Select Committee on European Union Thirteenth Report

Non-legal elements surrounding the Stability and Growth Pact

Code of Conduct

17.  The principle of co-ordinating national budgets through the Pact continues to be an evolving process. The core legal texts set out above are complemented by a series of declarations,[7] which are not legally binding but which nonetheless exert a powerful influence over the interpretation of the Pact. This evolution of non-legal instruments around the Pact is demonstrated by the 'Code of Conduct on the content and format of stability and convergence programmes', which was first added in October 1998, and then revised by the Economic and Financial Committee (EFC) in June 2001. This latest version of the Code of Conduct was adopted by the Ecofin Council on 10 July 2001.

18.  The guidelines set out in the Code constitute a code of good practice and a checklist to be used by Member States in preparing stability or convergence programmes. The new code encompasses a set of standardised tables. It also suggests that the annual updates are all submitted in the autumn, within a period of one and a half months. The aim of the guidelines is to facilitate the evaluation of the programmes by the Commission and Council. The Code explicitly states that the guidelines "are indicative and may be developed further over time, building upon the best practice emerging."[8]

The target date for achieving a balanced budget

19.  There have been other important developments around the Pact. For example, in the Amsterdam Resolution, the Member States committed themselves to the medium-term target of achieving budgets that are 'close to balance or in surplus'. Yet neither the Resolution nor any of the other legal instruments of the Pact specifies the date by which Member States must achieve this target of a balanced budget. Nonetheless, various attempts have been made to define the target:

·  the 1999 Broad Economic Policy Guidelines (BEPGs) urged Member States "to achieve budgetary positions of close to balance or in surplus by the end of 2002";

·  the 2000 BEPGs brought this date forward, proposing that Member States should "meet a budgetary position of close to balance or in surplus earlier than envisaged in the updated stability and convergence programmes and, as a rule, in 2001";

·  the 2001 BEPGs maintained the revised date, recommending that Member States "meet, as a rule and in keeping with last year's commitment, budgetary positions of close to balance or in surplus in 2001".

20.  Eight of the twelve Eurozone countries achieved the objective by 2001. The other four EMU countries (France, Germany, Italy and Portugal) have, in the Commission's words, "been struggling ever since."[9] Consequently, the target date has been postponed repeatedly. The 2002 BEPGs stated that the medium-term target of budgets 'close to balance or in surplus' was to be achieved by 2004 at the latest for Germany, France, and Portugal, and by 2003 for Italy because of its high level of debt.[10] During the Barcelona Summit, in March 2002, all the EU Heads of State and Government reaffirmed their commitment to reaching or maintaining the target by 2004.[11]

21.  In September 2002, the President of the Commission and Commissioner Solbes said that the deadlines for reaching a balanced-budget could "no longer be a moving target, since this not only undermines the credibility of the prevention arm of the SGP but it also reduces the room of manoeuvre of the countries concerned." They called on the Member States to commit to "a strict and enforceable adjustment path including an agreement on in any case a swift return below the 3 % threshold, and a minimum required rate of structural adjustment of 0.5 % of GDP." Yet, whilst calling on Member States not to move the target date again, the Commissioners recognised that their suggested adjustment path "would imply that close-to-balance would be reached [by the Member States] in 2006 at the latest." (op cit.) At the Eurogroup meeting on 7 October 2002, the Member States agreed to pursue the Commission's suggested continuous adjustment path for the underlying balance.[12] Consequently, it would appear that the medium-term target has been moved back once again.

Box 2 The Stability and Growth Pact and the United Kingdom
The United Kingdom has signed up to the Stability and Growth Pact and is subject to its rules. If the United Kingdom budgetary position were to significantly diverge from the medium-term target or if the UK were to run an excessive deficit, it would be censured by the Commission and in the Council, as Director General Regling made quite clear to us (Q 280). This censure could involve various different stages. If, as part of the monitoring and surveillance process outlined in Regulation 1466/97, the Council, on the basis of a Commission recommendation, judged that the United Kingdom budgetary position significantly diverged from the medium-term target, the Council could address an 'early warning' recommendation to the UK Government to take the necessary adjustment measures to prevent the occurrence of an excessive deficit. If the divergence persisted or worsened, the Council would make a recommendation to take prompt corrective measures. In the event of the Council finding that the UK had an excessive deficit under Regulation 1467/97, the Council would make a recommendation to the UK with a view to bringing the situation to an end within a given period. As a Member State that is not a member of the Eurozone, however, the United Kingdom could not be sanctioned for running an excessive deficit or for any other budgetary position that did not comply with the rules of the Pact.


