The Stability and Growth Pact – Status in 2004
Thomas Haugaard Jensen and Jens Anton Kjærgaard Larsen, International Relations
Introduction
During the economic slowdown in recent years, an increasing number of EU member states have had difficulties complying with the limit of 3 per cent of GDP for government budget deficits set out in the Treaty. This is a consequence of their non-compliance with the Stability and Growth Pact in previous years.
In 2003 Germany and France exceeded the 3-per-cent limit for the second year running. The UK, the Netherlands and Greece also exceeded the limit in 2003. In the autumn of 2003 the Stability and Growth Pact's excessive deficit procedure was suspended for Germany and France in view of their non-compliance. The non-compliance has also intensified the debate on whether the rules of the Pact should be amended. This article, which is an element of Danmarks Nationalbank's annual status of the Stability and Growth Pact presented in the Monetary Review, summarises the events in connection with the excessive deficit procedure and the most recent assessment of the member states' stability and convergence programmes. A number of proposals for amendment of the Pact are also described.
The purpose and rules of the stability and growth pact
In the Economic and Monetary Union, EMU, monetary policy is determined by the European Central Bank, ECB, while fiscal policy is the responsibility of the individual member states. In order to ensure sound public finances and avoid inappropriate interaction between the single monetary policy and national fiscal policies, the EU Treaty and the Stability and Growth Pact[1] contain a number of fiscal rules. The central limitation in the EU Treaty is the prohibition against "excessive government deficits", defined as deficits exceeding 3 per cent of GDP. All EU member states are subject to the prohibition[2], but recommendations to take action to reduce excessive deficits can only be made to and sanctions only imposed on the euro area member states.
The Stability and Growth Pact is based on the 3-per-cent rule set out in the Treaty. A central obligation in the Pact is that all EU member states must seek to ensure a medium-term budgetary position "close to balance or in surplus". The "close to balance or in surplus" requirement will enable the automatic stabilisers[3] to work freely, dampening a "normal" cyclical downturn without the risk that the budgetary deterioration will lead to an excessive deficit. The interpretation of this "close to balance" obligation has changed since the Pact entered into force in 1999. In recent years the European Commission has in practice interpreted the obligation set out in the Pact as a cyclically adjusted budget balance[4] of at least zero, subject to a margin of uncertainty of 0.5 per cent of GDP.[5]
Since many euro area member states were far from "close to balance", approaching the 3-per-cent limit, the Eurogroup (the Ministers of Economic Affairs and Finance of the euro area member states) in October 2002 established the principle that the member states that had not yet achieved a budgetary position "close to balance or in surplus" should reduce their cyclically adjusted deficits by at least 0.5 per cent of GDP annually until a budgetary position close to balance or in surplus had been reached. In March 2003 the Ecofin Council (the Ministers of Economic Affairs and Finance of the EU member states) further specified that attention should be paid to country-specific factors, e.g. the long-term sustainability of public finances, in the assessment of a member state's compliance with the Pact. Implicitly, this provides for a slightly more flexible interpretation of "close to balance" for member states with a relatively low government debt.
Besides verbal criticism, no sanctions are imposed in case of non-compliance with the Pact, as long as the deficit remains below 3 per cent of GDP.
Problems with the 3-per-cent limit
The excessive deficit procedure was initiated for Germany in November 2002 and France in April 2003 as a consequence of the two member states' non-compliance with the 3-per-cent limit for government deficits in 2002. When the Ecofin Council has decided that an excessive deficit exists, it issues recommendations to the member state in question, which then has to take effective action within 4 months. The recommendations to Germany and France were issued in January 2003 and June 2003, respectively. According to the Stability and Growth Pact, excessive deficits must be corrected in the year after the existence of the deficit has been decided, unless exceptional circumstances apply. For Germany and France this would have meant correction in 2004. However, as a result of insufficient fiscal consolidation in previous years and the continued slowdown in growth, the deficits rose to approximately 4 per cent in 2003, with prospects of continued non-compliance with the 3-per-cent limit in 2004. Against this background, in the autumn of 2003 the European Commission recommended that the Ecofin Council order Germany and France to tighten fiscal policy to correct the deficits. However, the European Commission's recommendation entailed spreading the tightening measures over 2004 and 2005 in consideration of the weak economic growth, whereby the budget deficits would not have to be below the 3-per-cent limit until the year 2005. If the imposition had been adopted by the Ecofin Council and the two member states had failed to comply, the next step for the Ecofin Council would have been to decide whether to impose sanctions on the two member states.
Although the European Commission's recommendation went a long way in the interpretation of the rules in the Pact[6], the recommendation failed to muster the required majority at the meeting of the Ecofin Council on 25 November 2003. Instead, the Ecofin Council adopted a set of non-binding Council conclusions that softened the consolidation requirements for Germany and France in 2004 a little compared to the Commission's recommendation, but nevertheless maintained the requirement to bring the situation of excessive deficits to an end by 2005 at the latest. Only the euro area member states participated in the voting, and the Council conclusions were adopted by a small majority. Furthermore, the Ecofin Council's conclusions suspended the excessive deficit procedure for the two member states, whereby no sanctions would be imposed on them in the first instance. However, it was emphasised that the Ecofin Council is willing to continue the procedure on the basis of recommendations from the European Commission if the two member states fail to meet the obligations in the Council conclusions adopted.
