Implementation of the Pact
31. If a country has a deficit that exceeds the 3%
of GDP threshold then the 'excess deficit procedure' is launched.
The Commission prepares a report. Acting on the Commission's report
the Council decides by qualified majority voting whether an excess
deficit exists. If it does then it can recommend that the country
take corrective action to bring the situation to an end within
a specified period of time. If the Member State concerned persistently
fails to put in place the Council's recommendations, then the
Council may decide to apply one of a number of sanctions, ultimately
leading to fines for noncompliance lasting at least two
years. There is provision under the Treaty for a deficit over
3% not to be regarded as excessive if the deficit is only "exceptional
Countries like the UK that remain outside the eurozone are also
subject to the SGP but only 'endeavour' to avoid excess deficits
and are not subject to sanctions if they fail to do so.
32. Many witnesses referred to the importance of
'automatic stabilisers'. This is the process through which, during
an economic expansion, higher incomes lead to increased income
and corporation tax receipts and at the same time lower unemployment
leads to reduced social security payments. During an economic
slowdown or recession the opposite happens: government tax revenue
is reduced and more has to be spent on social security payments.
The overall effect reduces the government deficit during a period
of high growth and raises the deficit during an economic slowdown.
Automatic stabilisers help to reduce the volatility of the economy
over the cycle by boosting demand when growth is slow and reducing
aggregate demand when the economy is growing quickly.
33. Eight of the twelve eurozone countries achieved
the objective of a budget 'close to balance or in surplus' by
the year 2001. Germany, France, Italy and Portugal failed to reach
this objective and have continued to have difficulties since then.
To some extent, as some witnesses
and people to whom we spoke during our visit to Frankfurt suggested,
countries' current difficulties in complying with the requirements
of the Pact stemmed from a failure to strengthen their fiscal
position in earlier years when the economy was performing better.
Following the announcement that the budget deficit in Portugal
had increased to 4.1% of GDP in 2001, the ECOFIN Council on 5
November 2002 declared that an excess deficit existed in Portugal.
The Portuguese Government declared its firm commitment to reducing
their deficit below the 3% target in 2002, reducing the deficit
to 2.7%. At the ECOFIN Council of 21 January 2003, it was decided
that an excessive deficit existed in Germany in 2002, following
an outturn figure of 3.6%. An early warning was also sent to France
with a view to preventing an excessive deficit occurring in 2003.
The Council concluded that the French projection of growth was
optimistic and that there was a danger that the deficit would
breach the reference value in 2003. The French Government has
shown little desire to reduce the deficit for 2003 in the face
of weak economic conditions: the Prime Minister, Mr JeanPierre
Raffarin, was quoted as saying "When growth is uncertain
you do not lower spending more than necessarythat would
depress the economic climate even further".
Goldman Sachs recently contrasted the fortunes of the three countries
that had been subject to the excess deficit procedure: "Germany
and France allowed their budget deficits to breach the 3% limit
[in 2002]. Portugal by contrast embarked on a hefty fiscal contraction
to reduce its deficit below 3%. During the second half of 2002,
French and German GDP grew at an annualised rate of 1.25%, Portuguese
GDP declined at an annualised rate of 4.5%".
All three countries illustrate the possible consequences of failure
to address significant deficits in good time. However, Portugal,
which adhered to the stability and growth pact, suffered more
severe economic penalties than Germany and France which did not
adhere to it.
34. The TUC believed "that the Pact has put
too much emphasis on stability and not enough on growth"
and that more flexibility should be allowed in the event of growth
of less than 1%.
Professor Begg suggested in respect of reform of the Pact that
there is "a need for mediumterm fiscal rectitude ¼
The question is whether there is any way to combine the reaffirmation
of that with some operational structure which provides more shortterm
The Governor of the Bank of England took a similar line, saying
that "you obviously have to accept a commitment to fiscal
sustainability in the medium and long term but ¼,
in an environment of weak demand, you must let the fiscal stabilisers
operate and not have an artificial cutoff point" and
that "applying 3 percent absolutely rigidly would be unwise".
We recognise the fact that the countries now exceeding the
3% deficit limit of the Stability and Growth Pact would not now
be doing so if they had addressed structural fiscal weaknesses
before the present downturn. However, tightening fiscal policy
at this stage in the cycle could further exacerbate the downturn
in the eurozone. We conclude that a Treaty interpretation allowing
countries with relatively low overall debt levels to exceed the
3% limit during a cyclical downturn is essential. Governments
should, however, take advantage of any increase in economic growth
to reduce structural deficits. As growth in the eurozone recovers
it is important for those countries with significant structural
deficits to achieve an enduring strengthening in the fiscal position.
