The Stability and Growth Pact
– Status 2006

Borka Babic, International Relations

INTRODUCTION

Since the reform of the Stability and Growth Pact in the spring of 2005, a number of member states that exceed the Treaty's 3-per-cent limit for government deficits have been assessed under the excessive deficit procedure. Among them is Germany, which had not succeeded in reducing its deficit to below the limit of 3 per cent of GDP in 2005, which was the deadline for correcting the excessive deficit. In addition, around the turn of the year 2005/06, all EU member states submitted updated stability or convergence programmes that have been assessed by the European Commission and the Ecofin Council. On the basis of this experience, the article reviews the Pact in practice since the reform, as well as the significance of the reform to the actual implementation of the Pact.

The need for the rules of the Stability and Growth Pact and their effective implementation is confirmed by a continued substantial government budget deficit, and by many EU member states' deficits exceeding the limit of 3 per cent stipulated in the Treaty. However, the budgetary situation improved from 2004 to 2005.

THE CURRENT BUDGETARY SITUATION IN THE EU

The government budget deficit in the EU and the euro area was reduced from respectively 2.6 per cent and 2.8 per cent of GDP in 2004 to 2.3 per cent and 2.4 per cent in 2005. The deficit's reduction reflects a tightening of fiscal policy in most EU member states, including Germany and France. The structural balance^[1] has thus been improved by 0.8 per cent of GDP in both the EU and the euro area. 2005 saw relatively weak GDP growth which did not contribute to reducing the budget deficit.

Most member states showed better budget balances in 2005 than predicted in the updated stability and convergence programmes submitted around the turn of the year 2004/05, cf. Chart 1. However, the deficits of Hungary, Italy, Greece, the UK and Luxembourg significantly exceeded the estimate. Greece's budget deficit for the period 1997-2004 was adjusted upwards, which contributed to a larger deficit than planned in 2005. In Italy, both lower growth than expected and an easing of fiscal policy contributed to the substantial actual deficit. Fiscal policy was also eased in Hungary whose deficit of 6.1 per cent of GDP was the largest in the EU in 2005. Germany's budget deficit in 2005 deviated only slightly from the previous estimate, but the deviation was of importance as it meant that Germany's deficit exceeded the 3-per-cent limit.

The European Commission's spring forecast from May 2006 predicts an almost unchanged budget deficit in both the EU and the euro area in 2006 and 2007, cf. Table 1. Fiscal policy is expected to be tightened only slightly in this period.

MEMBER STATES SUBJECT TO THE EXCESSIVE DEFICIT PROCEDURE

Twelve member states, including five euro area member states, are subject to the excessive deficit procedure, having exceeded the 3-per-cent limit,^[2] cf. Table 2.

In 2005, five of the twelve member states had reduced the budget deficit to below the limit of 3 per cent of GDP.^[3] According to the European Commission's forecast, however, government finances in France and the Czech Republic are expected to deteriorate again, and the budget deficit is forecast to exceed 3 per cent of GDP in 2007, cf. Table 1. In addition, as from 2007 funded pension schemes cannot be included in the compilation of the budget deficit. This means that the deficits of Slovakia and Poland will exceed the 3-per-cent limit in 2007, cf. Chart 2.^[4] Cyprus, on the other hand, is expected to reduce its deficit further in the coming years.^[5]

According to the Commission's forecast, the UK will reduce its budget deficit to 3 per cent of GDP this year, and in 2007 Germany's deficit is expected to be clearly below the 3-per-cent limit, cf. Chart 2.

Germany given notice to correct its deficit
Germany's budget deficit has exceeded the 3-per-cent limit since 2002, and the excessive deficit procedure was initiated at the beginning of 2003. In January 2005, the deadline for correction of the deficit was extended from 2004 to 2005. The deficit in 2005 was 3.3 per cent of GDP, which still exceeded the 3-per-cent limit.

At the recommendation of the Commission, the Ecofin Council therefore decided in March 2006 to take the next step in the excessive deficit procedure, i.e. in accordance with article 104.9 of the Treaty to give notice to Germany to correct the deficit by 2007 at the latest.^[6] This is the last step before sanctions may be imposed, and Greece is the only other member state to have been given notice to correct its deficit.

Germany has thus been given notice, i.e. the type of recommendation that Germany, like France, avoided in 2003. At that time, the Commission proposed giving notice, but the Council did not have the necessary majority to adopt the decision, so the excessive deficit procedure for these two member states was held in abeyance.  This led the Commission to bring the matter before the European Court of Justice in 2004^[7] and the Pact was subsequently reformed.

