Europe’s Budget Revolution – From Covid-19 Recession to Progressive Reconstruction

The 2020 coronavirus crisis has pushed the European Union to a critical level of innovation regarding its fiscal capacity. The dogma of keeping the EU budget at around one per cent of the Gross National Income (GNI) and balancing it every year evaporated within a space of a few months. Notwithstanding some initial hesitation, the counter-cyclical response on the part of the European Central Bank (ECB) was swift and decisive, especially compared to the previous crisis. On the other hand, the recession has reignited the debate around the economic architecture of the European Union (EU), with a focus, once again, on the possibility of common fiscal capacity. In May 2020, the Commission put forward an ambitious, almost revolutionary, two-tier proposal, that was, after modifications, adopted by the heads of state and government in July 2020.

New spending instruments for a post-Covid recovery

After discussing the subject in a marathon 100-hour-long session, the European Council decided to create an effective fiscal capacity to confront the recession triggered by the Covid-19 pandemic. The main products are the newly conceived anti-crisis fund (Next Generation EU – NGEU), and the seven-year EU budget (Multiannual Financial Framework – MFF), under which the former is subsumed.This new direction is not only diametrically opposed to the macroeconomic framework of the 2010-2012 period, but also breaks decisively with the endemic prevarications so typical of the Juncker period.

Ever since Jean-Claude Juncker and his budget Commissioner Günther Oettinger put forward the new draft MFF, the debate has been overshadowed by the repercussions of Brexit, and the resistance of various groups of countries to changes in the EU budget, either in qualitative or quantitative terms. In February 2020, the European Council came close to adopting a watered-down version of an unambitious blueprint. Covid-19 has not changed everything, but it has resulted in a tidal change on some most critical aspects of EU fiscal doctrine.

Once it was understood that to eliminate the coronavirus, many economic and social activities had to be brought to a halt, public attention shifted to rapidly rising unemployment as one of the highest risk factors. Suddenly, a statement made by Richard Nixon 50 years ago could not have appeared more apt: “we are all Keynesians now”. Looking at the 2020 crisis response, one is struck by a significant, if not compelling, contrast between the austerity focus guiding the response to the previous Eurozone crisis and, this time around, a willingness to engage in counter-cyclical policies like job-safeguarding and income-protection to counter the ongoing recession triggered by coronavirus.

How to finance the recovery has been one of the pivotal questions since the beginning of the "Great Lockdown" in March 2020. Though Europe again appeared divided on the question of solidarity, the debate quickly took on a new dimension thanks to the proposed 80 per cent increase in the overall fiscal capacity of the EU, the creation of a counter-cyclical stabilisation function, and the possibility of financing transfers from jointly issued debt.

Importantly, the EU-level response to the labour market crisis emerged even earlier than the budgetary initiative. Already in March 2020, the Commission put forward a proposal for the creation of a European instrument to provide temporary support to mitigate the risk of unemployment in an emergency or, as it is referred to in short, SURE. Even if this initiative fell short of instituting general unemployment insurance (or at least reinsurance), it has created an effective tool to support short-time work (STW or Kurzarbeit) schemes in EU Member States.

But it is the scale, mission and functioning of Next Generation EU which constitute a major breakthrough here. For the first time in its history, the EU will be borrowing from capital markets to finance expenditures throughout the Union. NGEU is organised under three chapters: Supporting Member States in their recovery efforts, kick-starting the economy while encouraging private investment, and learning the lessons from the crisis(the latter includes inter alia a new health programme). In terms of sheer scale, the most significant component of the package is the Recovery and Resilience Facility (RRF), which furnishes large-scale financial support (up to 310 billion euros in grants and up to 250 billion euros in loans) to facilitate both public investment and reforms while laying a focus on green and digital transformation. This is intended to make the EU's national economies more resilient and better prepared for the future.

The politics of a fiscal paradigm shift

Arriving at this juncture has required a sea change in Germany’s approach to the question of Europe. Angela Merkel, who had already been responsible for some major U-turns in domestic German policy (e.g. family policy, nuclear energy policy and immigration policy), subsequently orchestrated yet another volte face that has extraordinary significance for the survival of the European Union. The role of the Social Democratic Party, which once again, after a long break, holds the reigns of the finance portfolio, should not be underestimated, either. Though proceeding cautiously at the beginning, Olaf Scholz first forwarded some new ideas, proposed some new directions and then took action on these, bidding farewell to the era of single-minded German economic policy reduced to the pursuit of fiscal discipline in good times, and austerity (especially vis a vis others) in bad times.

Needless to say, the EU should have embraced much more fiscal risk-sharing back in the previous crisis. But even if the old model was doomed, the conditions for the new one to be born were not yet in place. When the newly elected French President, Emmanuel Macron, then put forward bold ideas to bolster the EU in 2016, Berlin remained stubbornly quiet. But better late than never! Covid-19 triggered the necessary action, helping Germany to become a genuinely unifying force just when the government in Berlin was also assuming the rotating office of presidency of the Council of the European Union, adding a formal leadership role to informal channels of influence.

