European Union Studies Center

The Graduate Center

of the City University of New York

Occasional paper n. 68

Euro Area Fiscal Policy after the Reform of the Stability and Growth Pact

Moreno Bertoldi

Counselor

Head of Economics and Finance

Delegation of the European Commission to the United States

December 2005

The working paper is based on a presentation I gave on the same subject at the European Union Studies Center, The Graduate Center of the City University of New York on 4 November 2005. I’m grateful to Amy Medearis, Michele Salvati and Ann Wadia for useful comments to an earlier version of the paper. I’m also grateful to Prof. Hugo Kaufmann and to the participants to the seminar for the stimulating discussion. The opinions expressed in the paper belong to the author only and should not be attributed to the European Commission. The usual disclaimer applies.

Euro Area Fiscal Policy after the Reform of the Stability and Growth Pact

Moreno Bertoldi

Counselor

Head of Economics and Finance

Delegation of the European Commission to the United States
 

Index

1. Introduction                                                                                                    p.  3
2. The economic rationale for sound fiscal policy                                              p.  3
3. Different ways to achieve sound fiscal policies. Enlightened discretion

          versus rule-based system.                                                                               p.  4

4. Fiscal rules in the “original” Stability and Growth Pact                              p.  6
5. The preventive and corrective arms of the Stability and Growth Pact         p.  7
6. The mixed results of the “original” SGP                                                       p.  7
7. Why reform the Stability and Growth Pact?                                                  p. 10
8. The reform of the Stability and Growth Pact                                                 p. 11   
9. Criticism of the SGP                                                                                       p. 13
10.  Some answers to the critics of the reform                                                     p. 15
11. Fiscal policy after the reform of the Stability and Growth Pact                    p. 17
12. Conclusions                                                                                                     p. 18

References                                                                                                                 p. 19

Tables and figures                                                                                                     p. 21

Abstract

While the monetary framework of the Euro area is now well established, the fiscal framework has recently gone through a major reform, triggered by the crisis of November 2003, when the majority of the European Council decided to hold in abeyance the Excessive Deficit Procedure for France and Germany. The reformed framework has somewhat lost in terms of simplicity and transparency, but its economic rationale has been strengthened and clearer provisions have been introduced. Some critics consider that the reform has softened the Pact beyond repair and foresee that from now on the rules will be adjusted in response to violations. Other critics still think that the Pact is a straightjacket that impedes a full recovery of the European economy. This paper argues that both criticisms are unconvincing and that the reformed Stability and Growth Pact is a clear improvement of the Euro Area fiscal framework and has better chances of succeeding than its predecessor.
 

1. Introduction

Since its creation there has been a lot of debate on whether the rules contained in the Stability and Growth Pact were what the Euro Area needed to ensure that its decentralized fiscal policy would be implemented in a sound manner. Some economists considered the original Pact too stringent and unable to play an effective counter-cyclical role. Other economists thought that, rather than introducing a stringent “commitment technology”, it was better to let markets make the difference, by rewarding the economies with appropriate fiscal policies, and punishing those with unsound ones.

When the Pact was put into operation, some limits and inconsistencies emerged. For instance, it would have been helpful to use the early warning mechanism foreseen by the Treaty to push Member States to consolidate their fiscal position in good times, so that they would have had more margins for maneuver during a slowdown. Tensions on how to apply the rules also appeared. Things were made worse by the shallow economic slowdown of 2001-2002 that was not followed by a robust recovery. Because of growing deficits due to low tax receipts, increase in spending due to the work of automatic stabilizers, growth in public expenditure embedded in existing entitlement programs, and, in some countries, untimely tax cuts, a number of Member States (among them the biggest ones) found themselves trapped in a low growth – medium-size (but growing) deficit equilibrium from which they had difficulty in finding a way out. Structural reform would have helped in the medium-long term, but not in the short term. In some cases, like Germany, it seemed to make things worse. The reform of some entitlement programs triggered an increase of the precautionary savings of German households, which weakened further economic activity. The Pact was increasingly seen by the Member States in difficulty, as a rigid instrument, incapable of recognizing the efforts made to correct the situation in a complex economic environment.

Against this background, the ownership of the Pact weakened. In November 2003, the tensions culminated in a conflict between the Commission and the Council regarding the procedures to apply to France and Germany to reduce their excessive deficits. At that moment, the rules-based fiscal framework of the Euro Area looked to be on the brink of collapse. To defuse the crisis, proposals were made by the Commission and the Presidency to modify the Pact and continue to ensure sound fiscal policies in the Euro Area through a different, more flexible, but still rules-based, system. The reform of the Pact was completed in June 2005. The key questions that surround this reform and that will be discussed in the paper are (1) Why should the reformed SGP be more successful than the “original” one? (2) Does its increased flexibility/softness still force Member States to carry out sound fiscal policy or is the entire fiscal framework of the Euro Area drifting towards higher deficits? and (3) Can the reformed Pact still play a useful role in addressing some of the long-term challenges of the Euro Area?

