Europe’s revamped fiscal rules promise discipline and stability, but Italy’s numbers tell a different story. Once realistic multipliers and hysteresis are built in, consolidation pushes debt up, growth down, and recessionary pressure outwards across the eurozone, hardly a recipe for sustainability.
The new European economic governance framework outlined under the recent reform of the Stability and Growth Pact, on 21 June 2024 had the European Commission transmit to all Member States with public debt exceeding 60% of GDP or a public deficit greater than 3% of GDP a country-specific reference trajectory for net primary expenditure. This trajectory sets, for each year of the adjustment period (lasting four or seven years, as is the case for Italy), a maximum growth rate for net primary expenditure, and its purpose is to reduce the structural primary deficit[1] by an amount determined by the Commission on the basis of its Debt Sustainability Analysis (DSA). According to the Commission’s forecasts, in fact, these adjustments should ensure that, at the end of the adjustment period, the structural primary balance reaches a level which, if maintained over the following ten years, would guarantee the medium- to long-term reduction and sustainability of public debt. In practice, the Commission will monitor the strict compliance of the agreed path of net primary expenditure over the adjustment period. Compliance is assessed solely on the basis of net expenditure developments, together with the overall deficit and debt ceilings.
Under the previous rules of the Stability and Growth Pact, instead, the fiscal stance of Member States was assessed mainly through the structural balance, that is, the cyclically adjusted budget balance net of one-off measures. The Commission monitored the annual improvement in this indicator, which had to amount to at least 0.5 percentage points of GDP per year until the medium-term objective was reached. This approach relied heavily on the estimation of potential output and the output gap, both of which are unobservable and subject to large revisions.
The 2024 reform was widely expected to mark a significant change — allowing for more room for public investment and a lesser emphasis on austerity. However, many of the expectations have been disappointed. Although the reform replaces the monitoring of the structural balance with that of net primary expenditure, the estimation of potential GDP continues to play a crucial role, since it underlies the definition of the expenditure trajectory itself. In practice, this trajectory is designed so that the growth rate of net expenditure remains below the projected growth of potential GDP, thereby ensuring a gradual decline in the debt-to-GDP ratio over the adjustment period.[2]
My new INET working paper adopts a theoretical approach that differs from that of the European Commission and examines the impact of the fiscal consolidations required by the reference trajectory on Italy’s debt-to-GDP ratio — a trajectory designed to place this ratio on a plausibly downward path. Using the Commission’s own Debt Sustainability Analysis for Italy as a baseline, it builds a simple debt-dynamics model with fiscal multipliers, tax-revenue feedbacks and interest-rate effects, and asks under what conditions consolidation actually pushes the debt ratio up instead of down.
The Commission’s forecasts rest on a fundamental assumption, common to all countries, which, if removed, would yield markedly different outcomes. This assumption is that the output gap will close in the third year following the end of the adjustment period. In other words, while the Commission acknowledges a (moderate) negative impact of fiscal tightening on GDP performance, it assumes this effect to be temporary. Consequently, after three years the GDP growth trajectory is expected to return to its potential path, determined solely by the availability of labor, capital, and productivity, under the assumption that these supply-side factors are unaffected by fiscal policy. In previous exercises, the Commission typically assumed that the output gap would close within five — rather than three — years. The shortening of this horizon to three years is a change for which no justification is provided in the official documents.[3]
In this paper we rely on the Commission’s estimates and forecasts for Italy pertaining to the reference trajectory communicated in June 2024.[4] These scenarios have since been superseded by the national medium-term fiscal-structural plans submitted by Member States. However, the aim of the analysis presented in this working paper is to highlight the conceptual implications of the Commission’s methodological framework.
We find that in fact, if one rejects the assumption that actual output tends to converge towards its potential level and instead assumes that a fiscal tightening can have persistent effects, the restrictive policies implied by the new governance framework would slow growth and undermine the sustainability of public debt. This would, in turn, lead to further tightening measures, additional depressive effects, and so on. Moreover, the fact that a large share of Euro Area economies would simultaneously be forced to implement austerity measures could amplify the recessionary effects: given the Euro Area’s high degree of trade integration, simultaneous reductions in demand would generate significant negative spillover effects among member states.[5] These effects would add to, and could be exacerbated by, protectionist measures implemented by the United States. Furthermore, slower growth could undermine financial market confidence, making public debt even less sustainable.[6]
In other words, once we abandon the comforting fiction that output automatically returns to “potential,” the new fiscal framework looks less like a path to sustainability and more like a mechanism for locking Italy, and much of the euro area, into a self-defeating cycle of austerity, weak growth and rising debt.
Notes
[1] The structural primary deficit is the government budget deficit net of interest payments on public debt, cyclically adjusted to remove the effects of temporary economic fluctuations and one-off fiscal measures. It is intended to capture the underlying fiscal position of a country, excluding both cyclical and transitory components. However, this indicator is unobservable and relies on estimates of potential output and of the output gap that are highly uncertain and subject to large ex-post revisions. These methodological limits have been widely discussed in the literature and acknowledged by the European Commission itself (see European Commission, Communication on orientations for a reform of the EU economic governance framework, COM(2022) 583 final, November 2022). See footnote 14 below for the definition of the (non-structural) primary balance.
[2] For further discussion of the new EU fiscal rules, see Schuberth, H. (2024), ‘The European Union’s New Risk-Based Framework for Fiscal Rules – Overly Complex, Opaque and Self-Defeating’, Institute for New Economic Thinking.
[3] See Heimberger, P., Welslau, L., Schütz, B., Gechert, S., Guarascio, D., Zezza, F. (2024), “Debt Sustainability Analysis in Reformed EU Fiscal Rules”, Intereconomics, 59(5), p. 278.
[4] Commission prior guidance calculation sheet – Italy, 21 giugno 2024 (https://economy-finance.ec.eur… ).
[5] Blanchard, O. J., Leandro, A., Zettelmeyer, J. (2021), ‘Redesigning EU fiscal rules: from rules to standards’, Economic Policy, 36(106), p. 209; Heimberger, P. (2023), ‘Debt sustainability analysis as an anchor in EU fiscal rules. An assessment of the European Commission’s reform orientations, in-depth analysis requested by the ECON committee of the European Parliament’, p. 10.
[6] Cottarelli, C., Jaramillo, L. (2012), ‘Walking Hand in Hand: Fiscal Policy and Growth in Advanced Economies’, IMF Working Paper WP/12/137, p. 6.