The conclusions of the Ecofin Council thus disregarded the envisaged excessive deficit procedure, cf. Box 1. Against this background, in January 2004 the European Commission decided to bring the procedure concerning the decision of the Ecofin Council of 25 November 2003 before the European Court of Justice to seek legal clarity and predictability of the rules in the Stability and Growth Pact, also with a view to future enforcement of the rules. The European Commission finds that the Ecofin Council could have opted for amendment of the content of the Commission's recommendation, but not amendment of the "legal form" of the recommendations to be issued to the two member states. The Ecofin Council should have issued an imposition on the two member states rather than legally non-binding Council conclusions. The Commission's legal action is not intended to force Germany and France to implement further consolidation measures. The European Court of Justice is expected to rule in the matter in the middle of 2004.
|
From recommendation to sanctions in the excessive deficit procedure
|
Box 1
|
|
The excessive deficit procedure is described in the Treaty (Article 104) and detailed and clarified in the Stability and Growth Pact. The procedure is as follows:
According to the Stability and Growth Pact the sanctions shall always start with a non-interest-bearing deposit to the EU of 0.2 per cent of the member state's GDP plus a premium depending on the extent to which the deficit deviates from the 3-per-cent limit. In the following years it may be decided to impose a further deposit depending on the extent to which the deficit deviates from the 3-per-cent limit. The deposit may not exceed 0.5 per cent of GDP annually. If the member state fails to correct its deficit, the deposit is normally converted into a fine after 2 years. |
|
The excessive deficit procedure for Portugal was abrogated by the Ecofin Council in May 2004. The procedure was initiated in September 2003 after it had been ascertained that Portugal's budget deficit amounted to 4.4 per cent of GDP in 2001. Action including non-recurring measures brought Portugal's deficit below the 3-per-cent limit at 2.7 per cent of GDP in 2002 and 2.8 per cent in 2003. The European Commission's 2004 spring forecast expects Portugal to exceed the limit of 3 per cent of GDP again in 2004 and 2005, unless fiscal policy is tightened further.
In 2003 the Netherlands. the UK and Greece joined the group of member states with a budget deficit close to or exceeding the 3-per-cent limit stipulated in the EU Treaty, cf. Table 1. Consequently, in April 2004 the European Commission initiated the excessive deficit procedure for the Netherlands and the UK. A decision concerning Greece has awaited validation by Eurostat of the budget figures for 2003. After preliminary revision Greece's 2003 budget deficit was compiled at 3.2 per cent of GDP at the beginning of May 2004. Since the UK is subject to a special derogation as long as it does not participate in the euro area, it is not covered by the Treaty's prohibition against excessive deficits, but is nevertheless obliged to seek to avoid such deficits.[7] The European Commission's assessment of the UK was lenient since the deficit is expected to fall below the 3-per-cent limit again in 2004, and the UK's government debt is one of the lowest among the EU member states. The Netherlands' excessive deficit is primarily attributable to a severe recession in 2003. The Netherlands implemented considerable public budget cuts in 2003, and again in April 2004 the Dutch government took steps towards further consolidation to bring the deficit below the 3-per-cent limit. The European Commission finds that without these further consolidation measures the deficit would remain above 3 per cent of GDP in 2004 and 2005.
| Government budget forecasts in the stability and convergence programmes of the EU member states, 2004-2007 |
Table 1
|
|||||||
| Per cent of GDP |
2000
|
2001
|
2002
|
2003
|
2004
|
2005
|
2006
|
2007
|
| Euro area member states | ||||||||
| Belgium |
0.2
|
0.5
|
0.1
|
0.2
|
0.0
|
0.0
|
0.0
|
0.3
|
| Finland |
7.1
|
5.2
|
4.3
|
2.3
|
1.7
|
2.1
|
2.1
|
2.2
|
| France |
-1.4
|
-1.5
|
-3.2
|
-4.1
|
-3.6
|
-2.9
|
-2.2
|
-1.5
|
| Greece |
-2.0
|
-1.4
|
-1.4
|
-3.2
|
-1.2
|
-0.5
|
0.0
|
-
|
| Netherlands |
2.2
|
-0.0
|
-1.9
|
-3.2
|
-2.3
|
-1.6
|
-0.9
|
-0.6
|
| Ireland |
4.4
|
1.1
|
-0.2
|
0.2
|
-1.1
|
-1.4
|
-1.1
|
-
|
| Italy |
-0.6
|
-2.6
|
-2.3
|
-2.4
|
-2.2
|
-1.5
|
-0.7
|
0.0
|
| Luxembourg |
6.3
|
6.3
|
2.7
|
-0.1
|
-1.8
|
-2.3
|
-1.5
|
-
|
| Portugal |
-2.8
|
-4.4
|
-2.7
|
-2.8
|
-2.8
|
-2.2
|
-1.6
|
-1.1
|
| Spain |
-0.9
|
-0.4
|
0.0
|
0.3
|
0.0
|
0.1
|
0.2
|
0.3
|
| Germany |
1.3
|
-2.8
|
-3.5
|
-3.9
|
-3,251
|
-2.5
|
-2.0
|
-1.5
|
| Austria |
-1.5
|
0.2
|
-0.2
|
-1.1
|
-0.7
|
-1.5
|
-1.1
|
-0.4
|
| Euro 12 |
0.2
|
-1.6
|
-2.3
|
-2.