2. The economic rationale for sound fiscal policy

Creating the conditions for a sound fiscal policy was one of the European policymakers’ major concerns when, in the early 90s, they decided to go ahead with the project of Economic and Monetary Union and the introduction of the single currency. In an economic policy framework like the one in place in the Euro Area, where monetary policy is centralized in the ECB but fiscal policies remain decentralized and there is no sizable federal budget, low fiscal deficits and steadily declining debt/GDP ratios are necessary conditions for effective macro-economic governance.

Although fiscal deficits can play a stabilizing role during economic recessions, persistent fiscal deficits negatively affect economic activity. Recent works from Gale and Orszag (2004) and Engen, Glenn and Hubbard (2005) indicate that a sustained increase in US government deficit amounting to 1% of GDP raises interest rates roughly 20 to 60 basis points, with the weight of evidence around 30 basis points. This has a negative impact on investment and reduces the growth potential of the economy (Congressional Budget Office (2005)). In the case of the Euro Area, there is a further reason to keep fiscal deficits under control: the rapid ageing of the population. To preserve and make sustainable their social models without reneging on welfare commitments despite the additional strain an ageing population will put on public finances, in particular in the fields of pensions and health expenditures, the Member States of the Euro Area must move now towards fiscal positions close to balance or in surplus.

3. Different ways to achieve sound fiscal policies. “Enlightened discretion” versus  rules-based systems

Ideally, “enlightened discretion” looks like the best option to achieve sound fiscal policy over the cycle. Faced with a slowdown of the economy, an “enlightened” government would let the fiscal deficit to widen moderately to support economic activity. Once the recovery is under way, the same government would withdraw the stimulus and consolidate public spending, avoiding the development of structural deficits and the accumulation of a large and growing stock of government debt. Compared to “enlightened discretion”, rules-based systems are only second best solutions. Even if they incorporate some flexibility, rules-based systems cannot adjust as promptly and appropriately as “enlightened discretion” to the uncertainty and vagaries of the business cycle. Furthermore, the risk of running pro-cyclical fiscal policies is higher than with “enlightened discretion”, in particular when rules-based systems contain ceilings to deficit and debt levels that a country can run[1]. Finally, in the upswing of the cycle, the fiscal consolidation implemented by policymakers risks being persistently smaller than would be required to put the country on a sound budgetary position over the cycle.

There is now a large body of literature explaining why even an enlightened government is likely to run a less than optimal policy[2]. For instance, the length of the period between the moment in which an economy slows down and the moment in which concrete fiscal counter-cyclical measures are implemented can be quite long[3], and the bulk of the stimulus may occur when the economy is already recovering and thus becomes pro-cyclical.

In addition to this, political economy theories tend to dismiss the chances that governments are, as a rule, able to adopt “enlightened discretion” in the management of their fiscal policy. On the one hand, governments are much more sensitive to the political-business cycle than to the business cycle tout court[4]. Therefore, in order to maximize their re-election chances, they are likely to raise expenditures or tax cuts ahead of elections even if this is not warranted by the economic situation of the country. On the other hand, governments have their own agenda (e.g., to push the size of government down by initially creating high deficits or, at the opposite end of the political spectrum, to expand the welfare state) and its implementation can require the creation of structural deficits. Since the burden of adjustment of these deficits can be easily passed to future administrations, the absence of fiscal rules can exacerbate this deficit bias.

In the case of an economic and monetary union (EMU) there is an additional risk: free riding. Since monetary policy is managed at “federal” level and the exchange rate is not any longer an instrument of economic policy, fiscal policy for sovereign nations in EMU becomes the most effective tool for macroeconomic stabilization and for stimulating the economy in the short term[5]. Therefore, governments may be tempted to over-use it, in particular if they think that they will be able to shift part of the costs related to higher fiscal deficits and debt to other members of EMU and to the central bank. Since in EMU market feedback is small, excessive fiscal deficits in an individual country do not cause a rise in that nation’s interest rates and do not affect the exchange rate of the monetary union. However, large and cumulative deficits by a number of free riders would lead to increased pressure on the central bank, which would be pressed to allow higher inflation to reduce the real value of those obligations. As pointed out by Martin Feldstein (2005), “a country that increases its own budget deficit contributes to this Eurozone problem but does not bear any disproportionate share of the adverse effect. The free rider problem becomes increasingly important as the number of countries in the European Economic and Monetary Union increases. It is this fiscal externality that justifies an agreement among countries to limit the deficit.” (p.2)

4. Fiscal rules in the “original” Stability and Growth Pact

For the reasons just explained in section 3, EU policymakers agreed to set up for the Euro Area a rules-based fiscal framework based on numerical targets and ceilings on deficit and debt and on the planning and control of government budgets[6]. The numerical targets were set in a Protocol to the Maastricht Treaty. These numerical targets are “3% for the ratio of the planned or actual government deficit to gross domestic product at market prices; 60% for the ratio of government debt to gross domestic product at market prices.” (Protocol (No5) on the excessive deficit procedure, Article 1).

