The Stability and Growth Pact

 

Definitions and Purpose

The Stability and Growth Pact (SGP) forms part of the rules and procedures for fiscal policy of the member states of the euro area.

The SGP has been subject to criticism long before it was officially agreed at the EU summit in Dublin in 1997 and ever since. The debate about the SGP reflects some of the deep ideological divisions that have accompanied the creation of economic and monetary union. The opponents of the SGP have criticised inter alia that it is pro-cyclical and anti-growth.

One of the underlying economic arguments in favour of the SGP is the disputed concept of the fiscal theory of the price level – the notion that the price level is determined by fiscal policy. Another reason is that the absence of a fiscal-rule would entice countries to pursue beggar-thy-neighbour policies by running excessive debts, in the expectation that they will be bailed out by the monetary union. The assumption is based on the view that financial markets cannot effectively discipline profligate governments by pricing debt appropriately.

 

This is how the European Commission explains the rationale behind the SGP:

 

“It was … recognised that the loss of the exchange rate instrument in EMU would imply a greater role for automatic fiscal stabilisers at national level to help economies adjust to asymmetric shocks, and would make it "necessary to ensure that national budgetary policies support stability oriented monetary policies". This is the rationale behind the core commitment of the SGP, i.e. to set the "… medium-term objective of budgetary positions close to balance or in surplus…" which "… will allow all Member States to deal with normal cyclical fluctuations while keeping the government deficit within the reference value of 3% of GDP".

 

Contrary to popular perceptions, the SGP does not set the 3% deficit-to-GDP target. This target was already included in the Maastricht Treaty of 1991. The Maastricht Treaty contains two articles relevant to the fiscal framework, Art. 99 and Art. 104. The SGP consists of two Council Regulations 1466/97 and 1467/97, and sets out in detail how the rules of the Maastricht Treaty are applied. The regulations were amend in the year 2005, hence Council regulation 1055/2005 and 1056/2005. (see list of legal references below)

 

EU Procedures for the conduct of fiscal policy are the Excessive Deficit Procedure, the Mutual Surveillance Procedure (Articles 99, 100, 111 TEU) and the Stability and Growth Pact (Regulations 1466/97, 1467/97, 97/C236/01-02). The No-Bail-Out-Rule (Articles 103 TEU, Article 21 ESCB Protocol) protects member states from becoming responsible for financial liabilities of other member states against their will. The following table summarizes the various procedures.

 

 

The annual EU Procedures with respect to fiscal policy and actors involved 

Procedures	Form of Coordination and Instruments	Actors	Tasks
Multilateral surveillance   (Article 99 (3) Amsterdam Treaty))	Monitoring process Peer review	ECOFIN Council European Commission Member states   Economic and Financial Committee	The Process monitors and assesses the economic developments and policies in member states as well as in the community as a whole. It forms the basis for community compliance procedure (Article 99 (4))
Excessive Deficit Procedure (EDP) (Article 104)   Stability and Growth Pact (SGP) Regulation 1467/97	Common rules and objectives Budgetary surveillance Pecuniary sanctions   Member states submit annually stability or convergence programs	ECOFIN Council European Parliament National governments (finance ministries) European Commission Economic and Financial Committee	The EDP and SGP represent an obligation on member states with high debt ratios to achieve medium-term balanced budgets or surplus. Member states with low debt ratios are allowed to run a 1% deficit

 

 

The SGP itself consists of three elements:

1. A political commitment by all parties to stick to the budget rules and surveillance procedures.

2. The requirement that euro members shall regularly stability programmes, which are examined by the Council. The procedure includes an early warning mechanism.

3. A penalty procedure could be invoked by the Council if a member states breaches the 3% ceiling. At the end of this process, the Council can vote to levy a fine on a country failing to abide by the rules.

 

The history of the SGP

 

The history of the debate leading up to the SGP is long. It has its roots in the Keynesian-Monetarist controversies of the 1960s and 1970s. The early debates about European Monetary Union began in the early 1970s. Dyson and Featherstone (1999) are the most authoritative reference for the debate up until the negotiations of the Maastricht Treaty in 1991. Rather than reproducing this narrative, we found the following extract from Jean-Pisani-Ferry essay Only One Bed for Two Dreams: A Critical Retrospective on the Debate over the Economic Governance of the Euro Area useful.