The Commission's assessment of Germany in connection with the excessive deficit procedure attached importance to the German government's presentation of an economic-policy strategy that as a central element included correction of the excessive deficit in 2007, and to the fact that the strategy is being implemented. In 2007 the general VAT rate will be raised from 16 to 19 per cent, and the structural deficit is planned to be improved by 1.1 per cent of GDP. On the other hand, the structural balance is expected to remain by and large unchanged in 2006. In this case the Commission has applied a flexible interpretation of the framework of the Pact, accepting a reduction of the structural budget deficit  that is only on average in line with the benchmark requirement of at least 0.5 per cent per annum, and which lies at the end of the period. The Commission finds the planned tightening to be sufficient to ensure sustainable correction of the excessive deficit by 2007.

Other member states subject to the excessive deficit procedure
Until the end of 2005 France by and large followed the same path as Germany in the excessive deficit procedure, also with 2005 as the deadline for correction. In contrast to Germany, France's budget deficit was reduced to below the 3-per-cent limit in 2005, cf. Table 1. The reduction from 2004 to 2005 was largely attributable to one-off revenue items that contributed 0.6 per cent of GDP, and cannot be regarded as permanent. The deficit is expected to rise a little again in 2006 and to exceed the 3-per-cent limit in 2007, cf. Chart 2. Consequently, it is possible that the excessive deficit procedure will not be abrogated, but only de facto suspended until firmer figures for the deficit in 2006, and the budget for 2007 are available.

In July 2005 the excessive deficit procedure was initiated for Italy and later in the year for Portugal. The deadline for correction of the deficit was set at 2007 for Italy and 2008 for Portugal. The Commission's latest forecast, cf. Chart 2, indicates that significant further tightening measures are required for these two member states to manage to correct their excessive deficits within the respective deadlines. The Ecofin meeting in March 2006 decided that for the time being, no further steps would be taken in the excessive deficit procedure for Italy.^[8]

Greece was the first member state to receive a notice, issued at the beginning of 2005, to implement certain measures to correct the excessive deficit by 2006. Greece was given only one extra year to redress its budgetary situation, even though it has a relatively large deficit. Greece's 2005/06 stability programme predicts a reduction of the structural budget deficit by 1.1 per cent of GDP in 2006. According to the Commission's examination of Greece's stability programme, the planned fiscal consolidation is consistent with correction of the deficit in 2006.  

The UK has posted a deficit exceeding 3 per cent of GDP since the 2003/04 fiscal year, but at that time the deficit was assessed to be temporary. The deficit remained above 3 per cent in the following years, and the Commission's 2005 autumn forecast showed that the deficit would not fall below 3 per cent in the 2006/07 fiscal year^[9] either. As a result, the excessive deficit procedure was re-initiated. In January 2006, the Council thus adopted a recommendation concerning correction of the deficit by the 2006/07 fiscal year. Since then, the budgetary situation has improved, and the Commission's May 2006 forecast expects a budget deficit of approximately 3 per cent of GDP in the 2006/07 fiscal year.

Several new EU member states reduced the deficit to below the 3-per-cent limit in 2005. Among them, Cyprus reduced its deficit to 2.4 per cent of GDP, so the excessive deficit procedure is expected to be abrogated. In the Czech Republic, Slovakia and Poland, the deficit was also reduced to below the 3-per-cent limit. In the Czech Republic, the deficit is expected to rise above 3 per cent again this year, but according to the Commission's assessment of the Czech convergence programme the planned fiscal-policy measures are sufficient to bring the deficit below the 3-per-cent limit by 2008. In Poland and Slovakia, the budgetary situation will be affected by the fact that from 2007 funded pension schemes can no longer be included in the calculation of the deficit, cf. Chart 2. In contrast to the Polish deficit, Slovakia's deficit is still expected to be relatively close to the 3-per-cent limit after adjustment to the new rules.

Malta also significantly reduced its budget deficit in 2005, and the deficit was only just above the 3-per-cent limit, cf. Table 1. The Commission finds that the planned fiscal-policy measures are sufficient to ensure a deficit below 3 per cent in 2006. In contrast, the government finances of Hungary deteriorated strongly during 2005. As a consequence, at the end of 2005 the Council for the second time during that year decided that Hungary has failed to plan sufficient measures to correct its budget deficit in 2008. This is confirmed by the Commission's May 2006 forecast which shows a growing deficit. The deficit excluding funded pension schemes is expected to be 8.4 per cent of GDP in 2007, cf. Chart 2. The Council was not satisfied with Hungary's 2005/06 convergence programme either. The programme predicted a reduction of the deficit to below the 3-per-cent limit in 2008, but without closer specification of how this would be achieved. The Council has therefore invited Hungary to prepare an adjusted convergence programme by 1 September 2006.

INCREASED FOCUS ON PREVENTIVE ELEMENTS OF THE STABILITY AND GROWTH PACT

Many EU member states' problems with large budget deficits in recent years are to a high degree attributable to insufficient consolidation of government finances in the good times, i.e. when growth was strong.

For this reason, the 2005 reform was aimed to strengthen the preventive arm of the Pact by e.g. introducing differentiation of the medium-term objectives (MTO) between the member states, cf. Box 1.