Around these reference values EU policymakers have developed an elaborate legal framework to achieve “sound public finances”, as stated in Art. 4(3) of the Treaty on European Union. As well summarized in CEPR (2003), “EU procedures with relevance to the conduct and coordination of fiscal policy are the Mutual Surveillance Procedure (Art. 99), the ‘no bail-out clause’ (Art. 103), the Excessive Deficit Procedure (EDP, Art. 104), and the Stability and Growth Pact (SGP, Council Regulations 1466/97, 1467/97, Council Resolution 97/C236/01-02). Article 99 holds that Member States of the EU regard their economic policies as a matter of common concern and coordinate them through the ECOFIN Council and of the basis of ‘Broad Economic Policy Guidelines[7].’ The no-bailout clause protects the Community and the Member States from becoming responsible for financial liabilities of other Member States against their will. The EDP sets up a detailed process for monitoring the public finances of the Member States with a view to ensuring that they remain sustainable. It includes the mandate (Art. 3 of the Protocol) that the Member States of EMU should implement appropriate institutions at the national level that enable them to fulfill their obligations for maintaining sustainable public finances … [Finally], the SGP refines and concretizes the procedures of the EDP.” The SGP is therefore the “cornerstone of the fiscal framework of EMU”. (CEPR (2003), p.6).
 

5. The preventive and corrective arms of the Stability and Growth Pact

The Stability and Growth Pact, by defining and enforcing a set of rules aimed at preventing large fiscal deficits, is supposed to be the key instrument to ensure the commitment of Member States to fiscal discipline while allowing them to respond, within certain bonds, to the economic cycle.  The SGP consists of a preventive and a corrective arm.

The preventive arm stipulates that Member States achieve and maintain budgets close to balance or in surplus over the medium term. This should provide some margin for maneuver to an economy in the presence of a cyclical downturn and would allow automatic stabilizers to play freely while respecting the 3% of GDP deficit ceiling (this could not be the case if a country is running a deficit over the cycle. If the budget is not brought close to balance or in surplus in good times, there is the risk that the SGP rules could trigger pro-cyclical policies during a downturn). To demonstrate their commitment to achieve the “close to balance or in surplus” objective Member States must submit every year national stability programs in which they indicate the progress made and the time frame for the attainment of the objective. If there is a significant divergence between the stated objective and what has been achieved, the Council of Ministers, on the basis of a report by the European Commission, sends the government an early warning recommendation.

The corrective arm kicks in if the deficit of a country goes above the agreed numerical target (3%). In such a case the Excessive Deficit Procedure is activated. SGP sets the timetable for adjustment, as well as the possible sanctions if this adjustment does not take place (for more details, see tables at pages 21 and 22). The SGP also specifies when a waiver due to exceptional circumstances (e.g., a decline of real GDP by 2% or a natural catastrophe) may be granted.

6. The mixed results of the “original” SGP

Since its introduction, the Stability and Growth Pact has increased the macroeconomic stability of the Euro Area. The records in terms of budgetary balance, inflation and long term interest rates have improved significantly if compared to those of the 1980s and 1990s[8]. In addition, the SGP helped consolidate the progress made by less virtuous countries in the run up to the euro. For instance, in five years (1994-1999) Italy moved from a situation of high deficits, high inflation and high interest rates to a much sounder position and has remained there since the introduction of the euro (see figure at page 23).

The implementation of the Stability and Growth Pact has also made fiscal policy in the Member States of the Euro Area less pro-cyclical. Even in the absence of significant discretionary fiscal stimulus, fiscal policy was mildly expansionary thanks to automatic stabilizers. Contrary to some critics’ belief that the Pact would impose restrictive policies during economic downturns on Member States of the Euro Area, the SGP has allowed their fiscal position to deteriorate (the fiscal position of the Euro Area moved from a slight surplus of 0.1% in 2000 to a deficit of 2.9% in 2004), contributing in this way to support effective demand during the recent slowdown. As pointed out by the International Monetary Fund, “overall, fiscal policy during the cyclical downturn was in line with standard cyclical policy tenets. Countries generally allowed their automatic fiscal stabilizers to operate in the face of serial, unexpected growth shortfalls, including in 2003. This is in contrast with fiscal policy behavior during the pre-euro era, when most countries tended to conduct pro-cyclical policies. Moreover, the area avoided the weakening of fiscal positions observed in other major currency areas, which could prove difficult to reverse and put pressure on global interest rates, particularly if corporations seek to step up capital spending.” (IMF (2004)).