Medium term fiscal sustainability should remain the goal, but
if it does not allow flexibility the SGP will lose credibility
and jeopardise the ultimate objective. It is important that the
discipline of overall fiscal policy expressed in the Stability
and Growth Pact remains firm so that breaches of it do not become
a way of avoiding the structural reform needed for long term sustainable
Reform of the Pact
35. There have been calls for reform of the Pact
from many quarters. We have noted some suggestions in the previous
paragraph. Professor Michael Moore, of Queen's University, Belfast,
advocated scrapping the Pact with the exception of the target
of medium term fiscal sustainability.
Professor Anton Muscatelli, of the University of Glasgow, recognised
one criticism of the Pact in that "it gives too much emphasis
to deficits and too little emphasis to debt sustainability".
Some have commented that the Pact is asymmetrical in not establishing
any mechanism to encourage governments to improve underlying structural
deficits when their cyclical fiscal position is healthy.
36. Recognising some of the growing criticism of
the Pact, the Commission put forward a number of proposals to
improve its implementation.
Mr Regling described the proposals as intended to make the Pact
"a little more sophisticated and more country specific",
by allowing small temporary deviations from the 'close to balance
or in surplus' rule over the cycle where the deviation is to finance
a particular policy initiative with a longterm benefit for
the economy, and allowing more permanent deviations from the rule
where a country had a longterm healthy financial situation.
He thought it possible that "the UK might fall into this
category where we would consider more permanent small deviation
The proposals include measurement of the fiscal balance, for the
purpose of assessing adherence to the 'close to balance or in
surplus' rule, in cyclically adjusted terms. The proposals have
no direct effect on the basic 3% limit, because that is set in
the Treaty (rather than the Pact) and any change to it would require
a Treaty amendment. ECOFIN, in its broad endorsement of the Commission
proposals, noted "areas where further improvements could
be made or clarification was needed with regard to an effective
application of the Stability and Growth Pact. A pragmatic approach
seems appropriate which, while abiding by the Pact's rules, could
take reasonable account of specific situations." The ECOFIN
proposals were adopted by the European Council on 2021 March.
It remains to be seen how far the reforms in the interpretation
of the Pact agreed at the March European Council will work in
practice, and we believe the promised reforms must be closely
monitored to see if they do indeed deliver greater flexibility.
We note the principle that there should be more flexibility to
take into account the specific situation of individual countries.
This could allow higher levels of spending where debt sustainability
was not a problem. We note that the Treaty requires classifications
to meet the definitions of European integrated economic accounts
and that these are monitored by an independent committee convened
by Eurostat. It is equally important, however, that individual
countries are not allowed to escape the rules of the Pact by artificial
reclassification of their accounts or other adjusted accounting.
37. Reforms could go further, for example in the
treatment of investment spending. Professor Francesco Giavazzi
noted that "There is no attempt [or only a] very mild attempt
in the Commission proposal to make the point that current expenditure
is very different from investment expenditure and should be treated
very differently in the ¼
noted also that in the "second part of the 90s, public investment
in the euro area has fallen (as a share of GDP)".
The ability to provide for appropriate levels of public investment
is important for the UK and other euro countries, and it is particularly
important also for the accession countries which need to improve
their infrastructure to EU standards. Mr Regling told us that
"investment can also be financed through normal tax revenues"
and that this does not necessarily "mean higher taxationit
could also mean a restructuring of the budget on the expenditure
side; less current expenditure and more investment expenditure".
Though true that must not mean a bias against borrowing for investment
if resulting debt levels are sustainable.
38. The UK Government agrees with the principle of
a strong SGP founded on sensible fiscal policy coordination. The
Government supports a "prudent interpretation of the disciplines
of the stability and growth pact [that takes] into account the
economic cycle, sustainability of debt and the important role
of public investment".
The Government has also stated that the proposals made by the
Commission and adopted at the Council meeting of 21-22 March are
"in line with key aspects of the UK's prudent interpretation
of the Stability and Growth Pact".
We support the Government's view of the need for a prudent interpretation
of the Stability and Growth Pact taking account of the economic
cycle, sustainability of debt and the important role of public
investment. We recommend that the Government should set out at
the time of its euro decision its views on exactly how this interpretation
could be achieved within the existing framework and how far the
Council's recent reforms are from meeting these requirements.
