Changing Europe’s Fiscal Rules: Unleashing public investment for a socially just Green Deal


This paper critically examines whether the European fiscal framework will be sufficient to stabilise the macro economy in the aftermath of the multiple crises, let alone achieve the goals of a green transition that leads to full capacity utilisation of the economy. The  reader will come to understand that private finance alone is neither sufficient nor desirable to achieve the goals of a socially just green transition.


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The economy of the next decade and beyond is being created now, out of the Covid emergency and ensuing energy and cost of living crises. Europe’s lack of social and economic resilience in the wake of these crises is a clear indictment of collective fiscal policy failings and the missed opportunity to recover better from the 2008 Great Financial Crisis (GFC). Instead of scaling-up transformative environmental investment that would have simultaneously catalysed a strong recovery, reduced energy precarity, and boosted living standards, a policy of “austerity” (in the form of spending cuts) won the day. A return to business as usual – prioritising debt and deficit reduction over vital environmental, social, and economic goals – is simply not an option.

This paper critically examines whether the European fiscal framework will be sufficient to stabilise the macro economy in the aftermath of the abovementioned crises, let alone achieve the goals of a green transition that leads to full capacity utilisation of the economy (i.e. full-employment with well-paid jobs).[1] After reviewing the considerable size of the green investment gap, the reader will come to understand that private finance alone is neither sufficient nor desirable to achieve the goals of a socially just green transition. Fiscal policy must play a leading role, but for a variety of reasons the rules governing public finance are broken. Europe’s fiscal framework requires a bold overhaul to support immediate economic recovery efforts following Covid-19, whilst also tackling the pressing challenges of environmental breakdown, the future impacts of which could far exceed those from the pandemic.

The green investment gap

The European Commission’s most recent estimate of the “green investment gap” – the additional investments necessary to achieve the climate and environmental goals of the European Green Deal (EGD) – is €520 billion per year.[2] Yet, there is good cause to believe the Commission is vastly underestimating both the scale and timeliness of investments needed. The Commission’s own research suggests that making building energy efficient by 2050 could require €490 billion annually.[3] Accordingly, other estimates suggest annual investments of up to €855 billion (excluding transport) in the EU27 could be required to tackle climate change alone (thus precluding investments needed to thwart wider environmental breakdown).[4]  

As of January 2020, the Sustainable Europe Investment Plan (SEIP), also called the European Green Deal Investment Plan, aims at mobilising €1 trillion of sustainable investments from both the private and public sectors over 10 years (up to 2030) to finance the EGD.[5] In addition, of the €723.8 billion Recovery and Resilience Facility, member states are estimated to have allocated 40% of their spending in their recovery plans to climate measures.[6] Even so, by its own estimates of the green investment gap, the European Commission is optimistically only set to mobilise about a third of the public and private investment needed to realise its own EGD objectives.

The role of private finance

Robust reforms to monetary policy and financial regulation will be needed to stimulate green financial flows and harness the untapped potential of private finance.[7] On the other hand, subsidies, public guarantees, public–private partnerships, and so-called blended finance – as set out in the EU Sustainable Finance Agenda – will also play an important role in leveraging finance to green the economy. Vital though these measures are, an overreliance on re-orienting towards and mobilising to private finance will not be sufficient or desirable to meet the goals of the European Green Deal.

Firstly, there is a historical track record showing that private finance has often been ineffective in financing public goods and infrastructure.[8] It is often neglected that industrial transformations have always been state-led.[9] Secondly, given the urgency and scale of the challenge at hand, private finance (alongside the SEIP and NextGeneration EU) will still not be sufficient on its own.[10] Thirdly, scant attention is being given to the balance sheet position of much of the private sector. Many businesses have been forced to take out debt to deal with the economic consequences of the Covid pandemic and are still recovering from a debt overhang from the 2008 GFC. While there have been questions about what governments can afford, there is a strong case to be asking what a heterogeneous private sector can afford?   

Fourthly, investment will be needed not just in the places where markets can make use of the profit motives of firms alone. Funds will also need to flow into projects and investments that yield the highest social returns for people and communities, and sometimes in the absence of direct commercial interests. This not only means investing in assets deemed to be “public goods” but supporting jobs, economic security, and social well-being among places and industries that are already being neglected by the EU’s current economic model.[11] Fifthly, there are vital political economy questions surrounding whether firms should profit from owning strategically important public goods – effectively extracting rents from the rest of society and whether governments should de-risk such private-sector investments, guaranteeing profits for the investors[12]