As a whole, European fiscal policy under the “original” Stability and Growth Pact has been much sounder than in the past. Furthermore, fiscal imbalances in the Euro Area have been much smaller than in the United States and Japan despite the fact that in the last five years these two countries have grown faster (see table at page 24). In a medium-long term perspective the “original” SGP has fulfilled most of the objectives set when it was introduced.  For instance, fiscal slippages were lower and less pronounced than in the past (see figure at page 26), dangerous spillovers of unsound fiscal policies on monetary policy were avoided, and fiscal policy was moderately anti-cyclical[9].

However, these medium to long term successes of the “original” SGP cannot mask a number of failures that ultimately undermined its credibility as an effective mechanism to enforce fiscal rules in the Euro Area.

First, many Member States of the Euro Area did not consolidate their fiscal position in good times (namely in 1999 and 2000), so that when the world economy entered into recession in 2001 they were carrying structural deficits close to 2% of GDP, which inevitably, under SGP rules, limited their anti-cyclical margins of maneuver[10]. As a result, in the following years, many of them (all the big ones among them) were unable to hold the 3% line and were put under Excessive Deficit Procedure (see table at page 25)[11].

Second, in order to keep the deficit in check or at least avoid excessive slippages from the 3% threshold, governments often implemented fiscal consolidation through one-off rather than structural measures. In some cases this was coupled with “creative accounting” practices that made things worse. All these practices undermined the soundness of the fiscal adjustment, with negative repercussions on the medium-term performance of the economy.

Third, even when governments tried hard to carry out fiscal consolidation, the fiscal packages they put forward lacked coherence and relied excessively on tax increases[12]. The result was that they slightly depressed economic activity and were unable to clear the horizon for consumers and investors. Had the horizon been cleared by appropriate policy measures, Euro Area economies could have benefited from fiscal consolidation through a virtuous circle that, by eliminating some long term uncertainty regarding future taxation or the risk of inflating their way out of debt problems, would have positively affected business decisions about investment and hiring, as well as consumer confidence. Unfortunately, the quality of most of the fiscal packages put together by Member States was not good enough to affect expectations significantly and trigger expansionary fiscal consolidation[13], in particular in a context where the duration and depth of the slowdown surprised everybody and contributed to depress confidence.

Fourth, despite all efforts, the fiscal deficits continued to run above 3% because, as just mentioned, economic recovery was much more subdued than in the past. As a result, adjustment packages that ex-ante appeared sufficiently rigorous to bring, with a bit of luck, the fiscal deficit below 3%, ex-post proved to be inadequate because of the disappointing outcome on the revenue side. In the 2001-2005 period economic forecasts at all levels (national governments, international financial institutions, private sector)[14] overstated EU economic growth for the following two years. As a result, national authorities became increasingly frustrated with procedures that indicated that ex-ante the agreed adjustment was more or less fine, while ex-post moved the Excessive Deficit Procedure a step closer to sanctions because of the failure to achieve the fiscal objective despite the implementation of the adjustment package.
 

7. Why reform the Stability and Growth Pact?

The most important implication of the failures just mentioned was that the ownership of the Pact faded away in a number of countries. Trapped in a low growth equilibrium and struggling to introduce painful and politically costly structural reforms, these countries repeatedly missed the SGP targets and step by step moved close to the point of being sanctioned. Since governments in countries with excessive deficits considered that their efforts to avoid growing fiscal imbalances despite the difficult economic situation were not fully taken into account by the SGP and by the European Commission, they increasingly resisted compliance with the rules of the Pact. When in November 2003 the Commission suggested applying to France and Germany Article 104(9) of the Treaty[15], these two countries gathered a sufficient number of votes in the ECOFIN Council to put the procedure in abeyance.

The Commission brought the case to the European Court of Justice, which ruled that “the action of the Commission of the European Communities [was] inadmissible in so far it seeks annulment of the failure of the Council of the European Union to adopt the formal instruments contained in the Commission’s recommendations pursuant to Article 104(8) and (9) EC”. However, the Court also annulled “the Council’s conclusions of 25 November 2003 adopted in respect of the French Republic and the Federal Republic of Germany respectively, in so far they contain a decision to hold the excessive deficit procedure in abeyance and a decision modifying the recommendations previously adopted by the Council under Article 104(7) EC”.

