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Stability and Growth Pact


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Stability and Growth Pact

  1. 1. 1 Tyler Furnari Economics of the EU Professor Warin Scientific Paper #2 The Uncertainty Surrounding the Stability and Growth Pact of the EU Ever since its creation, the Stability and Growth Pact of the European Union has been a topic of heated political and economical debate. The Stability and Growth Pact was formally voted on and adopted by the European Council at the Amsterdam Summit in July 1997. In essence, the SGP’s creation was to give credibility to the Monetary Policy of the European Central Bank by forcing members entering the EMU to exercise fiscal discipline. The initial 12 countries that qualified for membership into the European Union needed the assurance that all other member states would adopt a policy of fiscal discipline, in order to avoid “spill over” effects between them. Countries that adhered to fiscal discipline, especially Germany, proposed the Pact’s creation to eradicate the generating of large annual budget deficits and accumulated unsustainable government debts. It was only through the reality of the SGP that the ECB could focus directly on its goal of price stability through monetary policy. Without the SGP’s existence, countries that entered the EMU would not have had the incentive to practice fiscal discipline, and thus would have run massive deficits devastating the credibility of the EU and triggering the ECB to finance the debt of irresponsible member states through expansionary monetary policy.
  2. 2. 2 The combination of the Maastricht Treaty and SGP constructed four rules for economic policy, which the European Council felt would aid the activities of the European Central Bank’s goal of price stability. “ The four rules are that the ECB would be independent from political influence; there would be no bailout of national government deficits; there would be no monetary financing of government deficits; and that member states would avoid “excessive” government budget deficits, i.e., deficits exceeding the equivalent of 3 percent of GDP” (Arestis, 8). All in all, the Pact set out to force all EU member states to target a medium-term objective, “which was to reach budgetary positions ‘close-to-balance or in surplus’ “ (Mathieu, 5). The surveillance of member states’ fiscal policies were annually reviewed each March by both the European Commission and the Council of Ministers of Economics and Finance (ECOFIN). The stability plans of each member country would then be thoroughly examined by the two parties and appropriate recommendations, if necessary, would be made to individual states. In addition, if a country violated the maximum deficit to GDP ratio of 3 percent three years in a row they would be sanctioned with fines by the ECOFIN. Ideally, according to the SGP, these fines would be equally distributed among the other EMU member countries for abiding by the SGP deficit criteria. The European Monetary Unification was implemented as of January 1999. This would be the first test of the SGP, since individual countries had lost their independence when it came to monetary policy, and thus fiscal policy remained the most powerful economic tool of autonomy for EU member states. The SGP was created to closely watch and punish those countries whose deficits were declared as “excessive”.
  3. 3. 3 Later in October 1999 economists, Roel Beetsma; and Harald Uhlig, would publish their essay “An Analysis of the Stability and Growth Pact” which constructed a model of centralized monetary policymaking and decentralized fiscal policymaking to mirror the economic policy of the SGP. They concluded through their fabricated model on the SGP, that countries that would be disinclined to join a stability pact would do so when forming a monetary union. “ The reason was that in a monetary union debt would be too high, because governments fail to fully internalize the benefits of reducing the debt in terms of lower future inflation” (Uhlig, 569). The critical literature and economic questioning of the SGP led Micheal J. Artis and Marco Buti in the year 2000, to test the economic credibility of the SGP’s medium- term fiscal targets. Their primary goal was to illustrate how to set “ a medium fiscal target which is “roughly right” ( Artis, 3). The fiscal policy of EU member states was simplified down to national fiscal authorities computing an estimated target for a balanced budget, and then relying on automatic stabilizers to work out their country’s ability to stay within the 3% deficit ceiling of the SGP. Overall, the two economists concluded that the targeting of the uniform 3% deficit ceiling was no longer becoming the predominant issue for the targeting of EMU member states, when setting their medium term fiscal budgets. On the other hand, individual EU member states were shifting from targeting the 3% deficit ceiling of GDP to targeting more cyclically adjusted country specific targets. In addition, Aris and Buti came to the realization that countries should be more prudent when setting their medium-term fiscal targets, in order to be able to have a safety margin to adjust to unexpected economic shocks to their specific countries. This work exemplified the reality of the economic disparities that
  4. 4. 4 existed throughout the EU, and the due consideration that should be paid to them, while applying the SGP deficit and debt ceilings. The shortcomings and flaws of the Stability and Growth Pact were perpetually taking place throughout its early implementation. By the turn of the century the future of the euro and the EMU were based largely on the SGP, and many economists disagreed with the Pact’s objectives. Three professors from the Jerome Levy Economics Institute of Bard College published one of the most potent critiques of the SGP and its severe implications on the future of the euro. In their collaborative public policy brief titled, “ The Future of the Euro: Is There an Alternative to the SGP” Philip Arestis, Kevin McCauley and Malcolm Sawyer, exposed the pact’s undemocratic spirit. They argued that an Alternative Pact be established that focused on full employment and the reduction of inequality and regional disparities. In their minds their Alternative Pact considered growth to be a more important policy objective than the ECB’s price stability. Furthermore, they discredited the economic theory underlying the SGP, which they labeled as “New Monetarism”. The essential elements of “new monetarism” undermined the democratic process that should be entrusted to politicians and the national governments of individual member states. Essentially “new monetarism” identifies “ politicians in particular and the democratic process in general cannot be trusted with economic policy formulation because it lead to decisions that have stimulating short term effects (for example reducing unemployment via higher government spending), but that are detrimental in the longer term (a notable example is a rise in inflation” (Sawyer, 9).