 

            “The Delors report of 1989 which was prepared by a committee (essentially formed of central bankers) indicated that economic and fiscal decisions ‘would have to be placed within an agreed macroeconomic framework and be subject to binding procedures and rules’ (Delors, 1989). This, the report added, ‘would permit the determination of an overall policy stance for the Community as a whole, avoid unsustainable differences between individual member countries in public-sector borrowing requirements and place binding constraints on the size and the financing of budget deficits’. Interestingly, this last sentence based the case for ‘binding procedures and rules’ on two distinct arguments: first, the need to determine the overall policy
stance – a Keynesian co-ordination argument; and second, the need to place constraints on the size of budget deficits – a fiscal discipline argument. Those two requirements would later form the basis for the two pillars of EMU in the Maastricht Treaty…

Maastricht

The Maastricht negotiations thus started on an ambiguous basis. Everybody was seemingly agreeing on the need for ‘binding rules for deficits’, but different players had different rationales in mind. Among the two main ones were Germany and France, the first primarily focused on the preservation of price stability and adamant that excessive deficits had to be avoided. The second favoured some form of co-ordination through the creation of an ‘economic
government’, an expression that had been adopted by the late Pierre Bérégovoy, at that time Minister of Finance, and whose exact meaning would remain somewhat obscure. In the eyes of the French (who had rather grudgingly agreed to relinquish the control of the central bank), it was politically important to give substance to an economic pillar beside the monetary pillar represented by the ECB and ‘economic government’ could contribute to it through speaking with one voice externally, co-ordinating economic policies and conducting exchange rate policy.

The French were not opposed to using the European framework to restrain fiscal profligacy (they could even see some potential benefit in imposing discipline from above). Similarly, as long as it did not mean control of the central bank by the Council, the Germans could live with an economic government (which somehow echoed the concept of ‘political union’, an equally vague notion that was widely regarded in Germany – including by the Bundesbank – as a precondition for monetary union). Neither of the two main players
therefore had the motive to oppose the view of the other and there was room for compromise.

The result was a treaty framework based on two pillars: a ‘German’ one (Art. 104), which states that ‘Member States shall avoid excessive government deficits’; and a ‘French’ one (Art. 99). which states that ‘Member States shall regard their economic policies as a matter of common concern and shall co-ordinate them within the Council’. A crucial difference between the two pillars was however that they were of unequal strength: while Art. 104 includes a specified objective, numerical targets and a detailed procedure (the excessive deficit procedure, or EDP) leading up to pecuniary sanctions, Art. 99 is a general-purpose provision with no  corresponding policy rule or ‘teeth’. Indeed the instruments it relies on, the so-called Broad Economic Policy Guidelines and the  surveillance of national policies within the Council, are both of limited effectiveness. With no legal basis for sanctions, the most Art. 99 can lead to is a non-binding recommendation by the Council…

Last Additions

The first pillar was strengthened in 1997, prior to the introduction of the euro, with the adoption of the SGP (technically secondary legislation based on Art. 104) at the insistence of German Finance Minister Theo Waigel, who worried about acceptance of the future currency by German public opinion. The aim was to remove the margin for discretion left by Art. 104, to ensure that theexcessive deficit procedure would be implemented according to a  predetermined timetable and to agree that the eventual sanctions would be levied according to a predetermined formula. In the eyes of its proponents, the Stability Pact should have replaced a  decision on the implementation of the excessive deficit procedure by a rule. However, the proposal met (especially French) opposition within the Council and the eventual (Belgian) compromise was the adoption of a rules-based framework that did not remove the need for Council decision at each step of the EDP but created the presumption that the Council would vote according to the provisions of the Pact.