Performance of the eurozone economy
39. The following graph shows the outturn and forecasts
for economic growth in the UK and the eurozone for 1997-2004:
Sources: HM Treasury,
Budget 2003, chart B5, p226, 2003/2004 midpoint of forecast range;
European Commission, Spring Economic Forecasts April
2003, table 0.1, p3
40. In the four years since the introduction of the
euro, the annual rate of growth of the eurozone economy has averaged
2.2%. This compares with annual growth averaging 2.4% for the
UK over the same period. Within the eurozone there were significant
divergences in growth rates between countries, with average annual
growth performance over the period ranging from 8.8% in Ireland
to 1.4% in Germany. Mr Regling told us that "when you look
at the period 1999-2002, there were two good years and two bad
years but this was also true for many other countries around the
world." However, the downturn of eurozone economic growth
during the world slowdown in 2001 and in the aftermath of September
11th was significantly more pronounced than that in the UK. European
growth was led by exports, while domestic demand remained weak
in the larger countries. In contrast in the UK domestic demand
has been the driver of economic growth. Unemployment in the eurozone
has fallen from 10.2% in 1998 to 8.5% at the beginning of 2003.
The record on employment growth for the eurozone as a whole has
been good, particularly amongst the smaller eurozone members.
41. Mr Regling identified one of the benefits of
the euro as removing the currency fluctuations between the participating
members, thus contributing to stability. He contrasted the experiences
since the introduction of the euro with those of 1995, when there
were "tremendous intraEuropean exchange rate variations"
and noted that "independent estimates done afterwards that
the German economy was affected by about 1% less real growth in
the year 1995".
The TUC drew attention to the higher levels of workplace productivity
in the eurozone than in the UK and stated that if "the UK
was part of the eurozone it would rank 10th out of 13 in terms
of overall economic prosperity (GDP per capita) and workplace
Miss Lea and Mr Martin Taylor suggested that UK productivity on
an output per head basis was lower primarily because the lower
labour costs compared to continental economies made it sensible
for businesses to opt for more labour intensity rather than capital
clearly greater capital investment would indeed be a boost to
42. As for the effect on trade between countries,
Mr Rake took the view that, by removing the national currency
barriers to trade, "the creation of the euro has led to a
rapid increase in crossborder trade in the eurozone, while
Britain's trade with Europe has stagnated." He cited Eurostat
figures indicating a 3% average rise in trade within euro countries
and a 0.4% fall in UK trade with the EU,
though the No Campaign argued that these figures were misleading
since they were based on trade as a percentage of GDP rather than
measured by volume.
43. With the advent of the euro structural reform
has assumed a greater importance for eurozone members for encouraging
economic growth. With internal exchange rates within the eurozone
abolished, a greater burden of adjustment falls on product and
labour markets, which need to be flexible to facilitate this adjustment.
The IMF has noted that "to maximise the benefits from the
introduction of the euro, it will be important to move forward
with structural reforms".
At the Lisbon meeting of the European Council in March 2000 Europe's
leaders set out a ten year strategy to make the EU "the world's
most dynamic and competitive economy". As part of the Lisbon
strategy a number of targets and objectives were set covering
areas such as labour markets and employment, research and innovation,
and further liberalisation of product and financial markets. Mr
Regling told us that it is important to recognise that "there
had been some progress" towards these targets "but not
enough". He acknowledged that "there is less progress
on labour market deregulation, making the labour markets more
flexible, particularly in some countries."
He also stated that the Commission takes the view that "the
low growth environment that we have at the moment should not be
an excuse not to do the reforms that we consider necessary".
44. The Chancellor regarded the economic reform agenda
as "absolutely critical to the future of European Union".
The Government recently published a White Paper on economic reform
in Europe and the progress that was being made towards the Lisbon
identified that of the different areas of the Lisbon strategy
there had been clear progress in six areas including employment,
research and innovation and energy markets, 12 others were listed
as work in progress, and there was limited progress in three areas.
In a foreword to the paper the Prime Minister wrote that "Many
countries have made impressive progress in cutting unemployment.
But the EU's Member States are still not doing enough to tackle
the fundamental barriers to job creation".
We agree that insufficient progress has been made in the eurozone
in making labour markets more flexible.
45. Miss Lea told us that "it is not just the
national governments of the eurozone countries that have to address
this problem. I would like to see the Commission itself address
the problems of labour market inflexibility".