  5. 5. 5 Secondly, the SGP and ECB’s objectives explicitly favored the use of monetary policy to control inflation, and thus their biased belief “that fiscal policy is impotent in terms of its long-run impact on real variables, such as output and employment” (Sawyer, 10). Consequently, the complete separation of monetary authorities (the ECB) and the fiscal authorities (the national governments) only added to the confusion and discretionary fiscal policies that would further thwart fiscal coordination in the EU. Other flaws brought up by Arestis, McCauley, and Sawyer address the ECB’s “narrow-minded” attention or objective of securing price stability without any explicit concern over other objectives. They assert that the level of economic activity or the exchange rates of the euro are other key objectives that the ECB should allocate more of its energy too. As stated in Article 105 of the Protocol on the European System of Central Banks “The Primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support general economic policies in the Community” (Sawyer, 10). In retrospect, the ESCB has been anything, but impartial to the objective of price stability according to their actions. Another key factor preached by this working paper is the sole use of monetary policy in the hands of the ECB, as its only way to hold down inflationary pressures. Any signals of inflation in the EU economy will likely lead to increases in the interest rate, which in the eyes of economists will be “ exacerbated by the lack of active fiscal policy and the absence of other mechanisms to stimulate aggregate demand” ( Sawyer, 11). Overall, the institutional framework of EU at the present time is not able to sufficiently provide strong fiscal policy. Furthermore, the relatively small EU budget in comparison to the combined GDP of the EU members contradicts the MacDougall Report, written to
  6. 6. 6 the European Commission, which states that monetary union of the EU would not be possible without a vast community budget that could be employed for fiscal policy. Thus, the EU’s inability to effectively structure an adequately sized budget for fiscal policy has negatively hurt the EMU’s economic policies. The alternative of three professors is the “Full-Employment, Growth, and Stability Pact” which would reiterate Keynesian economics, and allow greater flexibility for national governments to employ fiscal policy. In addition their Alternative pact would accommodate for a greater number of regional disparities that the SGP ignores, such as countries economic performance, unemployment rates, and per capita income levels). Moreover the “Full-Employment Growth and Stability Pact” would support creating more EU institutions to more effectively handle the demands of the EMU, instead of the ECB being the sole institution with a connection to the single currency. The essential goal of the Alternative Pact’s fiscal policy would be to implement it at the EU level, which would be a more effective structural framework, since “there would only be small leakages abroad of any demand stimulus from fiscal policy” (Sawyer, 16). Finally, a set of coordinated fiscal policies between national governments of member states, together with an EU-level policy, should define coordinated fiscal policy, which would be geared at achieving only high levels of economic activity. As for the Alternative Pact’s monetary policy, it would restructure the objective of the ECB by having it focus on developing collective wage determination and effectively trying to evenly distribute Investment throughout Europe. Subsequent to these conditions being changed there should be a wider representation in the ECB to
  7. 7. 7 decide interest rate changes because of the “vast number of distributional consequences and differential impacts on regions and industries” (Sawyer, 24). Although, the Bard faculty greatly manifested the diverse problems surrounding the SGP they did not cover all areas. Another problem brought up in Catherine Mathieu’s and Henri Sterdyniak’s essay, “ Reforming the Stability and Growth Pact: Breaking the Ice” is the debt limit criterion, which has not been considered since 1997 based on the fact that several Member countries have debt levels largely above 60% of GDP. These countries consist of Italy, Belgium and Greece, which through political maneuvers were allowed to enter the EMU, despite their fiscal discipline in question. The working paper that sheds the most light on the arbitrary measures of the SGP’s criterion lands on Mauro Visaggio’s “ Does Stability and Growth Pact Provide an Adequate and Consistent Fiscal Rule?” published in June 2004. The paper examines the fiscal rule of Treaty of Maastricht and the SGP, which imposes countries to converge in the medium run towards a structural public balance equivalent to 0% through fiscal discipline adhering to the safeguard ceiling of 3% of deficit to GDP ratio. Mauro Visaggio discovered that the fiscal rule was adequate and consistent in ensuring the final goal towards a public debt of 0% for EU members; however the fiscal rule seems to be arbitrary. “ Furthermore it is necessarily arbitrary since on the theoretical ground it is not possible to discriminate which specific value is more adequate or better for public debt sustainability: therefore there exist infinite values on which the total budget balance can be fixed for ensuring the sustainability of public debt”(Visaggio, 24). Overall, the severe criticism of the Treaty of Maastricht and SGP’s arbitrary criteria seems to be credible to some degree.
