101 proposals to reform the stability and growth pact. why so many? A survey.

Author:Jonung, Lars
Position:Report
  1. INTRODUCTION (1)

    The purpose of the paper is to analyze the large number of proposals for reforming the Stability and Growth Pact (SGP) presented by professional academic and non-academic economists in recent years. The background for our study is the crisis of the EU fiscal framework which led to the suspension of the SGP in November 2003 and the adoption of a reformed SGP in March 2005. Growing political tensions went along with a lively discussion about the main caveats of the EU budgetary framework and potential solutions. The discussion within political and academic circles gave rise to a veritable industry of 'SGP therapists' who produced a wide range of proposals on how to properly implement fiscal policy-making in the Economic and Monetary Union (EMU).

    When viewed from an adequate distance, the discussion about the SGP can be read as the symptom of a more fundamental disagreement. As regards the political debate, it could simply be taken to mirror conflicts of interest or dynamic inconsistencies which feature prominently in the political economy literature. The disagreement among professional economists has a somewhat different connotation. It clearly signals the lack of consensus about the proper goals and instruments of fiscal policy, either in a domestic and or in an international setting. Even the empirical question about the effects of fiscal policy measures on domestic and international demand is disputed. There is also a lack of agreement concerning the proper institutions for framing fiscal policy. This state of affairs is in sharp contrast to the case of monetary policy, where there is more of a consensus about the goals, instruments and institutional framework of monetary policy-making.

    The fact that the EMU is a unique construction adds to the debate. The euro area is the first monetary union in history where a group of independent countries devolve their monetary sovereignty to a common central bank, the European Central Bank (ECB), while retaining domestic control over fiscal policy, thus giving economists new turf on which to test their ability to present policy proposals. And they have used this opportunity amply.

    The paper is organised as follows. Section 2 reviews the history of the SGP. This survey is crucial to understand the economic and political background of the many proposals for reform. Section 3 examines 101 proposals of reform of the SGP using cluster analysis. Each proposal is classified according to a number of variables such as the main policy objective pursued and the proposed degree of policy modification involved. Section 4 compares the actual reform of the SGP adopted by the Council of the European Union with the academic debate reflected in the 101 proposals. Section 5 offers an explanation of why there are more than one hundred proposals on the market for reforming the SGP. The final section concludes.

  2. SAILING WITH THE SGP: A HISTORICAL OVERVIEW

    The SGP is a rule-based framework for the coordination of national fiscal policies in the EMU. It was established to address the risk of negative spillovers from the budgetary positions of individual Member States into the common monetary policy. It consists of (i) a preventive part which requires Member States to attain sustainable medium-term budgetary positions, and (ii) a corrective part laying out procedural provision for the correction of an excessive deficit. (2)

    Whether there is a need for a common framework for fiscal policy co-ordination and, if so, how it should be designed, has never stopped being debated, though the intensity of the debate has ebbed and flowed.

    2.1. DESIGNING, BUILDING AND NAMING THE SHIP: FROM MAASTRICHT TO A STABILITY AND GROWTH PACT

    Before the Maastricht Treaty was signed in 1992, the debate mainly revolved around the question whether an optimal currency area was a pre-condition for a successful monetary union or whether monetary integration itself could drive harmonisation. (3) As regards fiscal rules, there was a majority view that restrictions on national fiscal policy were necessary. Prominent dissidents include Bean (1992).

    In the mid-1990s, Germany got cold feet as its domestic climate became more hostile to the idea of EMU. The Germans' fear was that once countries had passed the convergence tests and entered EMU, their incentives to stick to budgetary discipline would evaporate. To persuade Germany to give up the DM, more assurance was required that fiscal policies would remain sound also inside the EMU, especially on the part of members with a history of high inflation, deficits and debt. In 1995, the German Minister of Finance Theo Waigel proposed a 'Stability Pact for Europe' where the 3% of GDP deficit objective (one of the convergence criteria for joining the euro) would become a firm upper ceiling, sanctions for exceeding the reference value would be automatic and a new Stability Council comprising only participating Member States would implement the framework. The end product was far less mechanical. The Commission set up a framework that (i) clarified the provisions of the Maastricht Treaty regarding the excessive deficit procedure, and (ii) committed the members of the monetary union to a medium-term budgetary objective of 'close to balance or in surplus'.