|
-2.3
|
-1.8
|
-1.2
|
-0.7
|
| Non-euro area member states | ||||||||
| Denmark2 |
2.6
|
3.1
|
1.7
|
1.5
|
1.5
|
2.0
|
2.0
|
2.33
|
| UK |
3.8
|
0.7
|
-1.6
|
-3.2
|
-2.6
|
-2.4
|
-2.1
|
-2.0
|
| Sweden |
5.1
|
2.8
|
-0.0
|
0.7
|
0.4
|
1.2
|
1.6
|
-
|
| EU-15 |
1.0
|
-1.0
|
-2.0
|
-2.6
|
-2.2
|
-1.7
|
-1.2
|
-0.9
|
| Note: The "shaded" member states had a deficit of at least 3 per cent in 2003.Source: The figures for 2004-07 are from the 5th updated version of the stability and convergence programmes, while the figures for 2000-03 are final data from the European Commission. 1 Including the revision after the reform package of 17 December 2003, cf. Aktualisierung des deutschen Stabilitätsprogram, January 2004, Bundesministerium der Finanzen. 2 Figures compiled in accordance with the definition applied in the EU under the excessive deficit procedure. 3 Target for 2010. 4 Based on the figures for the fiscal years from 2000-01 to 2007-08. |
||||||||
The 5th updated version of the stability and convergence programmes
According to the Stability and Growth Pact the EU member states must each year prepare stability programmes (the euro area member states) or convergence programmes (the non-euro area member states). In the programmes the EU member states must present their government budget plans for the next 3 years as a minimum. GDP growth has continued to decline in the EU member states since the last round of stability and convergence programmes at the beginning of 2003. Thus, GDP growth fell from 1.1 per cent in 2002 to 0.8 per cent in 2003. For most member states the absence of the upswing and the postponement of planned fiscal consolidation measures led to a deterioration of the budget from the expectation at the beginning of the year, cf. Chart 1. The government budget deficit for the EU member states taken as one rose for the third year running from 2.0 per cent in 2002 to 2.6 per cent in 2003. Only Belgium, Ireland, Luxembourg, Spain and Austria reported better-than-expected budget balances. Among the member states with a deficit the UK, France, Italy, Portugal, Germany and especially Greece and the Netherlands reported too optimistic expectations of their budgetary paths. Box 2 summarises a recent survey of the quality of the stability and convergence programmes.
| Actual and estimated budget balance 2003 |
Chart 1
|
 |
|
| Source: European Commission and the 4th updated version of the member states' stability and convergence programmes. | |
|
Historical budget and growth forecasts in the stability and convergence programmes
|
Box 2
|
|
The annually updated stability and convergence programmes of the EU member states play an important role in the European Commission's and the Ecofin Council's surveillance of the fiscal development in the individual member states. The surveillance is made easier, the more accurate the programmes' forecasts. Strauch, Hallerberg and von Hagen (2004) provide a systematic analysis of the accuracy of the historical programme forecasts compared with the actual development in the period 1991-2002.1 The forecast errors, calculated as the difference between the actual and expected development, are analysed in relation to the projection period and for the individual member states. As regards the programmes' budget forecasts in the period 1991-2002, the average deviation from the actual budget development is rather limited, but the accuracy tends to decline as the projection period gets longer. The low average deviations are primarily attributable to the symmetrical distribution of the forecast errors around the actual result. The budget forecasts for the subperiod 1999-2002, when the programmes were prepared according to the Stability and Growth Pact, show a similar pattern. The accuracy of the growth forecasts forming the basis for the budget calculations is generally at the same level as the accuracy of the growth forecasts of international organisations like the IMF and the European Commission. As regards the individual member states, there are indications of systematic deviations in the forecasts. Portugal, Greece, Italy, France and to some extent Germany have presented too optimistic forecasts of their budget deficits. On the other hand, the budget forecasts of Austria, Denmark, Sweden, the UK, Luxembourg and Finland have systematically been too cautious in relation to the actual budget development. A certain degree of correlation is seen between forecast errors in the budget and growth forecasts. Especially Germany, Portugal and Italy have overestimated growth, while Ireland, Sweden and the UK tend to underestimate growth. |
|
| 1 The programmes were not standardised until the Stability and Growth Pact was introduced in 1999. | |
As a consequence of the increased deficits in most member states in 2003, the planned fiscal consolidation in the coming years will take longer than expected in the 2003 programmes. In its spring forecast from April 2004 the European Commission expects France, Germany, Greece, Portugal, the Netherlands and Italy to have deficits exceeding the 3-per-cent limit in 2004, cf. above, unless further consolidation measures are implemented. Furthermore, the Commission expects France, Italy, the Netherlands and Portugal to also exceed the 3-per-cent limit in 2005. The Commission's growth and budget forecast for Italy in 2004 deviates considerably from the forecast in Italy's stability programme. In April 2004 the Commission proposed that the Ecofin Council issue an "early warning" to Italy with a view to avoiding excessive deficits.[8]
The development in the cyclically adjusted budget deficits
Despite mounting budgetary problems in several member states, the stability and convergence programmes were assessed at the beginning of 2004 without major tensions. Indeed, the opinions of the Ecofin Council attracted only limited media attention, which should be seen in the light of the events concerning Germany and France in November 2003 and of the vacuum until the legal action by the European Commission is resolved.