22.  The above sections demonstrate that the Stability and Growth Pact is firmly based on legal texts (the EC Treaty and the Regulations), which have been supplemented by various declarations and guidelines (Council conclusions, the Code of Conduct, the BEPGs) that are not themselves legally binding but are normative in effect. We return below (paragraphs 155-57) to this distinction, between what are often called 'hard' laws and 'soft' laws.

23.  There are many ways in which the Stability and Growth Pact could be changed. These include, at one end of the spectrum, amendments to the Treaty and, at the other, a new set of guidelines. Generally speaking, some of our witnesses advocated radical surgery for the Pact, which would involve changes to the Treaty and the Regulations; other witnesses called for more subtle amendments, which could be achieved within the current rules, by, for instance, the Ecofin Council revising the Code of Conduct or the European Council issuing a new statement on the Pact via the Presidency conclusions to the March 2003 European Council in Brussels.

24.  On 27 November 2002, the Commission issued a Communication that proposed developing further the interpretation of the SGP.[13] The Communication was generally welcomed,[14] perhaps because all but one of the Commission's proposals focus on changing the way in which certain provisions of the Stability and Growth Pact are interpreted, without changing the formal, legal rules of the Pact, as set out in the Treaty and the two Regulations (QQ 2, 263-64).

25.  We did not limit the scope of our inquiry; we gave full consideration to all of the proposals to change the Stability and Growth Pact that we heard, regardless of how they might be effected. It is clear that many changes to the interpretation and implementation of the SGP can be achieved without changing the legal framework of the Pact. Nonetheless, 2003 offers a unique window of opportunity for considering all of the various ways in which the legal aspects of Pact might also be changed, as the Convention on the Future of Europe is currently considering changes to the European Treaties ahead of the next Inter-Governmental Conference, which is expected to produce a new constitutional Treaty for the EU.

Why do we need a Pact?

26.  The Committee heard four main reasons why a Stability and Growth Pact is needed. First, the overarching reason is that the performance and management of national economies in the EU are a matter of common interest for the Community. Secondly, an important macroeconomic manifestation of the common interest is that the effects of public borrowing by one economy in the Eurozone may spill over onto other members of the Eurozone, and, consequently, there may be what is known as a 'free-rider' problem. Thirdly, in extreme circumstances, a heavily-indebted member of the Eurozone might default on its debt, imposing costs on all Eurozone members. Fourthly, low public debt would better enable Member States to prepare for the increasing public pension obligations to ageing populations. These four reasons are set out in more detail below.

1. Economies in the EU are a matter of common interest

27.  Wim Duisenberg, President of the ECB, has said that sound public finances "are in the interests of all Member States."[15] As can be seen from the box below, however, the EC Treaty goes further than this; the Member States have agreed that the economic decisions of one Member State are of interest to all the Member States. The Treaty makes clear that the economies of the Member States are "a matter of common concern" and that consequently they require co-ordination.

Box 3 The EC Treaty
Part One: Principles, Article 4(1)

the activities of the Member States and the Community shall include […] the adoption of an economic policy which is based on the close co-ordination of Member States' economic policies

Article 4(3)

[…] activities of the Member States and the Community shall entail compliance with the following guiding principles: stable prices, sound public finances and monetary conditions and a sustainable balance of payments.

Part Three: Community policies

Title VII: Economic and monetary policies,

Chapter 1: Economic policy, Article 99(1)

Member States shall regard their economic policies as a matter of common concern and shall co-ordinate them within the Council.

28.  A number of witnesses, such as Professor Buiter, emphasised that although fiscal policy in the EU was controlled at the national level, how such policies were managed was nonetheless a matter of common concern; these witnesses deduced from that position that some set of rules that were centrally monitored and possibly enforced was desirable (Q 2). For example, the TUC considered that macro-economic policy decisions in one economy had "knock-on impacts on others, increasing the potential benefits of effective policy co-ordination and the potential costs of member states pursuing beggar my neighbour policies." (pp. 58, 109)

29.  The Directorate-General for Economic and Financial Affairs in the European Commission said that "the key objective of policy coordination is to take account of spillovers of national policies. […] Co-ordination is needed to take account of direct cross-border spillovers of national policies on neighbouring countries."[16]