Mr Philip Stephens told us that the ECB also has a role to play
in encouraging structural reform and that the key thing is that
"the bargain is struck between the ECB and Governments that
trades flexibility in labour, product and capital markets offered
by the Governments in return for lower interest rates".
The Centre for European Reform, which issues a 'scorecard' for
progress against the Lisbon objectives, suggested in its most
recent report that, while Denmark, Sweden and Finland already
met most of the Lisbon targets and a second tier of countries
(which included the UK) were making "good progress",
the "eurozone's three largest economiesFrance, Germany
and Italyhave so far made little attempt to fulfil their
Lisbon promises, particularly labour market and pension reforms"
and that these three countries risked "becoming a drag on
the entire EU".
Structural reform is vital if the eurozone is to gain the full
benefits of the single currency. With the loss of monetary policy
independence, reform in individual countries must play an increasing
role in stimulating growth and reducing unemployment. We acknowledge
that there has been progress in some areas, but are concerned
that progress appears to be slow. The current weak economic conditions
should not be an excuse for the pace of reform remaining slow.
We welcome the contribution of the UK Government towards encouraging
structural reform. The ECB, the Commission and the Governments
of the Member States should work together to ensure that the promised
reforms are actually delivered as quickly as possible.
46. The growth and unemployment performance of the
German economy has been significantly worse than the eurozone
averages. The average growth rate over the years 1999-2002 was
1.4%, compared to a eurozone average of 2.2%. There was some debate
as to the reasons for this underperformance. Several witnesses
commented on the fact that interest rates were too high for the
German economy as a consequence of the 'onesize fits-all'
monetary policy of the ECB. Mr Geoffrey Dicks, of the Royal Bank
of Scotland, recognised that Germany was "going to suffer
in terms of growth and rising unemployment from the strictures
of the Stability and Growth Pact" as they are forced at a
time of cyclical weakness and rising unemployment into a fiscal
tightening, while acknowledging along with many other witnesses
that Germany would not be facing this problem if it had taken
advantage of better times to reduce its budget deficit. Mr William
Keegan, of The Observer, regarded "a reduction in
government spending in Germany ...at a time like this [as] the
'economics of the madhouse'."
The TUC believed that "Much of the underperformance
of the German economy can be traced back to the economic aftershocks
of reunification." Reunification brought an extra 16 million
people, with a highly inadequate economic infrastructure, into
a country with a population of around 63 million. Mr Regling quoted
an EC report which concluded that of Germany's underperformance
"half the problem comes from reunification and the other
half comes from the lack of structural reforms".
47. Many witnesses thought that Germany had locked
itself to the euro at an overvalued exchange rate, which meant
that manufacturing costs in Germany were much higher than elsewhere
in the European Union. Mr Anatole Kaletsky, of The Times,
drew attention to figures from the US Bureau for Labour Statistics
that manufacturing labour costs in France were "about 30%
cheaper" than Germany. Lower inflation was seen as a natural
adjustment process. Mr Roger Bootle, of Capital Economics, argued
that while "it is by no means the ultimate root of Germany's
problems" there is a sense in which being in the euro "blocks
off some of the more comfortable exits".
Many witnesses referred to structural problems with the German
economy, particularly with regard to the flexibility of labour
markets, which acted as a barrier to job creation. There was some
disagreement as to the effect which the euro would have on solving
these problems. Mr Rake of KPMG believed that over time the euro
would help "correct these issues"
whereas Mr Hamish McRae, of The Independent, believed that
it "it will be hard for other structural reforms to be put
in place in such a tight fiscal and monetary regime".
Mr Keegan drew attention to the higher productivity of the German
economy relative to Britain and stated that "In the short
run I would not be putting my money on the German economy but
in the medium to long run I would not be pessimistic".
Witnesses put forward a number of explanations for the recent
underperformance of the German economy and the extent to
which they were caused or made worse by the euro. Many stated
that the problems of the German economy were long term in nature
and related to the after effects of reunification. There was a
broad consensus that Germany entered the euro at an overvalued
exchange ratethough the current account is now returning
to substantial surplus. All witnesses questioned on the subject
referred to the fact that structural reforms are necessary if
Germany is to correct its underperformance.