As appears from Table 2, seven member states are not expected to achieve a budgetary position "close to balance or in surplus" in 2004 in accordance with the Commission's interpretation, i.e. a cyclically adjusted budget balance[9] of at least -0.5 per cent of GDP. Furthermore, Italy, the Netherlands, Austria and the UK will periodically deviate from the principle of reducing the deficit by 0.5 per cent of GDP annually.
| Cyclically adjusted budget balance |
Table 2
|
|||||
| Per cent of GDP |
2002
|
2003
|
2004
|
2005
|
2006
|
2007
|
| Euro area member states | ||||||
| Belgium |
0.1
|
0.7
|
0.6
|
0.1
|
-0.1
|
0.2
|
| Finland |
3.7
|
2.3
|
2.4
|
2.4
|
2.3
|
2.2
|
| France |
-3.8
|
-3.8
|
-2.0
|
-1.4
|
-0.8
|
-0.2
|
| Greece |
-1.6
|
-3.3
|
-1.8
|
-1.1
|
-0.5
|
-
|
| Netherlands |
-2.4
|
-1.7
|
-0.7
|
-0.5
|
-0.3
|
-0.5
|
| Ireland |
-1.9
|
0.1
|
-0.5
|
-0.4
|
-0.1
|
-
|
| Italy |
-2.2
|
-1.9
|
-1.6
|
-1.1
|
-0.5
|
0.1
|
| Luxembourg |
1.8
|
0.0
|
1.0
|
0.6
|
1.2
|
-
|
| Portugal |
-2.6
|
-1.7
|
-1.1
|
-0.6
|
-0.1
|
0.4
|
| Spain |
-0.2
|
0.4
|
0.1
|
0.1
|
0.2
|
0.31
|
| Germany |
-3.5
|
-3.2
|
-2.5
|
-2.0
|
-1.5
|
-1.0
|
| Austria |
-0.3
|
-0.9
|
-0.4
|
-1.3
|
-1.1
|
-0.5
|
| Non-euro area member states | ||||||
| Denmark |
0.,9
|
2.0
|
1.7
|
2.1
|
2.0
|
2.32
|
| UK |
-1.4
|
-2.8
|
-2.0
|
-2.2
|
-2.1
|
-2.0
|
| Sweden |
-0.6
|
0.7
|
1.3
|
1.8
|
2.0
|
-
|
| Note: The "shaded" member states are those that do not comply with the "close to balance or in surplus" requirement in 2004 or periodically breach the requirement to reduce their cyclically adjusted deficits by 0.5 per cent of GDP annually. Source: The figures for 2004-07 are from the 5th updated version of the stability and convergence programmes, while the figures for 2000-03 are final data from the European Commission. 1 2004-07 based on calculations from the European Commission on the basis of Spain's stability programme. 2 Target for 2010. |
||||||
The debt path
The debt ratio for the EU member states taken as one rose from 2002 to 2003. As Table 3 shows, in 2003 half the member states exceeded the limit for the government debt[10] of 60 per cent of GDP. In 2003 the debt of Belgium, Greece and Italy continued to exceed 100 per cent of GDP. The debt ratios of Germany and France rose strongly from 2002 to 2003, and both member states exceeded the 60-per-cent limit. As a result of the budgetary situation, Germany and France do not expect to reduce their debt to below 60 per cent of GDP within the programme period until 2007. Portugal's government debt is expected to peak at 60 per cent of GDP in 2004 and then decline until 2007. In its opinions on the Stability and Growth Pact in recent years the Ecofin Council has attached increasing importance to the member states' government debt.
| Government debt of the eu member states |
Table 3
|
|||||||
| Per cent of GDP |
2000
|
2001
|
2002
|
2003
|
2004
|
2005
|
2006
|
2007
|
| Euro area member states, according to the European Commission and their stability programmes | ||||||||
| Belgium |
109.1
|
108.1
|
105.8
|
100.5
|
97.6
|
93.6
|
90.1
|
87.0
|
| Finland |
44.6
|
43.9
|
42.6
|
45.3
|
44.7
|
44.9
|
45.0
|
44.6
|
| France |
57.2
|
56.8
|
58.6
|
63.0
|
62.8
|
63.2
|
62.8
|
61.8
|
| Greece |
106.2
|
106.9
|
104.7
|
103.0
|
98.5
|
94.6
|
90.5
|
-
|
| Netherlands |
55.9
|
52.9
|
52.6
|
54.8
|
54.5
|
53.7
|
53.0
|
52.2
|
| Ireland |
38.4
|
36.1
|
32.3
|
32.0
|
33.3
|
33.5
|
33.3
|
-
|
| Italy |
111.2
|
110.6
|
108.0
|
106.2
|
105.0
|
103.0
|
100.9
|
98.6
|
| Luxembourg |
5.5
|
5.5
|
5.7
|
4.9
|
5.2
|
5.0
|
-
|
-
|
| Portugal |
53.3
|
55.6
|
58.1
|
59.4
|
60.0
|
59.7
|
58.6
|
57.0
|
| Spain |
61.2
|
57.5
|
54.6
|
50.8
|
49.6
|
47.7
|
45.7
|
43.8
|
| Germany |
60.2
|
59.4
|
60.8
|
64.2
|
65.0
|
65.5
|
65.5
|
65.0
|
| Austria |
67.0
|
67.1
|
66.6
|
65.0
|
65.8
|
64.1
|
62.3
|
59.9
|
| Euro 12 |
70.4
|
69.4
|
69.2
|
70.4
|
70.0
|
69.4
|
68.4
|
67.6
|
| Non-euro area member states, according to the European Commission and their convergence programmes | ||||||||
| Denmark |
50.1
|
47.8
|
47.2
|
45.0
|
41.2
|
38.7
|
36.4
|
27.52
|
| UK1 |
42.1
|
38.9
|
38.5
|
39.9
|
40.2
|
40.8
|
41.1
|
41.4
|
| Sweden |
52.8
|
54.4
|
52.6
|
51.9
|
51.5
|
50.0
|
48.3
|
-
|
| EU-15 |
64.0
|
63.2
|
62.5
|
64.0
|
63.8
|
63.3
|
62.5
|
61.9
|
| Note: The "shaded" member states are those with a gross government debt exceeding 60 per cent of GDP in 2004. Source: The figures for 2004-07 are from the 5th updated version of the stability and convergence programmes, while the figures for 2000-03 are final data from the European Commission. 1 Based on figures for the fiscal years from 2000-01 to 2007-08. 2 Target for 2010. |
||||||||
The new member states and the Stability and Growth Pact
