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ESM and SGP reforms: two sides of the same coin and Italy’s non-credible threat

Source: Pixabay

The crises that were hitting Europe – from the COVID-19 in 2020 to the full-scale Russian invasion to Ukraine in 2022 – have demonstrated the urgent need of a reform of the European economic systems. As a result, in 2023 two pivotal reforms have been discussed, but they remain (as of today, 10th December 2023) pending.

On the one hand, the Stability and Growth Pact (SGP), the agreement that defines fiscal rules for member countries; on the other hand, the European Stability Mechanism (ESM), the European institution aimed at safeguarding its members in case of financial stress.

The SGP imposes constraints on fiscal policies that countries must uphold. Since March 2020, those rules have been suspended, through the general escape clause, to favour counter-cyclical measures during the recession caused by the pandemic. However, this clause is set to expire at the end of December 2023, reinstating the previous restrictions. Though, as we will deepen later, there is a particular need to renew current budget rules which are still tied to benchmarks established in the Maastricht Treaty (1992!). Nevertheless, an agreement has not been reached yet, even if negotiations seem to have intensified in recent days. The divergence is still between so-called frugal countries, convinced that objective and quantitative criteria are needed, and the Southern European bloc countries, which, out of necessity, advocate for a more flexible approach that takes into account significant investment commitments imposed by the EU (green and digital transition, investments for common defence, and so on).

Conversely, the ESM institution, often criticised for encroaching on member countries’ sovereignty in the event of adoption (financial crisis), holds strategic importance in potential debt or banking crises. Indeed, despite past crises appearing as distant and unrepeatable, recent challenges such as increasing member indebtedness and banking turmoil (March 2023) demand serious consideration. While the ESM certainly requires refinement, a treaty reform has been discussed, negotiated and ratified by 19 parliaments out of 20 (to date). Italy, however, stands as the sole obstacle for its implementation. The hard-right Italian government has repeatedly stated that, unless changes in the reform proposal or concessions on other issues, Italy intends to maintain its position. The implications of Italy's stance extend beyond the ESM, potentially influencing the negotiations surrounding SGP reform. 

In this complex diplomatic puzzle, this article aims to explain the functionalities of both the SGP and ESM and explore their interconnected reforms dynamics. In addition, it dares to delve into potential scenarios regarding the SGP reform in the light of recent developments. Yet, this analysis is aggravated by the complexity in understanding the role of the elephant in the (negotiation) room: Italy. Despite its worrying amount of public debt, the “Bel paese” could play a leading role in shifting the balance of the SGP reform by threatening not to ratify the ESM. As long as this threat is perceived as credible. 

Stability and Growth Pact in pills

“The Stability and Growth Pact (SGP) is a set of rules designed to ensure that countries in the European Union pursue sound public finances and coordinate their fiscal policies”. Famous thresholds such as deficit/GDP within 3% and debt/GDP within 60% are the main quantitative benchmarks that EU countries should have to respect. 

In March 2020, extraordinary circumstances forced the European Commission to adopt the general escape clause of the SGP which led to the temporary suspension of its fiscal rules in order to facilitate Member States in providing fiscal measures to support their economies with no budgetary limitations. This clause will then expire on the 31st of December 2023. 

However, member states believe that the actual framework is not satisfactory and therefore, since October 2021, the Commission has reopened the debate on the review of the EU’s economic governance framework. Which are the main reasons behind member states' concerns?

First, as it was mentioned before, the pandemic, the effects of the war in Ukraine and of the energy crisis have led to a vertical increase in public indebtedness. Nowadays, given the Government debt to GDP ratio (2023 Q2), half of EU member states would have to face an excessive deficit procedure (EDP) for debt/GDP violation if the 60% benchmark came back into force. 

Source: Eurostat

Second, the current framework has never been effective. Technically speaking, once a country violates the 60% debt rule, it must reduce its debt/GDP excess by 1/20-a-year; otherwise, sanctions can be applied. However, though infractions have taken place several times (almost 200), the sanction system has never been adopted. Totally useless.

The European Commission has indeed proposed that possible macroeconomic imbalances would be instead corrected through modifications in the national medium-term fiscal plans, which each EU member must compile. These adjustments would be conducted on changes in an observable variable such as the net primary expenditure (expenditure net of discretionary revenue measures, interest expenditure and cyclic expenditure). The Commission's aim was to increase the level of flexibility in the rigid SGP framework in order to transform it into a country-concerned instrument. 

Nevertheless, countries are failing in reaching an agreement.

