Can the Eurozone’s Stability and Growth Pact be Made to Work?

This column argues that the European Commission’s reform proposals for the pact include some good ideas but many bad ones. If adopted, it says the pact will not significantly advance fiscal discipline in the Eurozone but it could turn out to be a transition to an effective framework.

After months of negotiations at all levels, including the Van Rompuy task force and sharp statements by the German government, the Commission has put forward its proposal to reform the Stability and Growth Pact. The ball is now in the court of the Council of Finance Ministers who, in all likelihood, will give their blessings to the proposal, at least to its core.

The Commission, at long last, admits that there was something wrong with the pact, including after the 2005 revision that it had previously described as nearing perfection. The Greek debt debacle, and its contagious impact on several other countries, had made this position untenable. The creation in May of the European Fiscal Stability Fund, endowed with a mega-borrowing ability of €440 billion, was hard to swallow in some countries. After weeks of dithering, Germany pitched in but requested a rigorous hardening of the pact.

Diagnosis of the Eurozone’s ills

Any reform should start with a diagnosis of what was wrong. Simplifying somewhat, two main views have been advanced.

• The first one, which we could call the German view, is that the pact is too weak.

The sanctions are too lenient, they kick in too slowly and they are not automatic, meaning that they are decided by a political body prone to compromises and leniency (the EU’s Council of Finance Ministers, ECOFIN).

Indeed, the Council effectively has suspended the pact twice, every time it was about to impose sanctions, in 2003 (Germany and France were saved the disgrace) and during the current crisis.

• The second view, which we could label the institution view, is that the pact cannot work because it has the wrong objective and because the European Treaties identify fiscal policy as a matter of national sovereignty.

In that view, only institutional reforms can fix the problem – if possible at the European level (meaning a new treaty), or at the national level (meaning changes in national fiscal policy institutions). (See this point formally analysed in Krogstrup and Wyplosz 2006).

These two views are largely mutually exclusive. If the second view is correct, hardening the pact will not deliver what its sponsors want, namely forcing a sovereign government and its parliament to do what they do not want to do. If the first view is correct, changing institutions is unnecessary. It is puzzling, therefore, that the Commission endorses both views and advances proposals inspired from both of them. This could be a shrewd, diplomatic compromise if both categories of proposals were crafted to be equally effective. Unfortunately, the hardening proposals are relatively precise while the institutional proposals are too vague to make a serious difference.

The starting point

The initial Pact was sharply focused on the 3% ceiling on annual budget deficits. This objective ignored that governments do not have much control on annual budgets because tax revenues are strongly pro-cyclical. Additionally, the pact linked fiscal discipline, an inherently long-run concept, to short-term outcomes, annual budget balances.

• The first mistake, the cyclicality of budget outcomes, was recognised in the 2005 revision, which emphasised cyclically-adjusted budget balances.
• The second mistake is now, at great last, dealt with by recognising a well-established economic principle. That is, fiscal discipline is achieved when the public debt, as a share of GDP, does not increase and possibly declines in the long run.¹

The practical translation of this principle is elegant, but short-termist. The proposal reaffirms the 60% debt threshold, very unfortunately written into the treaty in the late 1990s. It requires that any excess above this threshold be reduced by one 20th each year over the three following years.

This way of turning around the 60% nonsense is undoubtedly clever. For example, a country whose debt stands at 100% of GDP must reduce this ratio by 2% of GDP every year. This is possible, indeed desirable, over a complete business cycle, but business cycles usually extend over more than three years. This seemingly small mistake is bound to undermine the debt criterion because culprits will have an easy time explaining that they did their best but, unfortunately, prevailing economic conditions stood in their virtuous way.

The mistake seems to be related to the three-year horizon enshrined in the Broad Economic Guidelines, a by-product of the Pact that has failed to make any difference outside of the walls of the Commission. Inward-looking considerations derail what could have been a significant step forward. Debt reduction will become the heart of the corrective arm of the pact, which comes into play when a country has failed to reduce its deficit below 3% of GDP.

The other proposals concern the corrective arm, a set of measures to be taken when a country starts to violate the pact. The Commission has long advocated tightening the noose early on, before reaching the stage where a country repeatedly fails to meet the pact and a sanction must be imposed. Indeed a preventive arm was adopted in the 2005 revision.

Sanctions

The correct underlying idea is that the key to fiscal discipline is to reduce the debt in good years, when economic growth generates large tax revenues, while fiscal policy must become expansionary in bad years. The plain lesson of the last few years is that the preventive arm has been useless as many governments have quickly spent revenue windfalls. It is tempting to associate this failure to the lack of sanctions.

This is indeed the conclusion that is being drawn. The proposal is that sanctions – a deposit of 0.2% of GDP – would kick in automatically as soon as the Commission issues a warning, unless, again, censured by a qualified majority of ECOFIN. The warning would be issued when a country whose deficit exceeds 3% of GDP fails to reduce it by 0.5% each year. Here again, the legacy of the mistaken focus on annual deficits weighs in.

The Commission adds another obligation for countries with an excessive deficit, which would be yet another reason to impose a sanction. The new obligation is that public spending should not grow faster than GDP. The objective is to strengthen the preventive arm. Many countries would do themselves a favour by reining in public spending as a share of GDP. In addition, there is convincing evidence that fiscal stabilisation is long-lasting when spending is reduced, not when taxes are raised (see Alesina and Perotti 2005 among others). The risk is that countries under the microscope of the Commission will keep spending growing at the required speed, and will let it grow faster once off the excessive deficit procedure simply because the first move will have been presented as an obligation imposed by “Brussels”, not as a welcome step.