The European Court of Justice ruling confirmed the key role of the rules-based system in the economic governance of the Euro Area, which can not be put in abeyance by a coalition of member States.

However, the Court ruling could not address the underlying causes of the “crisis” of November 2003. It was clear that in a number of countries the ownership of the Pact was lost, and the SGP was increasingly perceived as a hindrance or a nuisance to “good” economic policy, i.e. to measures able to reinvigorate the anemic economic growth of the last couple of years.

Furthermore, the perception grew among policy-makers and the general public that the Pact was excessively focused on procedures and lacked economic content. This was well summarized by then President of the European Commission Prodi, who qualified the Pact as “stupid”. As we have seen in section 3, a rules-based system is a second best and, since it cannot encompass all possible events, it incorporates a certain degree of “stupidity”. On the other hand, the advantage of a simple system is that its rules are clear, relatively transparent and easily enforced. There is a difficult trade-off between “intelligent complexity” and “simple stupidity”, a trade-off which is complicated further by the EU requirement of equal treatment of Member States[16]. The original SGP tried to strike a balance: it favored simple rules, but left to the Commission some margins for maneuver in their interpretation and implementation.

Since the introduction of the SGP the Commission tried to apply the rules with in a flexible and non-dogmatic way. However, rules cannot be stretched up to the point that they become meaningless[17]. The European Commission, in its role of guardian of the Treaty, has the obligation to apply rules and hold Member States to their commitments. So, when it became unavoidable to apply Article 104.9 to France and Germany, the flexible implementation of the original Pact proved insufficient to avoid a crisis. By putting in abeyance the application of article 104.9 to France and Germany, the Council de facto called for a reform of the Pact and the addition of more “intelligent complexity” to it.

8. The reform of the Stability and Growth Pact

To address the crisis over the implementation of the Stability and Growth Pact, in September 2004, in a Communication to the Council, the European Commission put forward five ideas to reform the SGP:

(1)   More focus on debt and sustainability;

(2)   Country-specific medium term objectives;

(3)   Consideration of economic developments in the implementation of the excessive deficit procedure;

(4)   Earlier action to correct inadequate budgetary developments;

(5)   better fiscal and statistical governance.

Although some of them were not fully included in the Council Conclusions of 23 March 2003 and in the Council Regulation n. 1005/2005 of 27 June 2005 that amended the SGP (in particular, the increase of the focus on debt and sustainability fell short of what the Commission initially proposed), these five ideas served as foundations for the reform of the Pact. The reform, while confirming the Treaty rules for economic and budgetary co-ordination as well as the 3% and 60% reference value for the deficit and the debt, introduces more “economic content” into the Pact, making it more flexible and complex. As European Commissioner Almunia pointed out just after the approval of the reform by the Council, “the key elements of the existing framework have been preserved, while more room has been created for sound economic judgment in the application of the rules”.

The SGP reform amends both the preventive and corrective arm of the Pact. With regard to the preventive arm of the SGP, the reform sets a country-specific budgetary objective (the medium-term objective) on the basis of the existing fiscal position (defined by the current deficit and debt ratios, as well as potential growth) of a country. If a country has a very low debt on GDP and high potential growth, and its public finances are developing in a sound manner, it is allowed to run a small deficit over the cycle. On the other hand, countries with high debt/GDP levels will be expected to run fiscal surpluses over the cycle. In this respect, the reformed Pact sets a minimum fiscal adjustment towards the medium term objective.

The reform also strengthens the commitment that Members of the Euro Area must take to avoid pro-cyclical policies in good times.  Against this background, the new regulation gives the Commission the option of giving “policy advice” to countries which are not sufficiently consolidating their public finances under favorable economic conditions.

In the past the Pact was criticized for not taking into account the fact that temporary deficits could arise from key structural reforms aimed at increasing the long term potential of the economy. The reformed Pact provides incentives to the countries that carry out structural reform, in particular those that have direct long term cost-saving effects and verifiably improve fiscal sustainability (e.g., a reform of the pension system), by allowing temporary infringements of the 3% deficit threshold. The new rules therefore ensure greater consistency between the objectives of fiscal discipline and the implementation of pro-growth reforms in the framework of the so-called Lisbon Agenda.

With regard to the corrective arm of the Pact, the reform introduces deeper and more comprehensive economic analysis in the application of the excessive deficit procedure. For instance, the new interpretation of the rules allows expanding the one-year deadline for the correction of the excessive deficit by an additional year where a correction in the year immediately following the detection of an excessive deficit could trigger pro-cyclical fiscal policies because of an economic downturn. This is a sensible decision, since the depth and length of economic cycles have become less stable in recent years. Therefore, the risk of carrying out pro-cyclical fiscal policies under the “original” Pact has increased. The new regulation reduces this risk, while still keeping the pressure on the country to re-enter from its position of excessive deficit.