    On the basis of 1997 outcomes, 11 countries qualified for EMU. The consolidation efforts were considerable, even if some 'creative accounting' and other one-off measures on the margin also helped bring government deficits under the ceiling. Moreover, 1998 was a good year in terms of economic growth creating some margin for manoeuvre within the 3% of GDP reference value and setting the scene for a good start of the EMU on 1 January 1999.

    2.2. SETTING SAIL AND ENJOYING FAIR WINDS: 1999-FISRT HALF OF 2001

    Building on the 1997-98 developments, the SGP got off to a smooth virgin voyage. In 1999, the first operational year of the SGP, the euro-area Member States' budgetary deficits continued to improve on the back of good growth conditions. Figure 1 presents the weighted budget balance for the euro area and the projections made across consecutive generations of stability programmes. It shows clearly that on average budget deficits in 1999-2000 came out better than planned. For 1999, the main explanation was the composition of economic growth which turned out to be very 'budget-friendly' yielding higher-than-expected tax receipts. (4) The easy sailing with high growth continued in 2000. (5) Eight out of twelve euro-area countries showed budget surpluses.

    The improvement of headline deficits concealed the fact that underlying budgetary positions did not change as much. According to the current Commission estimates the euro-area cyclically-adjusted budget deficit was close to 2% over the 1997-2000-period and the primary cyclically-adjusted balance deteriorated.

    In spite of improving headline budget figures, some discussion started on how to make the framework binding in good times as well as in bad ones. Some commentators, including the Commission, argued that it would be better to pay more attention to cyclically-adjusted budget figures.

    [FIGURE 1 OMITTED]

    In March 2003, following the November 2002 Commission Communication 'Strengthening the coordination of budgetary policies', the ECOFIN Council adopted a report formally changing the status of the cyclically-adjusted budget balance from a complementary analytical tool to a key element to assess compliance with a number of SGP provisions. (6) The report considered that the compliance with the close-to-balance-or-in-surplus requirement of the SGP should be assessed in cyclically-adjusted terms and that countries with a deficit must improve their cyclically-adjusted budget position and, in the case of euro area countries, by a minimum annual reduction of 0.5% of GDP. Unsurprisingly, experience gathered in practice has shown that cyclically-adjusted budget balances are frequently revised in view of the uncertainty surrounding real-time output gap estimates (see for instance Hughes Hallett et al., 2007).

    2.3. HITTING HEAVY WEATHER AND FINALLY RUNNING AGROUND: SECOND HALF 2001-MARCH 2005

    Towards the end of spring 2001 a decisive shift occurred when the economic cycle took a sudden turn for the worse, which give way to a protracted period of slow growth. Signs of procedural alarm started to show in 2002 as the first steps were taken to implement the SGP's corrective arm. Early that year the Commission recommended the Council to issue an early warning to Germany and Portugal as their deficits were approaching the 3% of GDP reference value. (7) The Council, however, decided not to follow the Commission's recommendation. This conflict contained already the key elements emerging in the forthcoming reform debate: the Council versus the Commission, small versus large Member States, acting early on indications versus waiting for outcomes.

    By autumn 2002, it was clear that both Germany and Portugal would breach the 3% of GDP reference value; the situation in France was also deteriorating rapidly. After this, things moved quickly. (8) The 2004 budget proposals showed that Germany and France would fail to bring their deficits below the 3% of GDP reference value in 2004 as required. At this stage the Commission asked the Council to issue a new recommendation to the two countries, requesting further action on top of that included in the 2004 budgets while at the same time postponing the deadline for meeting the 3% limit by one year, to 2005, in view of the weak economic outlook. However, at the meeting on 25 November 2003, the Council decided not adopt the recommendations and put the procedure on hold instead. The decision was not unanimous. Most of the smaller Member States (incidentally usually fulfilling the 'close to balance' requirement) voted in favour of the Commission's recommendation but the larger countries (France, Germany, Italy and the UK) formed a blocking minority.

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