But a breakthrough in one area does not necessarily mean progress everywhere. Quite the contrary: sometimes there is a price to be paid for a critical advance, and we have seen an example of this here. The European Council was about to include a decision on a serious and effective rule-of-law mechanism as part of the MFF deal, although the language eventually adopted did not go beyond the usual generalities. The main reason for this is that the European Peoples’ Party (EPP) has been unable to sort out its internal divisions on this question. But another reason is that the so-called Frugal Four (the Netherlands, Austria, Sweden and Denmark, with Finland later joining the club to make it the Frugal Five), decided to squander their political capital. Instead of focusing on improving the functioning of the EU budget, they have been all about achieving symbolic victories.

While posing as the voice of reason and prudence, and posturing as the democratic voice championing taxpayers’ interest, the Frugal Group managed to inflict some significant damage on the EU budget, not to mention the Community spirit. Instead of seizing the post-Brexit opportunity to bury the toxic budgetary practice of rebates, the Frugal Five instead sought an increase in these. In the conventional budget (MFF), they weakened the tools that constituted a clear European added-value in the allocation of resources and in the lives of its citizens (e.g. Erasmus, Just Transition). And in the new budget (Next Generation EU), they insisted on reducing the "transfer share" in favour of the "loan share", rendering this tool somewhat less effective in helping those regions suffering most from the recession triggered by the pandemic.

The progressive path towards a sustainable fiscal framework

In sum total, the outcome of the 2020 crisis response is not simply an example of the proverbial step in the right direction. The newly created instruments would appear to have some very important features with the potential to turn the MFF from its head to its feet, to borrow an expression from German philosophy, by assuming a proper stabilisation role at the Community level. In addition to various forms of passive support (e.g. suspending fiscal or competition rules in times of crisis), the EU has now become equipped with new instruments to provide active support.

Though a lot of steps still have to be taken to implement the new recovery instrument and ensure its effectiveness, May 2020 saw a change in sentiment which, if sustained, can turn out to be a game-changer not only in terms of short-term economic recovery, but also with a view to the longer-term reconstruction of the EU. While a delay in disbursement will mean that the new tools can only help ease liquidity bottlenecks at a later stage, the political commitment of EU Member States already helps to diminish the risks of insolvency, and thus the likelihood of disintegration.

This does not mean that there is nothing left to be done. The July 2020 decision is just the beginning of a transformation which could lead to a viable Economic and Monetary Union (EMU) and which would not hinder, and perhaps even facilitate, the rise of a Social Union as well. A few critical steps can be listed already here and now.

1. Consistency between the EU budget and the fiscal rules: It is not enough to create a new model budget. It is also important to revise the fiscal rules of the EMU. This review process was launched by Commissioner Paolo Gentiloni in early 2020, but now it has to catch up and become consistent with the new thinking embodied in Next Generation EU. If the rules of the Stability and Growth Pact (and the so-called "six-pack") are merely suspended to deal with the pandemic, but then subsequently re-introduced unchanged in 2022, we can easily end up just like back in 2011, with premature fiscal consolidation and a self-inflicted recession.
    
2. Creating room for operational improvements: Somebody also needs to address how EU funds operate. Heads of state and government may meet in Brussels for over a hundred hours, but with the discussion perhaps merely revolving around the sizes of various envelops and not even touching on the issue of how funds are disbursed. A lot depends on issues like the latter, however, and a method for carrying through operational reforms needs to be found quickly. In order to minimise the risks of abuse, the Commission ought to play a greater role in the disbursement of both new and old funds, which will require more staff and well-designed, efficient procedures.
    
3. Budget conditionality and protecting the rule-of-law: Rule-of-law conditionality has been discussed time and again, but it never ceases to leave one with the impression of a dead-end debate. Some progress can certainly be made here, but it is essentially wrong to reduce the debate over the integrity of EU funds to a tool that still needs to be invented and is to remain untested for some time. It is equally important to establish a powerful EU prosecutor with broad competences, and break the monopoly of shared management in the area of Cohesion Policy.
    
4. Strengthening the stabilisation function: If crisis-response is to become a more central part of the EU and, more specifically, the MFF, as it indeed should be, more innovation is needed, and it needs to come soon. Unemployment reinsurance is a logical next step for which the policy community is well prepared. Nor would this require extraordinary resources, while it would boost Europe’s safety nets. Maybe this or that actor in Brussels would like to pretend that a box has been ticked off the list by launching SURE, but this is undoubtedly not the case. As unemployment is bound to surge again in the case of a second lock-down, the urgency of such an initiative should be all the more obvious.
    
5. Budget size in a pre-federal Europe: The glass ceiling of one per cent of the Gross National Income (GNI) has been broken through. To find new and more sensible yardsticks for the MFF, it is time to carry out a comprehensive public finance study on the EU, similar to the MacDougall Report, which in 1977 concluded that up to 2-2.5 per cent of Member States' total Gross Domestic Product (GDP) should be centralised already at a pre-federal stage (not counting military expenditures). We need to think outside the box, but remain grounded in sound economic theory.
    

The views expressed in this article are not necessarily those of Friedrich-Ebert-Stiftung.