Upon joining the EU on 1 May 2004 the 10 new member states became "member states with a derogation" as regards EMU. This means that they must comply with the provisions of the Stability and Growth Pact, but – like Sweden, the UK and Denmark – they cannot be subject to an imposition to take action to reduce excessive deficits; nor can formal sanctions be imposed on them. Although the government debt is relatively small in most of the new member states, their budget deficits exceeded 3 per cent of GDP in 2003.[11] Consequently, the excessive deficit procedure will be initiated for these member states as well.
Proposals to reform the pact
The fiscal-policy experience in EMU has been both positive and negative. On the positive side is the marked fiscal consolidation in the years up to the commencement of the third stage of EMU in 1999, cf. Chart 2. Another positive factor is that the current budget deficits for the euro area as a whole – adjusted for the current weak economic development – are not severe. On the negative side, the euro area has failed to maintain the fiscal consolidation from the period up to 1999, which was actually an important objective in the Pact.
| Budget balance in the euro area member states |
Chart 2
|
 |
|
| Source: OECD Economic Outlook 74. | |
The requirement to comply with the "close to balance or in surplus" target within the horizon envisaged by the Stability and Growth Pact is thus perceived as a "moving target", which is pushed forward one year in every updated programme. Originally, compliance with the "close to balance or in surplus" target should have been ensured by 2002 at the latest, but, as mentioned, less than half of the EU member states complied in 2003, and Germany and the UK do not even expect to comply by the end of the programme period in 2007. Furthermore, the Ecofin Council's recent majority decision to suspend the excessive deficit procedure for Germany and France casts doubt on the future compliance with the rules stipulated in the Treaty and the Stability and Growth Pact.
There is broad-based agreement on the need to have a common fiscal-policy framework with a view to achieving sound public finances that are compatible with the ECB's objective of price stability. However, the incompliance with the Treaty and the budgetary rules in the Stability and Growth Pact has fuelled the debate on how to improve the Stability and Growth Pact. The debate intensified even more in connection with the enlargement of the EU. The new member states differ from the existing EU member states in terms of e.g. high growth and relatively low government debt. Some of the central arguments in this debate are described in the following.
The European Commission's proposal to strengthen the Pact
Already in November 2002, the European Commission proposed a number of principles to strengthen the implementation of the Pact[12] to pave the way for a more flexible interpretation of the rules. The increased flexibility envisaged by the Commission primarily concerned those member states that already complied with the "close to balance or in surplus" requirement and whose government debt was relatively low. The Commission found that these member states should be granted the scope of manoeuvre to operate with slightly higher budget deficits, e.g. in connection with structural reforms.
The Commission's proposals led to adoption by the Ecofin Council of a Report on "Strengthening the co-ordination of budgetary policies" on 7 March 2003. The Ecofin Council stated, among other things, that when assessing a member state's compliance with the Stability and Growth Pact attention should be paid to country-specific circumstances, including the long-term sustainability of public finances. As mentioned, this implies a certain scope for taking into account the member states' government debt. Overall, this represented a small adjustment of the principles of the Stability and Growth Pact compared to the Commission's original proposal.
In the wake of the course of events concerning Germany and France in 2003, the European Commission stated that it would prepare a new proposal based on the proposal of November 2002 to improve the framework for economic coordination in the EU. The proposal is expected to be submitted when the new European Commission is in office and when the European Court of Justice has ruled in the action brought before it by the Commission against the Ecofin Council.
UK considerations of a different interpretation of the Pact
In March 2004 HM Treasury published a Discussion Paper on the Stability and Growth Pact. According to this Paper, the Pact has tended to focus on short-term targets for public finances, with rather less consideration being given to government debt and longer-term political challenges such as the rising pension commitments in the future. Furthermore, the effectiveness of the Stability and Growth Pact has been adversely affected by the lack of attention paid to cyclical factors, especially when the economies were in the upswing phase of the cycle. HM Treasury therefore finds that the Pact can be improved in several respects.