48. The smaller eurozone countries have typically
outperformed the central countries. This has particularly been
true in the case of the Republic of Ireland which has grown at
an average annual rate of nearly 9% over the years 1999-2002over
four times the eurozone average. Irish unemployment is now at
4.4%, at a lower level than in the UK, having fallen from 12%
in 1995. The lower interest rates available to Ireland as a member
of the eurozone were partly responsible for the elimination of
this spare capacity within the Irish economy. The economy began
to overheat in 1999, which led to increased inflation, initially
exacerbated by the fall in the value of the euro, which pushed
up import prices due directly to the large proportion of Irish
imports that come from outside the eurozone (in particular, around
37% from the UK). Many of those to whom we spoke referred to the
potential benefit to the Republic of British membership of the
euro, in terms of reduced exchange rate volatility. Inflation
has now moderated slightly, falling from 6% in late 2000 to 4.9%
in March 2003, although it is still the highest in the eurozone.
49. As part of this inquiry the Committee visited
Dublin to examine the performance of the Irish economy. We were
particularly interested in the performance of the Irish housing
market since this is similar in structure to that of the UK, with
a significant proportion of debt at a variable rate. The reduction
in interest rates led to rapid growth in house prices in the years
leading up to the introduction of the euro, with annual increases
peaking at 30% in 1998. However in the years following the introduction
of the euro the rate of growth moderated, without leading to substantial
falls. This moderation was partly due to the increased supply
of housing, with housebuilding activity rising by 50% over the
past five years. The Irish economy has benefited from being
part of the eurozone in terms of gaining a credible monetary policy
and the elimination of exchange rate fluctuations against other
eurozone members. However, excessive inflation could lead to a
loss of competitiveness in the longer run if not matched by productivity
improvements. There may be a particular danger of this following
the appreciation in the value of the euro against sterling and
the dollar, especially if the UK remains outside the eurozone.
Experience of UK companies so far
50. While the UK remains outside the eurozone, many
British firms trading with Europe deal with the single currency
on a regular basis. ALSTOM already saw one benefit of the single
currency as "reducing the complexity and financial costs
... of transactions throughout the eurozone"..
The Engineering Employers' Federation told us that of respondents
to their survey "over six in ten companies" were conducting
some of their invoicing or purchasing in euros.
51. The Committee visited Northern Ireland to examine
the UK's land border with the eurozone. Ms Gault of the Northern
Ireland Hotels Federation told us that her members would be "dealing
with dual currency all along the border" although she highlighted
the problem for marketing hotels in Northern Ireland. The Committee
also visited the border town of Newry and witnessed the arrangements
for dual circulation of sterling and the euro. The euro was increasingly
in use as a currency of invoicing in Newry, a role that the punt
did not have previously. Many retailers used the euros they accepted
to pay suppliers throughout the eurozone, not only in the Republic
but also further afield in Germany and Italy. Some employees were
paid in euros.
52. Extensive use is of course also being made of
the euro by individuals travelling to eurozone countries. It
is clear that, both at the level of international businesses and
at local level, UK businesses and citizens are adjusting comfortably
to use of the euro. While UK firms are finding it relatively easy
to adopt operational strategies for living with the euro while
the UK remains outside the zone, longer term issues affecting
location and investment may well be contingent on knowing where
government policy is headed. UK companies need to see the analysis
of the five tests to provide such clarification.
49 Under the Pact, a deficit is automatically regarded
as temporary if output fell by over 2% in the year in question,
and may be regarded as temporary if output fell by 0.75-2% Back
See for example Q 296 [Mr Martin Weale] Back
Financial Times "France refuses to take steps to curb
budget deficit" 25 February 2003 Back
Goldman Sachs, European Weekly analyst 28 March 2003 Back
Ev 53 Back
Q 301 Back
Qq 1182, 1195 Back
Qq 802, 805 Back
Q 561 Back
Strengthening the co-ordination of budgetary policies European
Commission communication, 21 November 2002 Back
Qq 464-5 Back
Q 488 Back
Ev 199 Back
Appendix 3, para 24 Back
HC Deb, 14 March 2003, col 491W Back
Q 461 Back
Ev 50 Back
Q 366 Back
Ev 32 Back
Ev 73 Back
IMF World Economic Outlook, April 2002, p 25 Back
Q 474 Back
Q 475 Back
Q 1139 Back
HM Treasury Meeting the Challenge: Economic Reform in Europe
February 2003 Back
ibid (Foreword) Back
Q 387 Back
Q 71 Back
Centre for European Reform Press Release 10 March 2003 Back
Q 48 Back
Q 477 Back
Q 298 Back
Q 114 Back
Ev 1 Back
Q 32 Back
Ev 154, para 10 Back
Engineering Employers' Federation: Manufacturing and the euro-any
change? 2002 Back