Reform of the SGP

After the end of the dotcom bubble in 2000, the growth of the euro area economies began to deteriorate strongly, but not so much that it would have justified an exemption from the SGP rules. During the long period of below-trend growth from 2001-2005 the SGP came under intense criticisms from economists and policy makers alike on the grounds that it was too inflexible, that it set the wrong incentive, that it encouraged pro-cyclical behaviour, and that it discourages economic reform. In the spring 2005, the European Council decided to amend the SGP.

The following is a summary of the main changes.

 
Outlook

In recent times, the debate about the SGP has calmed down a little, as the euro area economy recovered, and as the deficits of several countries were on target to fall below the 3% ceiling. We do not expect any changes to the pact soon. It is presently the intention of the great majority of finance ministries in the euro area to allow the reformed pact to work. The present assessment by finance ministers is that the new rules are working. But since the introduction of the new rules coincided with an economic upswing, it is difficult to make an accurate assessment at this stage. At the very least, one would need to see how the system responds in the next downturn. We would expect that the debate about the fiscal framework may resurface again at that point.

The debate about the pact is therefore unlikely to over. The new rules, however, have addressed some of the criticisms of the original pact.

 -          The original SGP allowed large deficit overshoots only in a small number of predefined events, the most important being a recession which annual growth decline by more than 2%, or 0.75% if this is accompanied by other aggravating factors. The new rules also allow exceptions during periods of low growth (but not recession), such as the 2001-2003 period.

-          The scope for temporary overshoots has been widened in order not to discriminate against structural reforms, which may carry short-term costs.

-          The implantation rules have also become more flexible, in general to give governments a little more time.

-          The old stability pact focused almost exclusively on adjustments during bad times. The new rules at least give some recognition to the need for adjustment in good times, by stipulating that revenue windfalls should be used for debt reduction and by extending the early warning procedures.

 But the new arrangements have left some previous shortcoming of the SGP and the Maastricht Treaty unchanged, and introduced a few new problems.
-          We are still targeting deficits, rather than debts, which has encouraged the widespread use of creative accounting.
-          The old medium-term budgetary objective – balanced budget or surplus – has been replaced by new rules that are equally arbitrary. Under the new rule, governments with low levels of debt should be heading for a cyclically adjusted deficit of 1%, while the original objective should remain valid for the others. There is no economic rationale for any of these numbers.
-          The list of exemption for the temporary overshoot list is large. It includes R&D and other “European policy goals”. The list is structured in such a way that governments should find it relatively easy to make the case for a temporary exemption.
-          While there is now at least some recognition that adjustment should occur during good times, the asymmetry remains. The good-times procedures are significantly softer than the bad-times procedures.
-          The new SGP has nothing to say on how to raise long-run growth, and includes no procedures, let alone proposes institutional arrangements for a co-ordination of wider economic policies, including of economic reforms.

 References:

 The literature in this field is vast. In the following we produce only a small selection.

 For a good overview of goals and the legal background, see the European Commission’s stability pact website. The following are the relevant legal texts:

 

Article 99 of the EC Treaty - the multilateral surveillance
Article 104 of the EC Treaty - the Excessive Deficit Procedure (EDP)
Protocol on the EDP annexed to the Treaty
Council Regulation 3605/93 on the application of the Protocol on the EDP
European Council Resolution on the Stability and Growth Pact
Council Regulation 1466/97 on the strengthening of the surveillance of budgetary positions and the surveillance and coordination of economic policies
Council Regulation 1055/2005 amending Regulation (EC) No 1466/97 on the strengthening of the surveillance of budgetary positions and the surveillance and coordination of economic policies
Council Regulation 1467/97 on speeding up and clarifying the implementation of the EDP
Council Regulation 1056/2005 amending Regulation (EC) No 1467/97 on speeding up and clarifying the implementation of the excessive deficit procedure

 

For the history of EMU up until the Maastricht Treaty see

 

Dyson K, Featherstone K, The Road to Maastricht – Negotiating Economic and Monetary Union, 1999

 

The above extract about the ideological debate about the stability pact are taken from

 

Pisani-Ferry J, Only One Bed for Two Dreams: A Critical Retrospective on the Debate over the Economic Governance of the Euro Area, JCMS 2006 Volume 44. Number 4. pp. 823–44

 

 

The following are a good selection of economic articles about the SGP. They are taken from the Euro Homepage, Giancarlo Corsetti’s excellent euro website at the European University Institute in Florence.