The Discussion Paper does not put forward specific proposals on how to reform the Pact, but a "prudent" interpretation of the Pact is envisaged, which builds on the Code of Conduct adopted by the member states in 2001 and on the Report on "Strengthening the co-ordination of budgetary policies" adopted by the Ecofin Council in 2003. The interpretation attaches importance to improved consideration of the economic cycle, the long-term sustainability of public finances and public investment.
The interpretation focuses on the economic cycle because the automatic stabilisers must be able to operate fully and symmetrically to ensure economic stability. This is only compatible with sustainable public finances if the member states consolidate their public finances in periods of high growth. The UK therefore emphasises the need to focus on cyclically adjusted budgets.
A low level of government debt entails lower interest expenditure, thus enhancing the fiscal-policy scope. This provides a sufficient margin for the automatic stabilisers to work in full without endangering the sustainability of public finances. Furthermore, at a low level of debt more resources are available for public investment. The Discussion Paper refers to selected academic proposals to the effect that member states with a low level of debt should be subject to less restrictive conditions regarding the size of their deficits.
According to HM Treasury, public investment generates a future return, so expenditure, as well as revenue, should be distributed over the investment horizon, which is not the case today. In order to strengthen the public-investment incentive, the Discussion Paper proposes to exclude investment costs from the government budget balance. This proposal relates to the "golden rule", i.e. the government budget deficit must not exceed the expenditure for public investment.
Academic proposals to reform the Pact
The academic world has put forward several proposals to amend the Treaty and the provisions of the Stability and Growth Pact. There is general agreement on the need for a Stability and Growth Pact, but there is also a wish to enhance the flexibility and credibility of the Pact. A number of problems with the Treaty and the Pact in its present form have been pointed out:
- The 3-per-cent rule is too rigorous, inflexible and generally lacks credibility since it has come about without any real economic foundation.
- The Treaty and the Pact apply the same rule to all budget deficits, irrespective of substantial differences between the member states' debt ratios.
- The "close to balance or in surplus" rule implies long-term debt ratios of zero. This is in conflict with the "golden rule" argument, whereby public investment may be financed via public indebtedness.
- The Treaty is asymmetrical, i.e. the requirements of consolidation in high-growth periods are inadequate.
- The sanction mechanism lacks credibility.
A large part of the criticism is based on the fact that there is no real economic foundation for the 3-per-cent limit, so there is no reason to believe that this is the optimum rule for all participating member states in terms of welfare. Several economists regard this rule as more or less random (Eichengreen, 2004). This has spurred a number of reform proposals to either improve the current rule or to shift the focus of the Pact from budget deficits to government debt. The relationship between budget deficit, growth and a constant government debt in the longer term is described in Box 3.
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The background to the treaty's budgetary restictions
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Box 3
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One of the purposes of the Treaty's deficit and debt criteria was to prevent irresponsibly high government budget deficits. The limits of maximum 3 per cent of GDP for budget deficits and 60 per cent of GDP for government debt were stipulated against the background of an average debt level in the EU of 62 per cent of GDP in 1992, and of an assumption of annual real GDP growth of 3 per cent as well as annual inflation in line with the ECB's definition of price stability of 2 per cent, corresponding to a nominal growth rate of 5 per cent. In the period 1992-2003 average real growth in EU-15 and the euro area amounted to 2.0 per cent and 1.9 per cent, respectively. The correlation between these figures can be illustrated by the following expression of the debt-to-GDP ratio:
where d is the government debt ratio, g is nominal growth in GDP and pd is the government budget deficit, including interest costs, as a ratio of GDP. Fixing the long-term debt ratio at 60 per cent makes it possible to calculate the government budget deficit that ensures a sustainable debt ratio at various nominal growth rates. This is illustrated in the Chart below. It appears that at a nominal growth rate of 5 per cent (3 per cent real growth and 2 per cent inflation) the limit for a budget deficit that will ensure a stable debt ratio of 60 per cent is just under 3 per cent. Conversely, a budget limit of 3 per cent does not ensure a stable debt ratio of 60 per cent if the growth rate is lower, which is currently the case in most EU member states. For instance, if nominal GDP growth is 2.5 per cent annually (1 per cent real growth and 1.5 per cent inflation) the budget deficit must not exceed 1.5 per cent annually. Correspondingly, lower real growth implies a higher long-term debt ratio for a given budget deficit of 3 per cent of GDP. If real growth is only 2 per cent annually instead of 3 per cent, the debt ratio will tend to converge towards 78 per cent. The above equation clearly illustrates that if the debt at a given time exceeds 60 per cent of GDP, the budget deficit, at a given nominal growth rate, must be lower than 3 per cent of GDP in a transition period in order to achieve a debt ratio of 60 per cent. |
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| Growth and budget deficit at a debt ratio of 60 per cent of GDP | |
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The proposals focusing on the ongoing budget deficit in the implementation of the Treaty and the Pact include modifications of the current system – especially regarding public investment, which introduces the idea of a "golden rule" for growth-enhancing public investment. Blanchard and Giavazzi(2004), like the UK Discussion Paper mentioned above, propose, among other things, that public investment should be excluded from the budget deficit considered in connection with the Stability and Growth Pact since public investment often generates revenue in the future. Only current interest costs and write-offs on the investment should be included. This aspect is particularly relevant to the new member states that are facing major public investment in infrastructure, etc.