Under the strict provision that effective action has been taken by the country concerned, the new rules also allow the Council to decide to repeat certain steps in the excessive deficit procedure. The Council also agreed to make less stringent the exceptional circumstances under which a waiver to the excessive deficit procedure could be obtained[18].

Finally the new agreement gives more attention to a provision of the Treaty allowing for a broader judgment when deciding on the existence of an excessive deficit and determining the deadline for its correction. The SGP now refers to the “relevant factors” that the Commission and the Council take into account for those decisions. These factors include, inter alia, developments in potential growth, prevailing cyclical conditions, debt sustainability, the implementation of policies geared towards meeting the objective of the Lisbon Agenda, the record of fiscal consolidation in good times, development aid, the cost of German unification, and contributions to the EU budget[19].

Compared to the “original” Pact, the reformed SGP also sets clearer conditions for the adjustment path out of an excessive deficit position. In particular, it sets a minimum fiscal adjustment of the size of 0.5% of GDP in cyclically-adjusted terms, irrespective of other relevant factors, that a country has to implement[20].

Complementary to these changes in the rules, the Council also agreed to a number of measures to improve fiscal governance within the EU. For instance, it suggested that national institutions and parliaments could play a more prominent role in domestic budgetary surveillance, thereby complementing the monitoring and surveillance procedures at the EU level. The Council also agreed to strengthen the overall functioning of the European system of statistics, not least to minimize the budgetary misreporting that in previous years undermined the credibility of the fiscal position of a number of countries.

9. Criticism of the SGP reform

The reform of the Pact has been criticized from various quarters. While a number of academics consider that it has excessively softened the Pact, making it less credible and more prone to fiscal loosening and growing deficits, a number of European policy-makers consider that the reform has not gone far enough and the SGP remains a straitjacket that does not allow fiscal policy to play fully its counter-cyclical role and support economic activity in the current cycle.

9.1. A too soft Pact?

In a recent paper Lars Calmfors noted that “the changes in the Pact are a large step away from a rule-based system back to a system of discretionary policy making” (Calmfors (2005), p.1). This step loosens fiscal discipline in the Euro Area in much the same way it occurred in many of its Members in the 1980s and 1990s. According to Calmfors, the largest damage made by the reform is “the credibility loss from the demonstration that the EU fiscal rules are endogenous and likely to be adjusted in response to violations” (p.1). He considers that, in future, the 3% deficit ceiling will not be a constraint any longer. At most it will operate as a “non-binding benchmark in the public debate”. He considers that a strict interpretation of the reformed Pact is very unlikely, since “the same forces that caused the breakdown of the enforcement mechanism in 2003 and the subsequent revision of the Pact continue to operate”.

Another critic of the SGP reform is Martin Feldstein. He points out that with the reform there is no longer any restraint on the deficit of individual countries. Furthermore, the SGP has become too lenient with regard to the timing of adjustment. As a result, “each country will find ways to rationalize growing fiscal deficits, comfortable in the knowledge that there will be no formal pressure from other EMU countries and that the interest rate effects will be the same for all EMU countries” (Feldstein (2005), p.9). Feldstein sees this as a dangerous miscalculation. Unfortunately “the European Council [in its March Conclusions] has done nothing to reconcile the independent fiscal decision making with the single currency”.

9.2. A Pact still too harsh?

Some policymakers, in particular from countries already in excessive deficit procedure[21], have criticized the reform of the Pact, since they consider that it does not go far enough. Further, by disallowing deficit exclusion of investment, R&D or tax reform, it still hinders economic recovery in the Euro Area. They also argue that at present inflation is well under control and risks of a spillover of expansionary fiscal policy on inflation (and therefore monetary policy) are practically non-existent. Since there is some slack in the European economy due to weak domestic demand, expansionary fiscal policies would be beneficial to economic activity, and putting recovery on a self-sustained path even if this implies that some countries will have to run temporary deficits above 3%. The cost of such an expansionary fiscal policy would be small, since worldwide interest rates are at historical lows and therefore the benefits of a stronger recovery would easily outweigh the costs related to the financing of the deficit. Once the recovery is re-established and the slack is reabsorbed, countries with high deficits would start again to consolidate their public finances.