European Stability Mechanism in pills

The ESM is a European institution, established by the Member States of the euro area in 2012, that basically mobilises fundings to provide stability support to ESM members which are experiencing, or are threatened by, severe financing problems. However, this institution lacks “popularity” among member states, and starting in 2018, ESM members have started discussing its reform. 

Overview: in order to safeguard ESM members, the institution offers financial assistance in several ways; precautionary financial assistance (two different credit lines; Pccl and Eccl[1]), direct stability support (loans and grants) and primary/secondary market purchases. All these measures are supplied under strict conditionalities (negotiated in a memorandum of understanding, MoU) but with facilitated interest rates. 

Since the MoU may impose heavy and unilateral structural changes, the ESM does not operate automatically but if and only if an ESM member addresses a request for one of its instruments.

The reform: in 2021, ESM member countries signed the Amending Agreement[2] of the ESM Treaty which provides a legal basis for a set of new tasks assigned to the ESM. These can be divided into three main areas.

First, changes in the eligibility criteria for precautionary financial assistance. Essentially, Pccl (precautionary lines) would become easier to get (no MoU requirement), while no changes are proposed for the Eccl. 

Second, a new compulsory tool to ease possible debt restructuring. The reform would implement so-called single-limb CACs[3] (instead of previous double-limb CACs). Debt stocks with the single-limb CACs require an easier threshold of bondholders to be reached in order to process debt restructure than the double-limb one. This is a pivotal reform since countries such as Greece have suffered from the previous overwhelming procedures to restructure their debt stock during the latest financial crisis. This implementation would make these operations smoother and less painful for countries.

Last, the introduction of a common backstop to the Single Resolution Fund (SRF). The SRF is the fund, financed by the banking sector, established by the EU for resolving failing banks in the context of the Banking Union. According to the ESM reform, in the event of SRF’s depletion, the ESM would act as a common backstop, supplying up to €68 billion in loans directly to distressed banks. Furthermore, this would be the first form of banking risk mutualisation among European member states.

Issues: the reformed treaty will come into force once it is ratified by all 20 ESM members’ parliaments. However, since October 2022, Italy remains the only country which has not ratified it yet, hampering possible benefits that the reform would provide. Anyway, until it takes effect, the ESM will continue to operate with the latest Treaty version and so, the current rules.

Meloni’s government has repeatedly justified its position assessing that: first, her government will never ask for the ESM assistance; second, Italy will request further in-depth analysis before ratifying the reform; third, Italy would propose a multilateral debate over the ESM instrument to transform it into a fund for investments related to the energetic transition.

Meanwhile the reform is pending, last March few banks suffered from financial turmoil in the US and in Switzerland. The EU banking system appeared to be resilient, but the introduction of the common backstop to the SRF has been seen as advisable by several experts.

Current state of affairs: Italian fears, EU insecurity, need for structural change

Although changes proposed in the ESM reform are relatively minor, and little would actually change, the new treaty would give more tools to the ESM to assist countries (especially in case of countries financial crisis or banking issues). As a result, the ESM reform is seen as a necessary step and Italy’s attempt to rediscuss it is mostly a diplomacy-oriented issue, having little to do with actual economy.

Italy is the second highest indebted country in the eurozone and therefore one of the most exposed to possible macroeconomic turmoil. Italy’s vulnerability leaves no room for negotiating flexible conditionalities in case of financial crisis. As a result, Italy has little bargaining power to rediscuss the ESM reform terms, which were voted unanimously few years ago. 

In addition, the ESM structure cannot be changed radically as it is the only safeguarding European institution in case of countries’ financing problems. Moreover, the Italian government has tried to manipulate the public debate, maintaining that the reform’s ratification would automatically entail a request of financial assistance for Italy along with a partial debt restructuring. This is totally false.

Indeed, Italy’s main fear over the ESM reform is exactly the possibility of debt restructuring. Let’s pretend that Italy was in a debt crisis, but it needs to get new funds. With the current ESM reform proposal, if a country does not manage to meet the requirements for obtaining neither the Pccl nor the Eccl credit lines, it would be obliged to restructure part of its debt stock if it wants to get access to ESM funds. 

Nowadays, Italian residents hold about 70% of the national debt. Its restructuring would impose an impressive tax on their wealth (with indirect effects on consumption), a negative reputational effect and a credit crunch (as Italian banks’ capital would be eroded by the loss on government bonds). It would be the beginning of an apocalypse and no government is likely to take this political responsibility. Therefore, Italy maintains its perplexity over the reform. 

However, Italy finds itself in a precarious position, negotiating the SGP deal under the shadow of having obstructed a reform unanimously approved by all EU members (ESM). The fragility of the Italian financial system exacerbates this predicament, casting a shadow on Italy's credibility and simultaneously posing a risk to the broader EU economy. 