Several academics propose to attach more importance to the individual member states' debt as a ratio of GDP than to the current budget deficit. Pisani-Ferry (2002) proposes to extend the 3-per-cent rule for a member state's budget deficit to include the member state's current debt ratio. This should make it possible for member states with a low debt ratio to operate with a higher budget deficit than member states with a high debt ratio. According to Pisani-Ferry, this can contribute to ensuring fiscal consolidation in periods of high growth since it enables member states with a low debt ratio to pursue more expansionary fiscal policy in a future downturn without breaching the rules. Proposals focusing on the debt ratio rather than on ongoing budget expenditure will benefit the new member states, which generally have relatively low debt ratios.
Another frequently discussed point of criticism is the asymmetrical structure of the Treaty. The current budgetary problems in several EU member states can to a large extent be attributed to insufficient consolidation in periods of high growth. Buiter and Grafe (2002), among others, regard the Treaty as asymmetrical in so far as the rules only limit deficits without giving the member states sufficient incentives to consolidate public finances in periods of high growth. Barysch (2003) argues that the rules concerning "early warnings", cf. p. 75, and sanctions must also apply to the member states that fail to meet their fiscal-policy objectives in good times.
Eichengreen (2003, 2004) stands for some of the more far-reaching proposals to reform the Stability and Growth Pact. The essence is that the EU focuses too much on numerical budget and debt rules that do not rest on a sound economic foundation, according to Eichengreen. Instead, the focus should be on fiscal-policy procedures and institutions. Eichengreen finds that chronic government budget deficits can often be attributed to inefficient fiscal-policy procedures and institutions, whereby decision-making competence is spread between central and local government. It should therefore be possible to exempt individual member states from compliance with the rules in the Treaty and the Pact, if the member states implement the "right" institutional framework for fiscal policy. In practice, Eichengreen proposes that the member states be assessed on the basis of an index of the quality of their fiscal-policy procedures and institutions. Eichengreen (2003, 2004) presents specific examples of the construction of this index where the member states are given points for their compliance with selected criteria related to the implementation of fiscal policy and structural reforms. Under the criteria, a member state is given points according to the degree of centralisation of spending decisions and the degree of implemented structural reforms, e.g. privatisation, pension reforms and labour-market reforms. According to Eichengreen, member states with a high index score will be able to exit from the excessive deficit procedure since there is no reason to assume that these member states will have permanently high budget deficits.
In the period up to the introduction of the euro in 1999, the consequence of non-compliance with the convergence criteria was exclusion from participation. The consequences of breaching the criteria were thus concrete and credible. The Stability and Growth Pact contains no similar incentives, which is often pointed out as a problem – especially if there is no political will to apply the sanction mechanism. According to the EEAG (European Economic Advisory Group), the Ecofin Council's lack of willingness to observe the Pact calls for the establishment of an independent institution to administer the excessive deficit procedure. The EEAG has put forward a specific proposal to transfer decisions concerning sanctions in connection with the excessive deficit procedure from the Ecofin Council to the European Court of Justice. Even though the member states with excessive deficits do not have the right to vote when recommendations and any sanctions regarding their deficits are considered, the EEAG states that there is a risk of member states with deficits helping each other out in political deals.
Assessment and conclusion
The excessive deficits of Germany and France in 2003 and the decision to suspend the excessive deficit procedure under the Pact for the two member states led many people to regard the Pact as inexpedient or even defunct. In this connection it can be said that if all the EU member states had complied with the requirement in the Stability and Growth Pact concerning a budgetary position "close to balance or in surplus" in the period up to the low growth in recent years, the current budgetary problems could have been avoided. The provisions in the Treaty and the Stability and Growth Pact are clear and controllable. Implementation of several of the proposals described in this article would introduce more elements of assessment, creating the scope for circumventing the rules. For instance, the proposal to exclude certain public investments from the government budget deficit could make it difficult to distinguish between public investment and public spending. It should also be noted that in practice, the current set of rules makes it possible to a certain extent to accommodate country-specific circumstances, such as the size of the member state's government debt and the volume of public investment. Against this background, there is no obvious need for major amendment of the rules. Indeed, a number of member states find that there is a less pressing need for amendment of the rules.
However, the decision of the Ecofin Council in November 2003 led to uncertainty concerning the legal status of the rules of the Pact, and the threat of sanctions in the event of persistent excessive deficits has lost some of its credibility. The fiscal discipline under the rules is not only brought about by preventing problems, but also by enforcing the rules when required.
Literature
Andersen, Allan Bødskov, Cyclically Adjusted Government Budget Balances, Danmarks Nationalbank, Monetary Review, 3rd Quarter 2002.
Bartholdy, Niels, The Stability and Growth Pact – Status After the First Round, Spring 1999 (in Danish), Danmarks Nationalbank, Monetary Review, 2nd Quarter 1999.
Bartholdy, Niels, and Lars Falkenberg, The Stability and Growth Pact – Status in 2003 (in Danish), Danmarks Nationalbank, Monetary Review, 2nd Quarter 2003.
Barysch, K., A pact for stability and growth, Center for European Reform, Policy Brief, October 2003.