Sixthly, if the private sector is left to finance the majority of the transition, the drive to retain certain profit margins will have important distributional effects (e.g. through higher everyday energy bills) but can also lead to significant macroeconomic instability in the long run. This is because – absent public finance and adequate social security – maintaining expected profits margins on private-sector investment may drive up energy prices, and thus the general rate of price inflation, which can possibly lead to recession and/or below-trend output growth.[13] Finally, there is a good case that leaving the majority of financing to the private sector perversely shifts the emphasis of climate goals towards profitability and financial returns. The underlying profit motive would increase pressure “to compete precisely when we must cooperate”.[14] 

The Stability and Growth Pact

Despite their crucial roles, the EU budget and private finance are limited in scope and not equipped to foster the investments needed to fill the green finance gap. In fact, more fiscal support will be needed to “crowd” private finance in.[15] Accordingly, if the European Commission intends to genuinely foster investment to accelerate the transition, it must work with national governments to boost green public investment. The primary means of doing this is through Europe’s main fiscal framework – the Stability and Growth Pact (SGP). Problematically, the rules governing public finance within the SGP framework are broken and actively stand in the way of successfully achieving a just low-carbon transition.  

In a nutshell, the SGP failed on its own terms.[16] Based on a set of macroeconomic axioms that imply economies have an innate tendency to self-regulate, in the aftermath of a downturn the economic output gap is assumed to close over the medium to long run. Output “naturally” bounces back to its underlying potential trend that is supply-determined and does not respond to changes in demand (i.e. fiscal policy). That is, even without fiscal policy interventions, the economy is assumed to eventually recover over the medium to long term. Unfortunately, despite the flawed means of measuring output gaps (whereby unemployment rates of 20% are considered normal),[17] the European economy did not return to its pre-crisis trend – a permanent loss in income followed, instead of “just a delayed recovery”.     

The design of fiscal rules therefore neglects that fiscal policy can play an important role in stimulating a recovery and bringing an economy back to full capacity. After the 2008 GFC, the endeavour to prematurely and excessively consolidate public finances – before full-capacity utilisation of the economy had been reached, as dictated by the fiscal rules – led to a fall in aggregate demand, a decline in economic output, and permanent economic scarring (see left panel of Figure 1a below). In an effort to repair their own balance sheets, European governments may have inadvertently weakened the financial position of the private sector, making it more vulnerable to shocks as a result. In short, European governments could have issued debt to stimulate their economies and potentially had the effect of crowding private finance in.

The depressed economic activity resulting from the fiscal rules led to a reduction in the tax take and an increase in the deficit, while a reduction in GDP reduced the denominator, and thus led to a higher debt-to-GDP ratio overall. Contrary to recent IMF analyses,[18] instead of reversing debt levels after the 2008 GFC, fiscal rules actually led to higher levels of debt overall (the right panel of Figure 1a below shows that harsher fiscal spending cuts are clearly correlated with higher debt levels in Europe). 

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While the European Central Bank (ECB) attempted to do its job of boosting aggregate demand through a raft of unconventional monetary policies, fiscal authorities were consolidating their spending in line with fiscal rules, which had the opposite contractionary effect.[19]

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The great irony is that, through its monetary policy stimulus – aimed at reducing both short- and long-term interest rates – the ECB ended up creating significant ”fiscal space” for European fiscal authorities. Indeed, interest rates and government borrowing costs have been consistently declining for almost three decades.[20] Still, fiscal rules and a built-in adherence to deficit fetishism (the opposite of deficit bias) has prevented member states from taking advantage of historically low rates to lock in debt for transformational investment. As recently noted by former World Bank, IMF, Danish Central Bank, and Goldman Sachs economist Erik Nielsen, “mindbogglingly, borrowing at zero or negative rates to save the planet continues to be a no-go for parts of the European political leadership”.[21]This clearly illustrates another important problem. Fiscal rules are built around considerably weak indicators of fiscal space that disregard important macroeconomic conditions (i.e. the state of low interest rates) and the role of central banks.[22]

In terms of fiscal space and important macroeconomic conditions – the current state of fiscal rules further ignores that the fiscal costs of inaction in boosting green investments will prove far more costly in the long run. Fiscal rules are built around the notion that a government should balance its books and reduce public debt levels in an economic upswing to supposedly create more space to borrow in the event of a crisis. However, given the environmental crisis is a structural issue with permanent effects, rather than a temporary one with side effects that can be remedied, cumulative pre-emptive spending and investment will be necessary over the short, medium, and long term. The alternative of waiting until the planet has overheated and biodiversity has been devastated is simply not an option – not only will fiscal costs be far more expensive, but it would come with certain permanent social, environmental, and economic losses that cannot be priced. 