 

General References:

Buti, M., Eijffinger, S. and D. Franco (2003), Revisiting the Stability and Growth Pact: Grand Design or Internal Adjustment?. CEPR DP 3692.

Von Hagen, Juergen (2003), Fiscal Dicipline and Growth in Euroland. Experiences with the Stability and Growth Pact, ZEI WP B06-2003.

Artis, Michael and M. Buti "Close to Balance or in Surplus" - A Policy Maker's Guide to the Implementation of the Stability and Growth Pact, EUI WP 2000/2

Artis M.J. and B. Winkler (1997), "The Stability Pact: safeguarding the credibility of the European Central Bank", EUI Working Papers, RSC No. 97/54

Beetsma R. (2001), "Does EMU need a Stability Pact?", in A. Brunila, M. Buti and D. Franco (eds.), The Stability and Growth Pact: The Architecture of Fiscal Policy in EMU, Macmillan.

Martin Feldstein (April 2005), "The Euro and the Stability Pact", NBER Working Paper No. 11249.

Heipertz, Martin and A. Verdun (2003), "Ruling Europe: Theory and Politics of the Stability and Growth Pact" Research Report, Max Planck Institute for the Study of Societies.

 

Explaining the economic rationale

 

Sargent, Thomas J., and Neil Wallace (1981): Some Unpleasant Monetarist Arithmetic“ Federal Reserve Bank of Minneapolis Quarterly Review 5: 1-17.

Woodford, Michael (2000): "Fiscal Requirements for Price Stability," Journal of Money, Credit, and Banking, forthcoming.

Chari, V.V and Patick J. Kehoe (2004), On the Desirability of Fiscal Constraints in a Monetary Union, NBER WP 10233

About the fiscal rules since Maastricht

Buiter W, Giancarlo Corsetti and Nouriel Roubini (1993), Excessive Deficits: Sense and Nonsense in the Treaty of Maastricht, CEPR DP 750.

Gali, Jordi and Roberto Perotti (2003), Fiscal Policy and Monetary Integration in Europe NBER WP 9773.

Critical views and proposals for reforms

Blanchard, Olvier J. and Francesco Giavazzi (2004), Improving the SGP Through a Proper Accounting of Public investment, CEPR Discussion Paper 4220

Wyplosz, Charles (2002), Fiscal Policy: Institutions vs. Rules, mimeo.

Buiter, W. and C. Grafe (2002), Patching up the Pact: some Suggestions for Enhancing Fiscal Sustainability and Macroeconomic Stability in an Enlarged European Union, CEPR DP 3496.

Razin, A. and E. Sadka (2002), The Stability and Growth Pact as an Impediment to Privatizing Social Security, CEPR DP 3621.

Eichengreen B. and C. Wyplosz (1998), "The Stability Pact: more than a minor nuisance?", Economic Policy, April, 26, 65-113.

Eichengreen B. (1998), "Saving Europe’s automatic stabilizers", National Institute Economic Review, January.

Buti, M. and G. Giudice (2003), "Maastricht’s Fiscal rules at Ten" in (eds.) Weiler, J.H., Begg, I. and J. Peterson: Integration in an Expanding European Union Blackwell: Oxford

Buiter, W. (2003), The Ten Commandments for a Fiscal Rule" Oxford Review of Economic Policy, 19, Spring, Supplement 1, pp. 84-99.

Buti, M., Eijfinger, S. and D.Franco (2003) "Revisiting EMU’s stability pact: a pragmatic way forward ",Oxford Review of Economic Policy, 19, Spring, Supplement 1, pp. 112-131.

Fatas, A., Hughes-Hallett, A., Sibert, A., Strauch ,R. and J. von Hagen (2003): Stability and Growth in Europe: Towards a Better Pact , MEI 13, CEPR, London.

McCauley, Kevin and Malcolm Sawyer (1999), An Alternative Stability Pact for the European Union, Jerome Levy Institute w.p. no. 296.

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