The Excessive Deficit Procedure Was Not Supposed to Be the "Naughty Corner"

July 3, 2019 3:00 PM

Italy’s growing public debt and its failure to comply with the European Union’s fiscal rules prompted the European Commission to warn that it might submit the country to an Excessive Deficit Procedure (EDP). The Commission finally announced on July 3 that, thanks to last minute fiscal measures, Italy would avoid the procedure “at this stage.” Markets and commentators have been treating the potential EDP as a major escalation, with yields on Italian government bonds moving substantially on news of negotiations between Rome and Brussels. But the Excessive Deficit Procedure was not designed to be a condemnation. Its original purpose was to soften the limits on deficits and debts set in the Maastricht Treaty of 1992, not to punish countries for exceeding them.

Euro area member states whose deficits exceed 3 percent of GDP or whose debt exceeds 60 percent of GDP face an Excessive Deficit Procedure, which is the corrective arm of the Stability and Growth Pact, the European Union’s fiscal framework. Once subject to the EDP, member states must follow an adjustment path, recommended by the European Commission and endorsed by the European Council, in order to reduce the deficit or debt below their limits.

These days, the EDP is seen as the sharpest possible rebuke of a member state, a naughty corner for fiscal delinquents. When formulating budgets, member states do everything they can to avoid breaching the 3 percent limit on the deficit. The prospect of an EDP for Italy due to high debt levels and the country’s negotiations with the Commission had market participants and journalists on the edge of their seats.

As pointed out by many economists, a hard, numerical limit on the deficit or debt is a bad idea. There is nothing magical about the 3 percent deficit level. The sky does not fall once it is breached, and therefore it follows that breaching this limit should not be avoided at all costs. This is why the EDP was created: to soften the limits on deficits and debts and dampen their procyclicality. Indeed, the procedure allows member states to exceed these thresholds and guides them on a path to reducing the deficit or debt below them. The adjustment path is set taking “relevant factors” into account, and it can be revised as new factors emerge. The Commission continuously monitors compliance with the recommendations but imposes fines only if a member state repeatedly ignores the Commission’s recommendations. In fact, no member state has ever been fined by the Commission for not complying with EDP requirements.

In other words, the EDP was not conceived as a purgatory, a place of suffering inhabited by the souls of member states expiating their sins. It was rather supposed to be more like a hospital observation room, where patients are monitored to prevent an illness or a worsening condition.

In 2009, when the Commission recommended a coordinated stimulus of 1.5 percent of GDP to boost demand under the European Economic Recovery Plan, it explicitly said that “It [might] lead some member states to breach the 3 percent GDP deficit reference value,” and that in those member states ”corrective action [would] have to be taken in time frames consistent with the recovery of the economy.”

In fact, many member states ended up in an EDP, and “corrective action” was taken, in some countries faster than in others. By 2019, Spain was the only country left in an EDP, although the original recommendation was for it to reduce its deficit by 2012.

Although the name does not help, we must stop thinking of the Excessive Deficit Procedure as a purgatory for sinners. If it is, then it is a rather nice one: Ironically, Italy would probably have faced lower required adjustments under an EDP than the requirements it currently faces, now that it has avoided the procedure. Contrarily to what many people think, Italy would not have been stuck in an EDP for decades until its debt-to-GDP ratio reached 60 percent, but rather for a few years until the debt was on a sufficiently declining path. If properly designed, an EDP could have been the place where a better policy mix was achieved, combining a softer adjustment path and policies to improve potential growth.

In a parallel world, in which market participants and journalists do not see the EDP as the worst possible condemnation by the Commission, and in which country leaders do not treat it as the paramount attack on their sovereignty, member states are happy to enter an Excessive Deficit Procedure because everybody wins: Member states are able to temporarily breach the deficit and debt limits if necessary in a recession or for other reasons, and the Commission gets to monitor conditions and ensure an eventual return to a lower deficit.