Of course, there is also an important flip side that warrants consideration. By boosting the supply potential and underlying productive capacity of the economy, the benefits of green public investment may end up paying for themselves and/or reduce debt-to-GDP ratios.[23] The fact that this can all be undertaken by issuing debt at historically low interest rates should make the decision an obvious one.     

There are a number of observable issues with the current fiscal rules – not least in relation to climate change and the green investment gap. For example, a 60% debt to GDP ratio is often argued to be “arbitrary”, not least because average debt levels in high income countries has doubled from 60% to 120% of GDP since the 1990s, while average borrowing costs have fallen from 9.4% to 0.5% (see Figure 2 below).[24] Despite facing a huge green investment gap, Italy and Portugal would have to run primary budget surpluses of 4-5% of GDP over the next decade and more.[25] Nevertheless, the thrust of the arguments made here is that European fiscal rules were designed irrespective of the current economic and environmental crisis – with long-term and large-scale public borrowing for transformational investment currently precluded by the SGP. Together these issues beg the question of whether fiscal rules and the SGP in its current guise represent the very definition of fiscal irresponsibility.

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Fiscal rules – a fit-for-purpose approach

Various welcome proposals are being considered to help achieve the goals of a green transition and fill the green investment gap – not least in the form of taxation, monetary policy, and wider regulatory reforms. Naturally, the new EU economic governance framework must encourage and support member states to ensure their tax policies and national budgets serve a socially just green transformation and the reduction of inequality. Likewise, the EU’s Recovery and Resilience Facility must be considerably scaled-up and made permanent. Institutional mechanisms through the European Semester will also need to be established for effective policy coordination, public accountability, and transparency to prevent the misuse of funding and corruption. A fuller discussion of these important reforms is beyond the scope of this brief paper, but the reader is reminded that nothing on the scale and speed of required investment for the EGD has ever been achieved before without significant national-level public-sector borrowing. Thus, the fiscal rules themselves require reform. 

Most recently, some momentum has been given to circumvent fiscal rules by establishing an off-balance sheet fund that is excluded from the deficit.[26] Such proposals are highly problematic, not least because of their complexity, and they must be independent of state control. And in so much as these would represent loans rather than tendering grants to the private sector, public goods would still rest in private hands – and all the problems that come with it. From a balance sheet position, governments would be missing the chance to inject a debt-free source of income into the private sector. Finally, the irony of this proposal is that, rather than actually change the SGP, the Commission would put significant effort into creating backdoor policies simply to get round existing ones.

A more credible and desirable proposal is a “golden rule” for public investment, which would exempt green capital investment (like green infrastructure projects) from narrow deficit targets.[27] However, the borrowing under such a rule would still be constrained by an overlap with a fiscal rule on current expenditure (i.e. everyday spending) and/or overall debt issuance. The negative financial returns (and cost of depreciation) would have to be covered by the current account, and therefore investment with low financial returns (i.e. many public goods) would not be covered. Importantly, policy-makers should be aware that this may risk leaving vital public goods in private-sector hands, or worse, such vital investments may be found wanting all together. Furthermore, depending on how it is formulated, vital investment and spending in social infrastructure, skills training, and adequate safety nets related to the Just Transition may be precluded by such a rule.  

In an unequivocally overhauled fiscal and monetary framework, a better solution would be to institute green capital investment and social infrastructure budgets tied to full-capacity utilisation and filling the green investment budget.[28] This would in effect mean that the capital budget could remain in deficit until the economy reaches the limits of its full capacity alongside other environmental objectives and/or constraints. The primary indicators for assessing fiscal space would be better connected to the productive capacity of the economy and the availability of real resources (i.e. levels of employment, wages, inflation, the current account balance, and environmental as well as biosphere constraints). When signs of the economy indicate that it is at, or approaching, its productive capacity limits, a smaller deficit or a surplus would be warranted.

Such a fiscal policy rule would work best in coordination with the ECB, but it is nevertheless generally consistent with central bank independence and a non-explosive path for the debt-to-GDP ratio at any reasonable rate of interest.[29] The rule implies that, as full-capacity utilisation and environmental targets are hit, debt levels would naturally begin to stabilise/converge. Any increased debt servicing (because of higher interest rates or further issuance of debt) would innately require a larger deficit. The additional deficit would raise spending and demand, putting the economy above its productive potential (and threatening the inflation constraint). Accordingly, in these circumstances, the rule would require non-interest expenditure (i.e. borrowing for the primary balance) to be cut or taxes raised in order to reduce the primary balance so that output would not exceed the productive potential or the inflation target, thereby stabilising the debt-to-GDP ratio.    