The stability and convergence programme updates submitted at the beginning of 2006 reflect this change since all member states except the UK have stated their MTOs.^[10] For most of the old EU member states the MTO is stated as close to balance,^[11] while the new member states have slightly less ambitious MTOs on average, which is related to these member states' higher growth potential and lower government debt, cf. Chart 3.^[12] Observance of the objectives would prevent the member states from exceeding the 3-per-cent limit.^[13]

The distance from observing the MTO varies across the member states, but in most cases, observing the MTO would require substantial adjustment, cf. Chart 4. Eight member states already observe their MTOs. Most of the remaining member states, including the three large euro area member states (Germany, France and Italy), do not expect to observe their MTOs in the programme period, i.e. by the end of 2008.

The rule concerning adjustment of the structural budget deficit by at least 0.5 per cent of GDP per year, cf. Box 1, is generally being respected, although there are exceptions. On average, the planned tightening measures in the member states in which cyclical development is favourable aim at slightly less than the required 0.5 per cent of GDP, so that these member states do not fully comply with the requirement of the Stability and Growth Pact of increased consolidation in good times.

In reality, the focus on MTO in the preventive arm of the Pact after the 2005 reform represents only a minor modification from previously. Before the reform, the member states were required to have a budget balance " close to balance or in surplus" , which has been interpreted as a cyclically adjusted budget balance of -0.5 per cent of GDP or better. This was generally reflected in previous stability and convergence programme updates, but often the objectives were not met. Repeated overestimation in the programmes of the development in the budget balance, particularly in the three largest member states, actually contributed to the loss of credibility for the preventive arm of the Pact. The positive aspect of the new approach to setting MTOs is that the member states have set their own objectives that reflect their economic circumstances, which can enhance their commitment to observing the objectives. However, apart from verbal criticism, there are still no sanctions in relation to non-observance of the preventive arm of the Pact.

LONG-TERM FISCAL SUSTAINABILITY

In the EU, pension and health expenditure will rise in step with the population's ageing. In the period until 2050, pension expenditure is expected to increase by 2.2 per cent of GDP and health expenditure by 1.6 per cent of GDP. There is considerable variation among the member states. In some member states the expenditure is expected to increase by more than 10 per cent of GDP, while in other member states ageing-related expenditure will decrease.^[14]

The large government debt in many member states also has an adverse impact on long-term fiscal sustainability, cf. Chart 5. In 2005 the debt increased by 1 per cent of GDP in both the EU and the euro area to 63.4 and 70.8 per cent of GDP, respectively.

A new element in the examination by the Commission and the Council of the 2006 stability and convergence programmes is an assessment of the risk concerning long-term fiscal sustainability as low, medium or high for each member state, cf. Chart 5. For Greece, the risk to fiscal sustainability is classified as high since Greece has the highest government debt in the EU as well as a large budget deficit and rising future pension expenditure. Italy's debt is almost as high, but since Italy has introduced pension reforms, it is classified in the medium category, alongside Germany and France.

Denmark is among the member states with the lowest risk to long-term fiscal sustainability. The Council has classified the risk as low in view of the sound government finances, but subject to the assumption that the planned increase in employment and low growth in public spending are achieved. This will require further labour-market reforms and tight expenditure control.

SUMMARY AND CONCLUSION

It was feared that the reform of the Stability and Growth Pact in 2005 would weaken the overall fiscal-policy objective and impede the implementation of the excessive deficit procedure. However, the reform has had no great impact so far. Despite extended provision for exemptions, the circumstances could not be regarded as exceptional for any member state, and no member state has met the conditions for including " other relevant factors" in the assessment of observance of the 3-per-cent limit. However, in some respects a flexible interpretation of the rules was
applied to determining the conditions and deadline for correction of Germany's deficit. This implied e.g. accepting that fiscal policy will not be tightened in 2006 and setting a longer deadline for correction.

On the other hand, the less rigid approach probably contributed to Germany accepting the notice to correct the deficit by 2007. Germany's acceptance reflects that its political and economic situation has changed compared to 2003 when Germany was not willing to accept a similar notice to correct its deficit. The acceptance also reflects Germany's renewed sense of political co-ownership of the Pact. Political support from the large member states is paramount to the viability of the Pact. The Council decision on Germany will impact on the assessment of other member states in the excessive deficit procedure.

The Pact's preventive arm has functioned as intended, at least in terms of the member states' determination of individual medium-term objectives. Time will show whether the objectives will be realised or whether the member states will go back to a situation with substantial deviations between planned and actual figures. The member states have determined their own objectives in accordance with their own economic circumstances, which may enhance their sense of commitment to implementation. There seems to be an increasing awareness among the member states that sound government finances are in their own long-term interest, not least in order to avoid having to tighten fiscal policy in bad times.