Hence, supposing that the Italian authorities understand the risk and would like to decrease it, we assume that negotiating the SGP deal would benefit negotiating the ESM reform.

On the general European level, the EU is facing two major issues: the high level of uncertainty, brought by the COVID-19 and the full-scale Russian invasion in Ukraine, which should be addressed by the creation of certain financial “safety mechanisms.” Along with other European financial programs, such as Next Generation EU, the previous goal of debt/GDP lower than 60% is virtually unachievable by the majority of European countries. 

We can see from here that all the parties are pressed, which generates some negotiation incentives. This, in its turn, can be used to implement possible improvement strategies.

Negotiations: possible strategies of addressing the stalemate

In the light of this state of affairs, we can see that the negotiating of the SGP and ESM are connected; hence we can assume that resolving one conflict will contribute to resolving the other, and, in general, improving the fiscal security of the EU. 

Therefore, we can try to propose some strategies to address the SGP problem, since it is pressing for all the participating countries. This creates an incentive to negotiate to all the members, which can be used to achieve a point where all the members will be better off. It is also important to note that we are not targeting the absence of debt, since the debt itself can be a positive factor of economic growth, and, especially, investments. Additionally, we should account for the debt generated in order to support the economy and society during crises, be it unemployment, natural disasters, fiscal turbulence, security issues, and green transition.

Below are the possible strategies of addressing the negotiation stalemate with respect to the SGP and the role that its final outcome could play for Italy’s ratification of the ESM.

To do nothing

This is the pathway that would be the most natural one in case the countries don’t achieve any results in the negotiation process. However, we consider this strategy of low use because it doesn’t change anything, conserving the dangerous situation as it is and prolonging the state of insecurity. Hence, we can consider this strategy the worst option.

Increase the threshold

The EU could establish a higher threshold which is achievable by more European countries, even by those which are heavily indebted. 

However, despite this goal being more achievable, it can be still considered unfair by countries such as Italy, since, considering their level of debt, such a change would be rather marginal and still too distant. In fact, if this negotiation doesn’t give a flexible enough option, which Italy was requesting, the chance that Italy will ratify the ESM reform will not increase. 

Additionally, the increase in the threshold can create a negative precedent, where instead of meeting a goal the countries just modify it.

Use the dynamic assessment

In response to the increased level of indebtedness due to anomalous events, the EU can adopt an incentive mechanism that would rather not take the current level of the debt to GDP but use the so-called dynamic assessment. This assessment can be carried out in various forms, including the evaluation of the budget plans, the plans on decreasing the level of debt, and other mechanisms to assess the “right”, more secure, direction of the development of the affected countries.

This scenario could also generate some level of discontent, since the norms and the assessment would probably be country-specific (e.g., Germany and Italy are in different indebtedness categories; hence the targets would be different), and because of this, unequal. 

However, this scenario is considered quite sustainable, since it encourages taking action now and has a mechanism to pose a more achievable goal in the process.


[1]: Pccl, Precautionary Conditioned Credit Line. Eccl, Enhanced Conditions Credit Line.

[2]: European Stability Mechanism (ESM). (2021). ESM Treaty – Amending Agreement

[3]: Synthetically, the CACs (Collective Action Clauses) are clauses that enable a 'supermajority' of creditors to modify essential payment terms of the contract, thus overcoming the problem posed by holdout creditors.


  1. International Monetary Fund. (2022). Reforming the EU Fiscal Framework: Strengthening the Fiscal Rules and Institutions.

  1. Osservatorio Conti Pubblici Italiani (OCPI). (2022). Il Patto di Stabilità e Crescita tra ieri e oggi.

  1. Peterson Institute for International Economics (PIIE). (2022). The European Commission´s fiscal rules proposal: A bold plan, with flaws that can be fixed.

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  1. Centro Macchiavelli. (2023). Sometimes they come back: the ESM reform and the Italian dilemma. 

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  1. Osservatorio Conti Pubblici Italiani (OCPI). (2020). Il MES: cos’è e come potrebbe essere utilizzato nell’attuale emergenza

  1. ANSA. (2023). Hope for final ECOFIN on Pact by year's end – Giorgetti.

  1. Eurostat, (2022, 22 April). Fourth quarter of 2021 Government debt down to 95.6% of GDP in euro area

  1. European Parliament (February 2021)Thematic Digest: “When and how to deactivate the SGP general escape clause?” 

  1. Pew Research Center (2023, 25 January). Many countries in Europe get a new government at least every two years

  1. Carsten Brzeski, Peter Vanden Houte (2023, 28 April). Stability and Growth Pact set for another makeover


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