Stability or Stagnation? How Europe’s fiscal rules are strangling growth

The 2024 Stability and Growth Pact reforms entrench austerity and stifle investment—challenging the new EU Commission to reverse Europe’s economic decline.

Fiscal policies in Eurozone countries have long been shaped by the Stability and Growth Pact (SGP). This framework was conceived as a means to enforce orthodox fiscal rules designed to steer member states towards balanced budgets. Although the SGP was temporarily suspended during the pandemic, it was reintroduced in 2024 with minor, largely superficial, revisions. The recent reforms for instance introduced individualised debt reduction paths with high-debt countries facing debt-to-GDP reductions of at least one percentage point annually on average during the adjustment period.

The core principles of the SGP therefore remain unchanged. The European Commission retains the authority to initiate so-called “excessive deficit procedures” against countries with budget deficits exceeding three percent of GDP. These procedures compel governments to implement austerity measures aimed at gradually reducing deficits, with the ultimate objective of achieving balanced budgets and debt-to-GDP ratios approaching 60 percent.

The effects are harmful. It is increasingly evident that this approach to fiscal policymaking is a significant factor in Europe’s low-growth environment and the widening productivity gap with the United States. The reasons for this are manifold.

First, the SGP is inherently biased against public investment. While the revised SGP permits some public investments to be excluded from regular budget calculations, the bulk of these expenditures must still adhere to the rule that additional public investment should be funded through higher taxes or cuts to other spending. In effect, most public spending cannot be financed through public debt issuance.

This rule contradicts basic economic logic. In the private sector, when a company invests in a productive asset that is expected to generate future revenue, it can finance the investment by issuing debt, provided the anticipated returns exceed the cost of borrowing (including any risk premium). Similarly, when a government invests in public assets—such as infrastructure—that will yield future benefits, it is economically sensible to fund such investments through the issuance of government bonds, as long as the expected returns exceed the borrowing costs.

With government bond yields for most Eurozone countries currently between two and three percent, there is ample scope for public investments to generate returns far exceeding these rates. This is especially critical in today’s context, where the need to build collective energy infrastructure and other public goods essential for a green transition has become urgent.

The prohibition on financing productive investments through public debt introduces an additional bias against public spending. Public investments typically benefit future generations, but under the SGP’s framework, current taxpayers must shoulder the entire cost. This creates a political disincentive for such investments. Politicians are unlikely to advocate for projects whose costs fall on today’s voters while the benefits accrue primarily to future ones. This disincentive is also evident in the data: during the 1980s and 1990s, public investment accounted for more than eight percent of total government spending in the EU. By the 2000s, this share had fallen to less than six percent.

Second, the persistent application of the SGP has entrenched a climate of austerity, which has stifled growth and productivity. Although member states were temporarily freed from fiscal constraints during the pandemic, enabling them to increase deficits and debt levels and avert a deflationary spiral, austerity measures were reinstated soon after.

This return to fiscal rigidity has had deleterious effects on both public and private investment. Since the global financial crisis, total investment in the EU has declined by roughly two percentage points of GDP, from 23 percent in 2007 to 21 percent today. This decline not only hampers current economic activity but also diminishes the economy’s long-term growth potential, as new capital investments often embody advanced technologies that drive productivity improvements. The Draghi Report has vividly illustrated how Europe’s productivity growth has lagged behind other industrialised nations, particularly the United States.

The implications are clear: austerity policies have long-term consequences for the supply side of the economy. By reducing investment, they constrain potential output and curtail productivity growth. Much of Europe’s fiscal strategy has been dominated by the belief—or ideology—that growth can only be achieved through structural reforms aimed at making the supply side of the economy more flexible and efficient. Yet, there is scant evidence to support the notion that such policies significantly enhance long-term growth. At the same time, the crucial role of demand-side policies in fostering sustained growth has been largely disregarded.

In conclusion, Europe’s relative economic decline is, in part, a direct result of austerity-driven policies. Reorienting fiscal strategies towards more active demand-side measures that prioritise public and private investment could play a pivotal role in reversing this decline and revitalising Europe’s growth potential. The new European Commission needs to tackle this challenge head-on. The economic and political stakes are high.

This article is part of the Project “EU Forward” Social Europe runs in cooperation with the Friedrich-Ebert-Stiftung.

Professor Paul De Grauwe holds the John Paulson chair in European Political Economy at the LSE’s European Institute.