10. Some answers to the critics of the reform

Those, like Calmfors and Feldstein, who consider that fiscal discipline in the SGP has been weakened beyond repair have overlooked the fact that the reformed Pact has also more stringent provisions regarding one-off measures, the minimum adjustment that is required to reduce excessive deficits (0.5% of GDP in cyclically-adjusted terms) or the more effective use of favorable economic periods for budgetary consolidation. Furthermore, it is quite surprising that they discard the enhancement of the economic rationale of the rules of the Pact, since this has been one the major criticism addressed to the “original” SGP when it was approved in 1996. If the objective of the Pact is to promote sound fiscal policy among the members of EMU and not simply punish the rule- offenders for the sake of enhancing the credibility of its corrective arm, then the reformed SGP is a better and more balanced framework if compared to the original Pact. Because of the reform, its anti-cyclical components have been strengthened, both in good and bad times, and the risks of sanctioning a country for the wrong reasons have been lowered.

Calmfors and Feldstein put too much emphasis on policymakers’ keenness to increase deficits. They seem to be prisoners of their deficit bias and fiscal rule endogeneity theories and do not see that there are also forces pushing in the opposite direction. There is no doubt that governments most of the time (but not all the time) have deficit biases, but there are also decreasing returns, both political and economic, in sustained fiscal deficits. Policy-makers are aware of that. If they do not act to curb growing unsustainable deficits, they risk being voted out of office[22]. Incumbents must also face the comparison game to which they are exposed by the opposition, the media and public opinion. For a government to have the worst track record (or one of the worst) in terms of public finance inside the Euro Area is unlikely to produce a large payoff, even if the deficit is created to distribute goodies to its own electoral base. But poor policies may offer benefits to others. For example, France and Italy could hide behind Germany bad track record in public finances. However, on this front, things are changing. If Germany is able to put its house in order, France and Italy will have to adjust their fiscal policy strategies accordingly[23].

Last but not least, “sound fiscal policies in the Euro Area” is a public good that benefits all its members. The SGP is the instrument needed to achieve such a public good. European governments are well aware of this. The crisis of 2003-2004 produced some serious damage, and part of the public good was lost. Such a loss was reflected in a number of economic and political indicators (e.g., the decline in confidence in the policy-making of the Euro Area by financial markets and the public, the general perception that the European construction was not progressing). Aware of the importance of a shared fiscal framework, the Members of the Euro Area opted for a fresh re-start on the basis of a reformed Pact. To be credible, this re-start can happen only once. Should a new crisis intervene and the Pact be put in abeyance again, there would be no room for further reform and the public good ensured by the SGP would vanish. This would put the economic and monetary union at risk and, by increasing uncertainty and financial market volatility, would negatively affect economic activity in the Euro Area. Against this background, policy-makers have to carefully consider the costs of being blamed by the opposition, the media and public opinion for the collapse of the European fiscal framework. This is not a light responsibility and will likely act as a major constraint towards those governments that, because of a deficit bias, might be tempted to renege or re-negotiate the new, more flexible, SGP rules.

With regard to the “fiscal policy still a straightjacket” critique, there are two main objections to it. First, there is very little evidence that, with the exception of Germany, the current economic slowdown in the Euro Area was the result of insufficient demand. In fact, the countries that in recent years had the best economic performances in the Euro Area (Spain, Finland, Belgium and Ireland) were also the countries that were able to keep their fiscal position close to balance or in surplus[24]. The insufficient progress made in structural reform is the main cause of the weak Euro Area recovery since 2003 and it is not surprising that the countries that in the last fifteen years have lagged behind in its implementation are also the economies with the lowest economic growth and the biggest fiscal imbalances[25].

Second, with its long term fiscal problems due to the rapid ageing of population and to the increase in health expenditures, the Euro Area cannot afford fiscal swings of the size of the one that took place in the US between 2000 and 2003 (6% in nominal terms and 4.1% in structural terms). Such a swing (and the difficulty of reabsorbing it) would have created a huge strain in the already unsatisfactory long term fiscal position of the Euro Area[26]. The Euro Area has to put its fiscal house in order as soon as possible if it wants to keep its welfare state systems viable and must be aware that over the long term it will only have narrow margins of maneuver for its fiscal policy. High fiscal deficits today may make them even narrower, with high potential costs in terms of future economic counter-cyclical stabilization and growth.

11. Fiscal policy after the reform of the Stability and Growth Pact

Fiscal policy developments since the reform of the Pact point to the possibility of renewed credibility for the reformed SGP. Greece should be able to move below the 3% deficit ceiling already in 2006 and the new German government has just agreed on a set of fiscal consolidation measures that should bring the deficit below 3% in 2007. France may already be able to move below 3% in 2005, although, because of one-off measures, further structural fiscal consolidation is needed in 2006 and 2007. Italy and Portugal have still some ground to cover before being removed from the Excessive Deficit Procedure, but their budgetary laws are moving these countries in the right direction. Implementation so far has conformed to the reformed rules and potential escape clauses have not been used or have been rejected by the Council on the basis of a Commission assessment. Fiscal policies in countries in Excessive Deficit Procedure are trying to live up to their commitments.