Blanchard, O.J. and F. Giavazzi, Improving the SGP Through a Proper Accounting of Public Investment, Centre for Economic Policy Research, Discussion Paper, 2004.
Buiter, W.H. and C. Grafe, Reforming EMU's Fiscal Policy Rules, in Marco Buti, Monetary and Fiscal Policies in EMU: Interactions and Coordination, Cambridge University Press, 2003, 92-145.
Deutsche Bundesbank, Monthly Report, February 2004.
Ecofin Council, Report on "Strengthening the co-ordination of budgetary policies", 7 March 2003 (available on the Ecofin Council's website: http://ue.eu.int/index.htm).
EEAG European Economic Advisory Group at CESifo, Report on the European Economy 2004.
Eichengreen, B., What To Do with the Stability Pact, Discussion Forum, Intereconomics, January/February 2003, 7-10.
Eichengreen, B., Institutions for Fiscal Stability, CESifo Economic Studies, Vol. 50, 1/2004, 1-25.
European Commission, Communication from the Commission to The Council and The European Parliament, Strengthening the co-ordination of budgetary policies. COM(2002) 668 of 27 November 2002.
European Commission, Opinion on the content and format of stability and convergence programmes (2001 code of conduct). European Economy No. 3, 2002 (downloadable from the website: http://europa.eu.int/comm/economy_finance/about/activities/sgp/codeofconduct_en.pdf)
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Fatás, A, et al., Stability and Growth in Europe: Towards a Better Pact, Centre for Economic Policy Research, Monitoring European Integration 13, 2003.
Frandsen, Tina Winter, The Stability and Growth Pact – Status in 2001, Danmarks Nationalbank, Monetary Review, 3rd Quarter 2001.
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Pisani-Ferry, J., Fiscal Discipline and Policy Coordination in the Eurozone: Assessment and Proposals, Note for the GEA meeting of 16 April, 2002.
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[1] The Stability and Growth Pact, which has been in force since the euro was introduced as the single currency in a number of EU member states on 1 January 1999, formally consists of a resolution of the European Council and two Council regulations adopted in June and July 1997, cf. Official Journal C 236, 2 August 1997 and Official Journal L 209, 2 August 1997.
[2] Except the UK, which is subject to a special derogation as long as the UK does not participate in the euro area.
[3] Economic activity has a direct effect on the government budget via the automatic stabilisers. During a cyclical upswing the budget balance is automatically improved via lower expenditure on e.g. unemployment benefits and higher tax revenue. This also dampens the growth fluctuations. A cyclical downturn equivalently encompasses a budgetary deterioration, which in turn reduces the slowdown.
[4] The government budget balance is influenced by a number of factors, including in particular the cyclical situation via the automatic stabilisers, which are not directly related to fiscal policy. A cyclically adjusted balance, i.e. adjusted for cyclical factors, therefore provides a more accurate picture of the actual fiscal development. However, the cyclically adjusted balance always contains estimated elements and is thus subject to uncertainty. The problems concerning the compilation of cyclically adjusted government budget balances are described in Allan Bødskov Andersen, Cyclically Adjusted Government Budget Balances, Danmarks Nationalbank, Monetary Review, 3rd Quarter 2002.
[5] As regards member states with a cyclically sensitive government budget, the European Commission states that an even better cyclically adjusted budget balance can be required. See The European Commission, Public Finances in EMU – 2001, European Economy, Reports and Studies, No. 3, 2001.
[6] It has subsequently been questioned whether the European Commission's extension of the time limit for correcting the budget deficits to 2005 was in accordance with the "spirit" of the Pact, cf. Deutsche Bundesbank (2004), p. 67.
[7] According to Protocol no. 25 to the Treaty, the UK is subject to a special derogation from the obligation of Article 104 (1) of the Treaty to avoid excessive government deficits. However, the UK is bound by Article 116 (4) to seek to avoid excessive deficits. Article 104 (9) and (11) regarding the imposition of measures to reduce the deficit and any sanctions do not apply to the UK, nor to the other non-euro area EU member states.
[8] The early warning system of the Stability and Growth Pact is described in Tina Winther Frandsen and Jens Anton Kjærgaard Larsen, The Stability and Growth Pact – Status in 2002, Danmarks Nationalbank, Monetary Review, 2nd Quarter 2002.
[9] The calculation of the cyclically adjusted budget balance and the European Commission's benchmarks are described in Tina Winther Frandsen, The Stability and Growth Pact – Status in 2001, Danmarks Nationalbank, Monetary Review, 3rd Quarter 2001.
[10] The criterion of the gross government debt not exceeding 60 per cent of GDP is also an element of the excessive deficit procedure. However, government debt exceeding this limit is acceptable if it is found that the ratio of government debt to GDP is sufficiently diminishing and approaching the reference value at a satisfactory pace. In practice the size of the government debt has not played the same role as the government deficit in the assessment of fiscal discipline in a member state. If the budget is close to balance, the debt ratio will decline under normal circumstances. The size of the debt is therefore not included as a target variable in the Stability and Growth Pact.
[11] The new member states' government budgets in 2003 are described in the article The 2004 enlargement of the EU, pp. 23ff.
[12] Communication from the Commission to The Council and The European Parliament, Strengthening the co-ordination of budgetary policies. COM(2002) 668 of 27 November 2002.