Under the proposal, therefore, each Eurozone member country will be subject to three budget criteria:

• the infamous annual budget ceiling,
• the new debt reduction obligation; and
• the spending growth limit.

In each case, a sanction can be imposed, initially as a deposit, then as a fine in case of non-compliance, and it would come faster than in the current version. The most important change concerns the decision process. So far, the process has involved the Commission recommending a sanction to ECOFIN and the Ministers deciding at a qualified majority.

Germany wanted to make the decision automatic, presumably giving the Commission the power to impose fines. In the end, the proposal is to reverse the decision mechanism. The Commission proposes a sanction to ECOFIN and the proposal is accepted unless a qualified majority opposes it. If this proposal is accepted, it would radically modify the situation and indeed give teeth to the pact.² Indeed, it is always difficult to assemble a qualified majority, so the default option, the one that applies in the absence of the required quorum, is the most likely outcome.

But quasi-automatic sanctions are likely to sow the seeds of a major conflict between member states and the Commission, and within member states as a sanctioned country will feel abandoned by the others. Imposing a fine on a friendly sovereign state, with a democratically elected government, is an unknown experiment. It will take a lot of courage – irresponsibility, some will say – for a Commission to trigger a mechanism which is bound to unleash violent anti-European sentiment. The proposal in effect puts the Commission in an impossible situation. Either it imposes a sanction, and the political reaction could be disastrous, or it shies away, and the pact is undermined, once again.

The Commission’s proposal recognises that fiscal policies are a national prerogative and that adequate country-level measures can increase the odds that fiscal discipline can be achieved without the pact paraphernalia (see Wyplosz 2005 for more discussion). All of the required ingredients are there: the need for honest statistical reporting, the need to separate the task of collecting data (which can remain in government control if integrity is guaranteed) from the task of making forecasts (which must be transparent and clearly related to other forecasts), the need for an independent watchdog, the need for multi-year programming and the usefulness of country-level fiscal rules. All of that must be put in place by 2013.

Vague definitions

The problem here is that the definition of what would be required remains vague. The independent watchdog is mentioned as desirable. Acceptable fiscal rules are not specified, nor are guarantees that the rules will be enforced. The only precise requirement is that of a “European semester”, which mandates that budget law drafts be submitted to the Commission in the first semester of each year, long before they are submitted to national parliaments. The idea is that the actual budget laws eventually submitted to parliaments will have been ex ante validated by the Commission as compatible with fiscal discipline. If it worked, it would be the solution to the conundrum of collective oversight when decisions are national prerogatives. Yet, everyone who has looked at the budgetary process knows that real-life budget laws are the outcome of fierce negotiations between the government and parliament, with considerable input from myriads of lobbies. The European semester is just another good but ineffective idea, which is precisely why it will cynically be accepted while much of the rest, which matters most, will not happen.

Finally, the Commission proposes that cyclical imbalances, eroding external competitiveness and current-account imbalances, be the object of detailed monitoring. The method will involve scoreboards and, when needed, detailed analyses by the Commission. The proposed enforcement mechanism is peer pressure.

Ten years of experience with the ill-fated Lisbon process, which relied on scoreboards and peer pressure, have demonstrated beyond doubt that such a mechanism is bound to fail. Worse, there is no explanation why current-account imbalances matter in a monetary union. Other monetary unions, federal states with a common currency like Australia, Canada or the US, do not even bother to measure sub-federal unit current accounts and yet, they work. Units with deficits simply see their money stocks shrink through capital outflows, which eventually force the required relative price adjustment.

The problem is one of price non-adjustments, made possible over the long run by wasteful public interventions. If fiscal discipline is established, non-adjustment then becomes an issue of misusing tax income, which should not be of concern to other countries. For example, had the government budget been balanced in Greece, current deficits would have reflected an excess of private spending over private income, possibly in response to perverse public policy incentives. The external debt would have been private. Foreign lenders, largely banks, would have known that they were taking unreasonable risks. If they had been properly regulated, this could not have gone very far.

Monitoring current-account imbalances thus appears as a substitute for adequate bank regulation and supervision, a clear third-best approach – or worse. In the end, the Commission proposal on economic imbalances is deeply misguided and a dangerous encouragement toward lax bank regulation and supervision.

A fair bet is that the pact will fail again, simply because the Commission does not have the power to impose discipline on reluctant sovereign states. The Commission is trying to raise its power at a time when inter-governmentalism is in ascendency and the Lisbon Treaty is clipping its wings. This is a very dangerous strategy. At the same time, the Commission recognises for the first time that decentralising the pact through country-level public debt rules is a crucial mean – in fact the only mean – toward fiscal discipline. The pessimist will be discouraged to see that so much effort will be lost in trying to make the pact work and that the proposed hardening will lead to major political conflicts bound to seriously undermine the single currency. The optimist will note that the correct solution enters official thinking for the first time so that, after the next crisis, the correct step could well be taken.

References

•Alesina, Alberto, and Roberto Perotti (1995), “Fiscal Expansions and Adjustments in OECD Countries”, Economic Policy, 21:205-248.
•Eichengreen, Barry and Charles Wyplosz (1997), “The Stability Pact: Minor Nuisance, Major Diversion?”, Economic Policy, 26:65-114.
•Krogstrup, Signe and Charles Wyplosz (2006), “A Common Pool Theory of Deficit Bias Correction”, European Economy, 275:1-29.
•Wyplosz, Charles (2005), “Fiscal Policy: Institutions Versus Rules”, National Institute Economic Review, 191:70-84.
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¹ Technically, the transversality condition is that the present value of the debt-to-GDP ratio converges to zero as the horizon extends to infinity.
² It remains to be seen whether this “reverse voting” procedure is compatible with the Treaty.

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