  8. 8. 8 The question of whether Europe should reform or get rid of the Stability and Growth Pact came to be the natural economic discourse since the inability of the European Commission to enforce economic sanctions on three countries’ defiance of the SGP debt ceiling of 3 %. France and Germany were two of the countries that had asked for the SGP’s creation solely to maintain fiscal stability in the EMU, but have generated a paradox of sorts by being the first two large EU economies to not respect the pact. Professor of economics Thierry Warin of Middlebury College draws many innovative conclusions in his essay, “ Should Europe Get Rid of the SGP.” Warin focuses on the disrespect of the fiscal policy criterion of the SGP and sees it as a clear sign as he states, “at least a reexamination” (Warin, 1) Furthermore, Warin addresses the problem of countries strictly following the SGP’s pledge of 3% of budget deficit every year. By doing so they could be jeopardizing their country’s social welfare by putting off social reforms such as pension plans, and innovative research and development. Also the SGP’s rigid fiscal policy would thwart investment by governments and also may not be desirable according to the “Treaty of Maastricht’s definition economic sustainability for the eurozone” ( Warin, 16) The most significant economic realization Warin addresses is the “impossibility to target a deficit of 3 % of GDP because countries don’t know what the GDP will be: it is an ex post rule. In other words, in order to ensure the respect of the SGP, a country has to target a deficit lower than 3 %. (Warin, 16) Professor Warin would suggest an alternative solution to the unrealistic target of the SGP’s deficit of 3% of GDP in his working paper “Stability and Growth Pact: An Index to Trigger an Early Warning Earlier?” In his 2005 discussion paper Warin simply states the rational solution to the ex post facto measure of the GDP, which relies on the
  9. 9. 9 forecasting abilities of the national administration, which would be an early warning by the EC to riskier budgets proposed by EMU member states. If this were to become a realistic option, Professor Warin declares that the EC would need to come up with a “ useful tool to identify the riskier budgets very early, and ideally, as soon as they are voted by the national parliaments” (Warin, 7) Once the EC decides what tool to assess to best identify riskier budgets they could fabricate an index that could help define “medium-term budgetary objectives” (Warin, 8) This is only one of many genuine answers to the fiscal policies constrained by the SGP’s criterion. Overall, Warin views the SGP in the following years as counterproductive because it takes too much power away from European national governments to practice individual fiscal policy, appropriate to their political societies. In addition, it would ask European economies to change more structurally, which usually is not favorable to the European constituents. However, getting rid of the SGP will only delay Europe’s incentive to work on the structure of their individual economies. The ECB’s Working Paper Series from January 2005 illustrates the dire need for a reexamination of the SGP objectives and realistic goals. The ECB sees the need for more procedural flexibility when it comes to strengthening the SGP credibility. “Overall the model suggests that procedural flexibility based on an independent and non-politicized judgment might well strengthen the SGP. However, it also identifies two cardinal conditions for that to be the case: an increase in flexibility should not be confused with a loosening of enforcement and excluding large fiscal slippages through budgetary opaqueness” (Beetsma, 34).