From a comparative viewpoint, looking at recent developments in the budgetary position of the US and Japan, the Euro Area does not appear to have moved towards loose fiscal policies. On the contrary, against Calmfors and Feldstein’s dire predictions, it is the Euro Area and its Member States that, among the big OECD countries, are making the biggest efforts to correct fiscal imbalances. And this situation is unlikely to change in the coming years. In the US, major structural reforms (Social Security, health care, tax reform) that had the potential to curb the US federal deficit have de facto been postponed to the next decade. In Japan, while there are talks to begin fiscal consolidation, there are no clear signs yet that this will start any time soon.

From what we know at this stage, the fiscal policy of the Euro Area after the reform of the Stability and Growth Pact seems to have started out on the right foot. Blocking majorities look now less likely because of (1) the increased economic substance of the reformed Pact; (2) the awareness that a new crisis of the SGP would destroy the public good represented by “sound fiscal policies in the Euro Area”; and (3) the possibility that a number of countries will move below the 3% deficit ceiling in the next two years. These countries will likely become more reluctant to put procedures in abeyance to favor other countries that did not make sufficient efforts to put their fiscal house in order. Furthermore, there are signs of a growing ownership of the reformed SGP by some Member States (in primis Germany) as well as a renewed determination to move towards sound public finances to be better able to face long term challenges such as the ageing of the population.

However, there are risks to this scenario. First, the major tests to the credibility of the reformed SGP are still ahead. Fiscal policies in large countries for 2006 and 2007 may still fall short of the Pact’s requirements and short term political considerations may overcome once again long term benefits that the reformed SGP provides. Second, to be viable, the reformed SGP requires that in the next couple of years the major countries of the Euro Area will move to fiscal positions close to balance or in surplus. This is easier said than done, since it does imply major (and unpopular) reforms. The fact that a major electoral cycle in the Euro Area should be over by spring 2007 (French Presidential elections) should help, but strong political commitment to such an objective is still lacking. However, if countries are not able to move in relatively good times to positions close to balance or in surplus, the Calmfors’ risk of an endogeneization of fiscal policy rules at the next recession may materialize and undermine the foundation of the reformed SGP.

12. Conclusions

Ultimately, the success of the reform of the Stability and Growth Pact depends on the political resolve by Euro Area governments to play by the new rules because they are convinced of the need to preserve sound fiscal policies as a public good for the Euro Area. The reformed SGP is the instrument that can deliver that good and avoid unwelcome spillovers on monetary policy.

The original Pact collapsed because of its intrinsic limits, rigidities and contradictions, as well as the weakening of ownership by the Member States of the Euro Area. The reform of the Pact took ten months of difficult negotiations. The final product may not be “optimal”, but it represents a clear improvement from the past: what has been lost in terms of simplicity and transparency has been more than regained by enhancing the economic rationale of SGP rules, building bridges between fiscal policy and structural reform[27], setting clear adjustment procedures, and strengthening the anti-cyclical components of the fiscal framework. Because of these significant changes there is no room for a further reform of the Pact: either it succeeds or the Member States of the Euro Area will have to concede that they are not able to live up to the obligations of a rules-based system. They will have then to find a way to make decentralized discretionary policies compatible, an almost impossible task.

If the renewed commitment of Member States to play by the rules is real (and this will be tested in the near future), the EU fiscal policy after the reform of the Stability and Growth Pact should become more (and not less) stringent and bigger efforts will be made to bring deficits below 3% by the major economies of the Euro area. This may appear as a paradoxical outcome, since the general impression is that the Pact has been made softer and easier to bend. However, since the alternative is in reality between a Pact that contains reasonable rules, a strict Pact with no enforceable rules and a framework with no rules at all, the first solution appears the most desirable one politically, and is likely to attract the highest level of commitment. Therefore countries like Germany, France and Italy all have a strong interest (maybe not the same, but not incompatible) in the success of the reform. This interest should be big enough to outweigh the short-term deficit bias that governments in general have in the implementation of fiscal policy. There are therefore good reasons to expect that, with a bit of luck (i.e., a business cycle that is not too unfavorable to the Euro Area), the implementation of the reformed Stability and Growth Pact will be more successful than the original SGP.
 

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Source: European Commission

 Breaches of deficit and debt criteria and the excessive deficit (ED) procedures in the Euro Area countries, 1999-2005