Under new European budget rules it is important to remain well below the 3% deficit limit

This emerges from a new analysis conducted by De Nederlandsche Bank, in which we compare the impact of the new European fiscal rules on different countries, including the Netherlands.

New fiscal rules are an improvement on paper

Well-functioning fiscal rules are essential for a stable monetary union (Dutch) because fiscal policy can fuel or help curb inflation and because excessive government deficits can jeopardise financial stability. The previous fiscal rules proved to be inadequate. They were too complex, posed unrealistic fiscal challenges and their enforcement was limited. In addition, they sometimes had ‘pro-cyclical’ effects. This means that when economic downturns occurred, countries took austerity measures that depressed their economies even more. Conversely, if they started spending more in good economic times, inflation ticked upwards. 

Seeking to remedy these problems, the new rules prescribe that all Member States prepare what is known as a fiscal structural plan, committing to a path for maximum growth in public expenditure and explaining how they will implement investments and reforms. The maximum permitted annual expenditure growth will be determined based on a debt sustainability analysis by the European Commission. This maximum expenditure path is designed to ensure that public debt is brought down (or stays below 60%) and the public deficit is reduced (or stays below 3%). If investment and reforms are sufficient, the fiscal structural plan may be extended over seven years instead of four. These adjustments help reduce the likelihood of pro-cyclical policies and create more room for growth-enhancing investment.

The European Commission is now seeking to simplify the rules by using a single control variable, which is government expenditure growth. The rules' technical details and intricacies remain complex, however. And while they impose a more realistic fiscal challenge, the task they set remains arduous. As a result, there is a real chance of insufficient compliance. For the rules to be effective, it is therefore important that the European Commission and the Council enforce them.

Fiscal challenge remains substantial for high-debt countries

Although the fiscal challenge for high-debt countries is less severe than before, it remains substantial. Figure 1 illustrates the fiscal challenge under the new rules, highlighting the required structural primary balance. This is the budget balance adjusted for interest expenditure and the state of the business cycle. The figure shows the balance to be achieved at the end of a seven-year adjustment period, setting it against past balances.

This shows that high-debt countries, such as France, Spain and Italy, need to achieve a structural primary balance that they have rarely, if ever, achieved in the past. France, for instance, needs to reach a balance of 0.9% by 2031, while that nation's balances have historically been between -4.5% and -0.9%. Moreover, the balance must be kept at this level for an extended period of time. For the Netherlands and Germany, the challenge seems more manageable. For example, in the past Germany has tended to have a higher balance than the level currently required by the European Commission.

Figure 1: High-debt countries will still face a substantial fiscal challenge

The red diamonds show the required levels of the structural primary balance in 2031, while the blue lines indicate historical realisations (minimum, 25th percentile, median, 75th percentile and maximum)

Remaining well below the 3% limit is important

As long as the Netherlands remains sufficiently below the 3% limit and the 60% threshold, the likelihood of intervention from Brussels is small. Under the new fiscal rules, the Netherlands must follow an expenditure path that ensures it achieves a structural primary balance of 0.1% by 2028. However, our latest Spring Projections show that the Netherlands will achieve a balance of -1% in 2028. The CPB Netherlands Bureau for Economic Policy Analysis more recently released new projections, which put the balance at -0.8% in 2028. The outlook for this balance has thus improved recently, but still insufficiently to ensure compliance with the required expenditure path. However, this is not an immediate problem as long as the Dutch budget deficit remains below 3% and public debt stays below 60%. The European Commission can only take enforcement action if these reference values are exceeded.

The risk of intervention from Brussels will only increase if the Dutch government moves closer to the 3% limit. Also, doing so will leave little room for manoeuvre to absorb setbacks, which increases the likelihood of procyclical policies and political turmoil. It remains important, therefore, to act on the recommendation of the Study Group on Fiscal Space (Dutch) and remain well below the 3% limit.

Adjustment needed, particularly to prevent public debt from mounting

Our analysis shows that, in the longer term, public debt will go up. This is mainly due to rising interest rates and ageing costs, whereas expected economic growth is modest. The proposed spending cuts in the outline coalition agreement do not affect this outlook.

Figure 2 illustrates how public debt develops under three scenarios: The CPB’s Macro Economic Outlook (“CPB September projections”), the DNB Spring Projections of June, which incorporate the outline coalition agreement (“DNB Spring Projections”), and the recommendation of the Study Group on Fiscal Space (“SGFS recommendation”). The DNB scenario assumes that, after 2028, deterioration in the structural primary budget balance will only reflect ageing costs. The SGFS recommendation scenario assumes that the government will be targeting a headline deficit of 2.1%, which implies that it will absorb the rising ageing costs and interest expenditure each year through structural reforms, higher tax revenues or lower public expenditure.

In the DNB Spring Projections, public debt is set to exceed the 60% threshold in 2032, reaching 76% of GDP by 2038. The more recent CPB projections show a similar picture. Accordingly, if no additional measures are taken during the current term of government, greater adjustments will be required in the future. This means leaving unpaid bills for future generations. When addressing the austerity challenge it faces, the government could again turn to the Study Group on Fiscal Space’s recommendation for guidance to prevent public debt from mounting. As Figure 2 shows, adhering to this recommendation should keep public debt below 60%, also in the longer term.

Figure 2: Public debt projections underline need for fiscal adjustment