Can the Stability Pact Be Reformed?

The European Commission recently proposed important changes to how the Stability and Growth Pact (SGP) is to be implemented. Now the Commission and ECOFIN (the committee of euro area finance ministers) are reviewing the proposals, as well as others put forward by member states. A decision is expected in the first half of 2005, but how the Pact will be revised remains uncertain.

The need for reform is self-evident: with structural factors accounting for 75-80% of aggregate budget deficits for the euro area in recent years, the Pact’s 3%-of-GDP ceiling for national budget deficits has been breached repeatedly since 2002. Smaller member states, notably Finland and Ireland (as well as Spain) and the two non-euro area countries Denmark and Sweden, have stuck to the principle of fiscal balance or small – though diminishing – surpluses. But the largest European Union members, including the United Kingdom, France, and Germany, have been unable or unwilling to play by the rules.

Indeed, France and Germany barely escaped financial sanctions in November 2003 for their violations of the Pact. Although the European Court of Justice later declared that decision invalid, the impasse remains. So either fiscal behavior or the Pact’s rules must change.

The European Commission’s recent proposals amount to a relaxation of its earlier hard-line stance, providing a catalogue of ways in which the fiscal rules can be made more flexible. But it is difficult to see how this hodge-podge will “strengthen economic governance” or clarify the Pact’s implementation.

None of the proposals are mutually exclusive, but there are trade-offs. If, for example, one extends the time period over which member states are required to conform to the rules, there is less need to modify the rules themselves. If deficits are redefined to exclude certain expenditures, the 3% ceiling can be observed.

But removing some public expenditures from the deficit runs counter to sound execution of fiscal policy. For example, Germany recently proposed that expenditures undertaken to meet European commitments – such as Rampamp;D spending to support the Lisbon agenda of enhanced productivity – be exempted. The problem is that allowing public investment to be financed by borrowing would lead to continuing disputes between the Commission and individual member states, because it relies excessively on that blurred distinction.

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Others seek to broaden the definition of “exceptional circumstances” to permit the deficit ceiling to be breached in any year with prolonged unsatisfactory GDP growth, not just -2%. In particular, countries that break the Pact’s deficit ceiling because they overestimated their growth – and hence government revenue – want to be treated more leniently than those who deliberately violate the rules. This may sound principled, but basing deficit monitoring on targets rather than outcomes merely strengthens an already powerful incentive for governments to rig their forecasts.

Yet an exception might be warranted where a violation of the deficit ceiling has led to fiscal tightening in line with advice from the Commission and endorsed by Ecofin. Having violated the ceiling in 2002, Germany looked set to do so again in 2003 despite tightening its budget along Commission lines. When it turned out that Germany’s starting position had been more unfavorable than initially thought and that revenues were again failing, Germany’s government objected to additional consolidation. Where a country’s fiscal adjustments have been approved by its peers, there should be limits on how much more can be asked of it.

All of this may be beside the point, for it is the threat of financial sanctions under the Pact that inspired governments to seek to reform its rules. But the Commission now proposes to put the emphasis entirely on peer pressure – naming and shaming offenders. This may encourage national policy-makers who defend the SGP’s deficit ceiling to continue to do so, but peer pressure will lose some of its effectiveness when the ultimate threat of sanctions disappears.

In short, the Commission’s proposals and the follow-up suggestions put forward by some governments have forced open a Pandora’s Box. Both the Commission and the euro area countries seem to be hoping that more rapid growth will ease – and ideally resolve – the dilemma that reform of the Pact has put before them.

TABLE 1

GENERAL GOVERNMENT FINANCIAL BALANCES

(% OF NOMINAL GDP)

2000-06

p Projected

Source: OECD Economic Outlook 76 database.

TABLE 2

GENERAL GOVERNMENT CYCLICALLY-ADJUSTED

FINANCIAL BALANCES

(% OF NOMINAL GDP)

p Projected

Source: OECD Economic Outlook 76 database.