Why Italy Should Not Postpone the Adjustment Required by the New EU Fiscal Rules

The new fiscal rules approved by the Council of the European Union (EU Council) in its meeting on December 20, 2023, mark substantial progress compared to the Stability and Growth Pact (SGP), as defined in the years 2005-2013.

However, the agreement reached by the EU Council and still to be submitted to the European Parliament (in part for co-decision and part for non-binding opinion) is a compromise that weakens many achievements characterizing the Commission’s proposal as defined in April 2023, and mainly in November 2022. In this perspective, it represents a lost opportunity to further improve European economic governance.

To compare the different steps in the evolution of the European Union’s (EU’s) fiscal rules, it can be useful to employ a specific theoretical key.

Thus, in an enlarged Policy Brief, I analyze the old SGP, the Commission’s proposal, and the new fiscal rules in terms of the principal-agent literature focusing on mechanism designs. In the related contracts characterized by imperfect information and incompleteness, the Commission plays the role of principal on behalf of the EU and the member states play the role of agents. This exercise leads to, at least, three implications.

First, the rule-based approach adopted by the SGP is incompatible with an effective mechanism design. Second, the risk-based approach adopted by the Commission’s proposal suits the effective mechanism design. Third, the new fiscal rules combine the risk-based and the rule-based approach, and this combination weakens the effectiveness of the mechanism design.

The Italian Public Debt in the New Framework

These implications can be applied to the Italian economy. In the last two decades, the Italian (and other) governments approved budget laws that were usually ex-ante compliant with the old fiscal rules; however, despite a moderate trend in the primary expenditures, the actual evolution of the Italian debt and deficit (as well as those of other member states) implied a systematic withdrawal from the ex-ante commitments.

Consequently, it became a common opinion that a significant part of the 2005-2013 SGP’s quantitative indicators were not implementable by the EU countries with significant fiscal imbalances.

Moreover, Italy was unable to reduce its public debt to GDP ratio during the positive phases of the economic cycle.

Finally, the inconsistencies in the old fiscal rules and the systematic free-riding behavior adopted by Italy and other member states have strongly contributed to the lack of trust at the European level.

In this negative setting, and independently of the temporary escape clause, the governments of the member states with significant fiscal imbalances continued to enjoy short-term but repeated flexibility. The lack of binding incentive constraints in the EU’s fiscal norms ensured the possibility of systematically withdrawing from the ex-ante commitments. This may explain why the current Italian government did not welcome the Commission’s proposal.

Officially, the Italian position was justified differently. Giorgia Meloni’s government expressed the fear that the national ownership and the related bilateral interactions with the Commission became a ‘Trojan horse’ for imposing the will of European institutions on national sovereignty.

Moreover, the Italian government complained that the Commission had not introduced the possibility of excluding (a part of) the investment’s expenditures from the current public deficits (a kind of ‘golden rule’). The Italian government apparently ignored that this possibility was indirectly incorporated in the extension of the national fiscal plans to seven years because this extension is based on the presence of reforms and investments that require a longer horizon to produce positive effects.

These (weak) arguments camouflage the real issue: the Commission’s proposal reduced the ex-post flexibility and increased the short-term political costs of fiscal adjustments.

Considering the previous conclusion, it is understandable why the Italian government did not like it but finally approved the compromise offered by the new fiscal rules.

With respect to the Commission’s proposal, the new fiscal rules further increase the costs of the possible national adjustments because the mentioned weakening of the ex-post compliance is more than compensated by the introduction of severe quantitative indicators. Hence, similarly to the 2005-2013 SGP, these new rules could require excessive fiscal adjustments from Italy.

However, they introduce a temporary regime (2025-2027) that allows member states with significant fiscal disequilibria to decrease the minimum yearly adjustments. In so doing, the new fiscal rules legitimize fiscal – even if limited – flexibility for the governments of fragile EU countries. The flexibility period overlaps the forecasted national political cycles. 

However, the introduction of a temporary regime in the new fiscal rules is a serious threat to the medium-long term sustainability of the Italian debt. A full exploitation of this limited flexibility would imply, ceteris paribus, a higher incidence of the Italian public debt to GDP at the beginning of the normal regime.

Given that Italy (and other EU countries) will likely be subject to a European procedure for excessive public deficit in 2025 and that it will utilize the reduced adjustments towards the threshold of 3%, it is reasonable to assume that the Italian multiannual fiscal plan will be launched at the beginning of the normal regime and will be confronted with a high public debt to GDP ratio.

Hence, this plan should determine severe adjustments to comply with the quantitative safeguards and the related constraints introduced by the new fiscal rules.

According to some recent simulations (Bruegel), Italy should implement a yearly surplus in its balance sheet of around 4% of GDP. This surplus is unsustainable over time.

The policy conclusion is that Italy must be compliant ex-post, and not only ex-ante, with the new fiscal rules if it intends to guarantee the long-term sustainability of its public debt and to rebuild its trustworthiness in the EU.

 To have an encouraging probability of obtaining this result, Italy should not utilize the temporary regime to postpone the required adjustments.

The right choice would be to implement fiscal adjustments at a pace compatible with its future multiannual national plan already during the European procedure for the excessive public deficit.

IEP@BU does not express opinions of its own. The opinions expressed in this publication are those of the authors. Any errors or omissions are the responsibility of the authors.

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