  10. 10. 10 The future of the SGP may be curtailed by the inability of the European Council to establish the SGP’s credibility by enforcing the necessary sanctions/fines on member countries who break the fiscal rule of 3% deficit of a country’s GDP. Harvard Professor Martin Feldstein gives the appropriate dismal view on the future the EMU and the Stability Pact in his paper “ The Euro and the Stability Pact” ( march 2005). In essence, Professor Feldstein concentrates on ECOFIN’s inability to impose fines called for in the Treaty of Amsterdam ( SGP), but detrimentally deciding instead to suspend enforcement in 2004. This allowed for the two biggest economies in the EMU, France and Germany, to undermine the credibility and future of the SGP. Furthermore, “ There is now a kind of gentlemen’s agreement among the Euro countries that the budget deficit limit will be redefined to focus on longer-term deficits rather than single years an on deficits that occur because of slow growth as well as outright recessions” ( Feldstein, 6). Recently there has been speculation between EMU members to create proposals to revise the way budget deficits are calculated. Examples such as excluding military spending, R and D spending, and contributions to the EU budget have gained the most attention. In March 2005 the European Council in Brussels issued an agreement entitled “Improving the Operation of the SGP”, which stated that the basic rules of the SGP would continue to exist; however, there would be specified exceptions to the interpretation of these rules. These exceptions made the original criterion of the SGP “effectively meaningless”. First, there is no longer an annual limit on the deficit, and a country facing economic hardship has five years to not breach the deficit ceiling. Also the exceptions to calculating the budget deficits essentially allow countries to perpetually
  11. 11. 11 run deficits exceeding the 3% ceiling of GDP of the SGP. “ If the spending that causes the violation is deemed to aim to “achieve European policy goals” or “foster international solidarity”, (Feldstein, 8) such as spending on education, research, defenses and etc., the country would not be penalized with sanctions/fines by the ECOFIN. The Economist concluded, “Rules have been so loosed that they have been rendered almost entirely meaningless” (Feldstein, 8) The economic reality of the Stability and Growth Pact is that it no longer contains any sense of credibility within and outside of the EMU. There are no longer any restraints on individual country deficits, which has already resulted in 5 of the 12 euro area countries to exceed deficits of 3% of GDP. The ultimate concern is that each EU state will continue to rationalize increasing fiscal deficits because of the absence of pressure from other EMU countries. There are many alternatives that have been suggested to the ECOFIN, but they have all been rejected, and the European Council’s Agreement of 2005 has only crushed any means of reestablishing fiscal discipline in the EMU. All in all, there is a dark cloud of uncertainty surrounding the future of the European Union’s Stability and Growth Pact in the contemporary European economy.
  12. 12. 12 Bibliography Arestis, Philip, McCauley, Kevin and Malcom Sawyer, 2001, “ The Future of the Euro: Is There an Alternative to the Stability and Growth Pact,” Pubilc Policy Series, Bard Publications Artis, Michael, and Marco Buti, 2000, “Close to Balance or in Surplus” A Policy Maker’s Guide to the Implementation of the Stability and Growth Pact,” European University Institute, WP No. 2000/28 Beetsma, Roel and Xavier Debrun, 2005, “Implementing The Stability and Growth Pact: Enforcement and Procedural Flexibility,” European Central Bank, WP No. 433 Buti, Marco, Eijffinger, Sylvester, and Daniele Franco, 2005, “The Stability Pact Pains: A Forward-Looking Assessment of the Reform Debate,” Tilburg University, WP No. 2005-101 Feldstein, Martin, 2005, “The Euro and The Stability Pact,” The National Bureau of Economic Research, WP No. 11249
  13. 13. 13 Fitoussi, Jean Paul, and Francesco Saraceno, 2002, “A Theory of Social Custom of Which Soft Growth May Be One Consequence. Tales of the European Stability Pact,” Observatoire Français des Conjonctures Économiques (OFCE) Governatori, Matteo, and Sylvester Eijffinger, 2004, “ Fiscal And Monetary Interaction: The Role of Asymmetries of the Stability and Growth Pact in EMU,” CESIFO WP No. 1354 Mathieu, Catherine, and Henri Sterdyniak, 2003, “Reforming the Stability and Growth Pact: Breaking the Ice,” OFCE, WP No. 2003-02 Uhlig, Harald, and Roel Beetsma, 1999, “An Analysis of the Stability and Growth Pact,” The Economic Journal, Vol. 129, No. 458, pp. 546-571 Veroni, Paola, and Francesco Saraceno, 2005, “Reform of the Stability and Growth Pact: Reducing or Increasing the Nuisance?” OFCE, WP No. 2005-1 Visaggio, Mauro, 2004, “Does Stability and Growth Pact Provide An Adequate and Consistent Fiscal Rule?” Universita degli Studi di Perugia Warin, Thierry, 2004, “Should Europe Get Rid of the Stability and Growth Pact?” Middlebury College Economics Discussion Paper, No. 04-15
  14. 14. 14 Warin, Thierry, 2005, “Stability and Growth Pact: An Index to Trigger an Early Warning Earlier?” Middlebury College Economics Discussion Paper, No. 05-02