Although the European Union already has much on its plate, from the war in Ukraine to challenges from populists within its own ranks, it urgently needs to reach an agreement on new budget rules to compensate for the lack of a fully federal fiscal union. The future of the monetary union is at stake.

Among all the big tests facing the European Union at the close of 2023, the most important will get the least attention. With European leaders working toward an agreement on new fiscal rules governing member-state budgets, nothing less than the sustainability of Europe’s monetary union is at stake.

Compared to this dry matter, other major issues on the agenda at this month’s EU Summit (December 14-15) will understandably seem more pressing. Senior officials in the EU, the United States, and Ukraine are warning that Ukraine’s ability to continue defending itself against Russia may be jeopardized if European governments and the US Congress fail to approve new military-aid packages by the end of the year.

While a Ukrainian defeat would erode the EU’s credibility and potentially jeopardize its security, European leaders also must address threats from within.

In fact, these problems are intertwined. Those challenging EU fiscal rules and those blocking funding for Ukraine are the same people. Led by Hungarian Prime Minister Viktor Orbán, the spoilers now include Slovakia’s new government under Robert Fico, and they may soon get a new recruit from “old Europe,” following the success of Geert Wilders’ right-wing Party for Freedom in last month’s Dutch elections. Worse, other member states may find these countries’ intransigence convenient, even if they do not say so openly.

To be sure, Europe’s populist problem may seem remote from the task of drafting new fiscal rules to replace the Stability and Growth Pact, which was shelved at the start of the pandemic in 2020. After all, most populist leaders are firmly focused on immigration and have abandoned talk of leaving the eurozone and reinstating national currencies. The original threat to monetary union – and thus to the European project more broadly – came not from politicians but from bond markets, during the sovereign debt crisis of 2011-12.

The good news is that calm prevails on that front, at least for now. Sharply declining inflation means that the European Central Bank may soon start reversing its interest-rate hikes, creating a more forgiving environment should European leaders fail to strengthen the monetary union with new fiscal rules.

The bad news is that failure on that front is all but assured. Even if leaders narrow their differences in the coming days, a final deal will be pushed into next year, and any new fiscal rules would not enter into force before 2025.

Failing to agree on new rules would be more significant than it may seem. Without progress toward correcting the eurozone’s fundamental flaw – the absence of a fiscal union – the EU will continue to sputter and struggle, like a ship with a hole beneath the waterline.

That hole was partly plugged by the €750 billion COVID-19 recovery fund, since renamed NextGenerationEU. The creation of an EU-level (fully federal) borrowing and funding instrument was hailed by many as Europe’s “Hamiltonian Moment,” recalling Alexander Hamilton’s consolidation of US state-level public debts under the federal government in 1790.

But while Hamilton helped turn the US from a confederation into a federation, Europe devised a solution that was both incomplete and temporary. National budgets still play a crucial role in stabilizing eurozone economies, each of which responds differently to normal business cycles and to abnormal shocks. To the extent that national fiscal efforts are being complemented by federal NextGenerationEU funding (Italy and Greece being the main beneficiaries), this support will expire in 2027.

Moreover, there has been no effort to repeal the provisions of the Treaty of Maastricht that require national budgets to conform to identical parameters to avoid bailouts. Instead, these circles have been squared by means of a de facto ECB bailout facility (the Transmission Protection Instrument), which can assist member states if the European Commission has approved their budgets. The question, then, is what criteria the Commission should follow in offering its approval.

The Commission’s own proposed fiscal rules attempt to square more circles. They would still require that national budgets trend toward the Maastricht Treaty limits on annual budget deficits and public debt – 3% and 60% of GDP, respectively. At the same time, countries may work toward those targets gradually and intermittently, with more flexibility to accommodate economic cycles.

But these proposals have little support among the main players. France is highly resistant to reducing its public deficits below 3% of GDP and has no plans to do so, while Germany is politically wedded to its “debt brake,” which formally limits deficits to just 0.35% of GDP. Though it has deviated from this benchmark in practice, a recent Constitutional Court ruling narrows the scope for the government to do so in the future and will likely increase German aversion to eurozone partners’ more relaxed policies.

Mario Draghi, the former ECB president who went on to serve as Italian prime minister, has also weighed in on the matter. In his NBER Feldstein Lecture this past July, he commended the Commission for the relative leniency of its proposed new rules, but faulted it for failing to marshal the public investment needed to revive Europe’s economic performance – and thus its political health.

Draghi’s own proposal is to make all capital spending a permanent federal competency. But given the democratic deficit – the “stealth federalization” – at the root of the euro project, he acknowledges that this would probably call for an explicit amendment to the European Treaties.

I think Draghi is right about the fundamentals of the matter. While I personally would vote against a treaty amendment – that is, in favor of a single market without a monetary union – I may well be in the minority. Either way, this most fundamental of questions must be put to voters. Otherwise, Europe will continue to flounder.

Historically, change in the EU has come only during crises. Must we suffer another one before we accept Draghi’s challenge?

Brigitte Granville, Professor of International Economics and Economic Policy at Queen Mary University of London, is the author of Remembering Inflation (Princeton University Press, 2013) and What Ails France? (McGill-Queen’s University Press, 2021).

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