[1] P. Sigl-Glöckner, M. Krahé, P. Schneemelcher, F. Schuster, V. Hilbert, and H. Meyer

(2021), A New Fiscal Policy for Germany (Forum New Economy Working Papers No. 2a),

[2] European Commission (2021), The EU Economy after COVID-19: Implications for Economic Governance,

[3] A. Hermelink, S. Schimschar, M. Offermann, A. John, M. Reiser, A. Pohl, and J. Grözinger (2019), Comprehensive Study of Building Energy Renovation Activities and the Uptake of Nearly Zero-energy Buildings in the EU, Cologne: European Commission,

[4] R. Wildauer, S. Leitch, and J. Kapeller (2020), How to Boost the European Green Deal's Scale and Ambition (ICAE Working Paper Series No. 111),

[5] European Commission (2020), “Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions”,

[6] European Commission (2021), Recovery Plan for Europe,

[7] New Economics Foundation, Positive Money and 350.Org (2020), The ECB and Climate Change: Outlining a Vision for Success,

[8] D. Gabor (2021), “The Wall Street Consensus”, Development and Change,

[9] R. Wildauer, S. Leitch, and J. Kapeller (2021), Is a €10 trillion European Climate Investment Initiative Fiscally Sustainable?,

[10] Counter Balance (2021), EU Green Deal: Reclaiming Public Investments for Socio-ecological Transformation,

[11] A. Stirling, D. Powell, & F. van Lerven (2019), Changing the Fiscal Rules Unlocking Public Investment,

[12] See e.g. Gabor (2021), “The Wall Street Consensus” (see note 8); see also N. Tankus, A. Bernal, and R. Carrillo (2019), “The Green New Deal Will Be Tremendously Expensive: Every Penny Should Go on the Government’s Tab”, Business Insider,

[13] For a more detailed explanation, see A. Jackson and T. Jackson (2021), “Modelling Energy Transition Risk: The Impact of Declining Energy Return on Investment (EROI)”, Ecological Economics 185: 107023.

[14] Tankus, Bernal, and Carrillo (2019), “The Green New Deal” (see note 12).

[15] C. Hepburn, B. O’Callaghan, N. Stern, J. Stiglitz, and D. Zenghelis (2020), “Will Covid-19 Fiscal Recovery Packages Accelerate or Retard Progress on Climate Change?”, Oxford Review of Economic Policy 36(Supplement_1): S359-S381.

[16] O. Costantini (2020), “The Eurozone As a Trap and a Hostage: Obstacles and Prospects of the Debate on European Fiscal Rules”, Intereconomics 55(5): 284-291.

[17] P. Heimberger and J. Kapeller (2017), “The Performativity of Potential Output: Pro-cyclicality and Path Dependency in Coordinating European Fiscal Policies”, Review of International Political Economy 24(5): 904-928.

[18] International Monetary Fund (2021, October), Strengthening the Credibility of Public Finances,

[19] F. van Lerven (2018), Ending the Fiscal-monetary Tug-o-war, New Economics Foundation,

[20] O. Blanchard, A. Leandro, and J. Zettelmeyer (2020), Revisiting the EU Fiscal Framework in an Era of Low Interest Rates,

[21] E. Nielsen (2021), “Sunday Wrap: Chief Economist’s Comment”, Unicredit Macro Research,

[22] F. van Lerven, A. Stirling, and L. Prieg (2021), Calling Time: Replacing the Fiscal Rules with Fiscal Referees, New Economics Foundation,

[23] A. Pettifor (2020), The Case for the Green New Deal, New York, NY: Verso.

[24] L. L. Pasinetti (1998), “The Myth (or Folly) of the 3% Deficit/GDP Maastricht ‘Parameter’,” Cambridge Journal of Economics 22(1): 103-116.

[25] Costantini (2020), “The Eurozone As a Trap” (see note 16); see also F. van Lerven (2021), Pick a Number, Any Number: Setting Arbitrary Targets for Fiscal Policy Risks Locking-in Fresh Rounds of Austerity, New Economics Foundation,

[26] M. Arnold (2021), “What Germany’s Election Means for the Country’s Debt Debate”, The Financial Times, September 21,

[27] C. Cottarelli (2020), The Role of Fiscal Rules in Relation with the Green Economy, European Parliament, requested by the ECON committee,

[28] The following is adapted and builds upon the idea of Costantini (2020), “The Eurozone As a Trap” (see note 16).

[29] W. Godley and M. Lavoie (2012), “Fiscal Policy in a Stock-flow Consistent (SFC) Model”, in The Stock-Flow Consistent Approach, ed. M. Lavoie and G. Zezza (London: Palgrave Macmillan), 194-215; S. T. Fullwiler (2016), “The Debt Ratio and Sustainable Macroeconomic Policy”, World Economic Review 2016(7): 12-42.