication Date:
08-2019
Content Type:
Working Paper
Institution:
Peterson Institute for International Economics (PIIE)
Abstract:
This paper explains and evaluates three proposals to create “safe assets” for the euro area based on sovereign bonds, in which sovereign risk is limited through diversification and some form of seniority. These assets would be held by banks and other financial institutions, replacing concentrated exposures to their own sovereigns. The paper focuses on three ideas: (1) to create multitranche “sovereign bond-backed securities” (SBBS), of which the senior tranche would constitute a safe asset; (2) to create a senior, publicly owned financial intermediary that would issue a bond backed by a diversified portfolio of sovereign loans (“E-bonds”); and (3) to issue sovereign bonds in several tranches and induce banks to hold a diversified pool of senior sovereign bonds (“multitranche national bond issuance”). Public attention (including public criticism) has so far focused on the first idea; the other two have not yet been seriously debated. The authors find that none of the competing proposals entirely dominates the others. SBBS do not deserve most of the criticism to which they have been subjected. At the same time, E-bonds and multitranche national bond issuance have several interesting features—including inducing fiscal discipline—and warrant further exploration.
Topic:
Economics, Regional Integration, Risk, and Fiscal Policy
Political Geography:
Europe

18. Creating a Euro Area Safe Asset without Mutualizing Risk (Much)

Author:
Alvaro Leandro and Jeromin Zettelmeyer
Publication Date:
08-2019
Content Type:
Working Paper
Institution:
Peterson Institute for International Economics (PIIE)
Abstract:
This paper explains and evaluates three proposals to create “safe assets” for the euro area based on sovereign bonds, in which sovereign risk is limited through diversification and some form of seniority. These assets would be held by banks and other financial institutions, replacing concentrated exposures to their own sovereigns. The paper focuses on three ideas: (1) to create multitranche “sovereign bond-backed securities” (SBBS), of which the senior tranche would constitute a safe asset; (2) to create a senior, publicly owned financial intermediary that would issue a bond backed by a diversified portfolio of sovereign loans (“E-bonds”); and (3) to issue sovereign bonds in several tranches and induce banks to hold a diversified pool of senior sovereign bonds (“multitranche national bond issuance”). Public attention (including public criticism) has so far focused on the first idea; the other two have not yet been seriously debated. The authors find that none of the competing proposals entirely dominates the others. SBBS do not deserve most of the criticism to which they have been subjected. At the same time, E-bonds and multitranche national bond issuance have several interesting features—including inducing fiscal discipline—and warrant further exploration.
Topic:
Economics, Sovereign Wealth Funds, Banks, and Risk
Political Geography:
Europe and Global Focus

19. The Return of Economic Nationalism in Germany

Author:
Jeromin Zettelmeyer
Publication Date:
03-2019
Content Type:
Policy Brief
Institution:
Peterson Institute for International Economics (PIIE)
Abstract:
ermany’s new National Industrial Strategy 2030, unveiled by Economy Minister Peter Altmaier in February 2019, advocates an aggressive industrial policy. Although it stays clear of the virulent economic nationalism of the 1930s and the protectionism of President Donald Trump, its tone and much of its content are unmistakably nationalist. Zettelmeyer concludes that three of Altmaier’s five proposals—attempting to further raise the German share of manufacturing, restricting non-EU imports of intermediate goods, and promoting national champions in Germany and the European Union—are bad policies. The two remaining ideas—preventing some foreign takeovers and ramping up state support for certain technologies—are somewhat easier to justify, based on either market failures or the risk of technological dependence on foreign companies susceptible to political interference. But even in these areas, the specific policies proposed may well do more harm than good.
Topic:
Economics, Nationalism, European Union, and Donald Trump
Political Geography:
Europe and Germany

20. The Greek Debt Restructuring: An Autopsy

Author:
Jeromin Zettelmeyer, Christoph Trebesch, and Mitu Gulati
Publication Date:
08-2013
Content Type:
Working Paper
Institution:
Peterson Institute for International Economics (PIIE)
Abstract:
The Greek debt restructuring of 2012 stands out in the history of sovereign defaults. It achieved very large debt relief— over 50 percent of 2012 GDP—with minimal financial disruption, using a combination of new legal techniques, exceptionally large cash incentives, and official sector pressure on key creditors. But it did so at a cost. The timing and design of the restructuring left money on the table from the perspective of Greece, created a large risk for European taxpayers, and set precedents—particularly in its very generous treatment of holdout creditors—that are likely to make future debt restructurings in Europe more difficult.
Topic:
Debt, Economics, Monetary Policy, and Financial Crisis
Political Geography:
Europe and Greece