30.  The Stability and Growth Pact is one way in which the Member States aim to achieve the economic co-ordination referred to in the Treaty. Professor Fitz Gerald explained how the transition to Stage Three of EMU "changed the operating environment for all member economies by creating new channels through which the actions of individual Members States could adversely affect the citizens of other members. It is this possibility of negative externalities for the union from fiscal policy in individual members (or a group of members) that required the addition of new rules for coordinating fiscal policy, leading to the agreement on the SGP." (p. 93) The introduction of the euro has led to a new structure of policy making for countries in the Eurozone. A single monetary policy and interest rate responds to Eurozone-wide economic developments, while fiscal policy remains at the national level to deal with asymmetric shocks within the Eurozone and country-specific developments. UNICE and the Commission emphasised the importance of tightly co-ordinated fiscal policies as a consequence of a unified monetary policy in the Eurozone (p. 69; Q 253). The ECB was obviously a strong advocate of the position that the EU economies were a matter of common concern. Mr Solans, Member of the Governing Council and of the Executive Board of the ECB, considered the Stability and Growth Pact as a "public good, indispensable in an economic and monetary union in which there are national fiscal policies."[17] Witnesses reported two particular potential problems that had given justification to fiscal policies being co-ordinated through the Stability and Growth Pact.

2.The free-rider problem

31.  One rationale for the Pact was to prevent members of the Eurozone accumulating excessive debts and deficits, the economic costs of which the Eurozone as a whole would have to bear.

32.  As mentioned above, all countries in the Eurozone share a common interest rate on their debt. Therefore, to the extent that higher public borrowing leads to a higher interest rate on public debt, the higher rate is paid by all Member States, not just the member whose borrowing increases. At the same time, the increase in interest rates occasioned by the borrowing of a single Eurozone member, being spread across all members of the Eurozone, is smaller than it would be if that State were not inside the Eurozone, but instead had an independent currency and its own exchange rate and monetary policy. The concern when establishing the Eurozone was that, because the financing costs would appear to be lower, Member States would face smaller market disincentives to public borrowing and so would run larger deficits. As a consequence, total EU government debt would increase, and the interest rate paid on it would in fact be higher. In the words of Professor Begg, the outcome of one country over borrowing would be "adverse for the fiscally virtuous as well as the sinners." (p. 24)[18]

33.  Two further arguments link higher public borrowing to higher interest rates. The first is that higher public deficits lead to higher demand for goods and services, and thus greater inflationary pressure. In order to keep inflation on target, the ECB then responds by setting higher interest rates, in effect penalising those Member States that had pursued sensible policies. The second argument is that higher levels of public debt—arising from the accumulation of past deficits—may lead to greater pressure on the ECB to accommodate inflationary pressures, in order to erode the real value of these debts. Financial market anticipations of higher future inflation raise the required yield on government bonds.

34.  Apart from the burden that higher interest rates impose on government finances, they also discourage private sector investment and reduce the growth rate of potential output. Consequently, the SGP was intended to produce an advantageous policy mix for the Euro zone. It was intended to lead to a combination of tight fiscal policy and less tight monetary policy to promote medium-term economic growth.

35.  In order to tackle this 'the free-rider problem', Member States decided that rules were needed to co-ordinate and restrict Member States' fiscal policies. Otherwise all Member States could be worse off in the end with higher interest rates, and possibly with higher inflation also. Many witnesses cited the free-rider problem as one of the main reasons behind the creation of the Stability and Growth Pact (pp. 58, 93, 107, 109, 110) and the Commission confirmed that this was the case, stressing that every country in the Eurozone still had "an obligation to watch out" for what its deficit situation meant for other countries in the monetary union and for the ECB (QQ 267, 276).

36.  However, Mr Crook saw "no evidence" to support the view that the over-borrowing of one country could drive up the interest rate for other Member States. He found that to be a "completely unconvincing" rationale for the Pact. He said that the Commission was "wrong about this." There was "no evidence" to suggest that there was "an EU-wide interest rate penalty for the over-borrowing of a single country" (QQ 139, 143). Professor Fitz Gerald also argued that in practice this problem was likely to be relatively unimportant (p. 96), and the TUC said that, since the formation of the euro, concern with the free-rider problem had "faded" (p. 58), but it was still a "potential problem" that would always remain in a situation where there was a single currency and countries borrowed against a common interest rate (QQ 215-17).

3.The default problem

37.  The second major reason for the Stability and Growth Pact, to which witnesses referred, was to prevent the problem of governments becoming very heavily indebted and then defaulting on their debt.

38.  We have seen that many witnesses suggested that being a part of the Eurozone could give Member States incentives for excessive borrowing, the effects of which would 'spill over' onto other Member States. An extreme manifestation of these spill-over effects, which featured prominently in our evidence, was that if a government chronically over-borrowed, in due course it might face problems in meeting interest payments on existing debt, and being able to refinance maturing debt, resulting in default. Professor Goodhart argued that the risks of default were further increased in the Eurozone, because Member States would not be able to monetise their debt when default threatened, as they could have done when they had their own monies (p. 97).

39.  Government default within the Eurozone would threaten the stability of the financial system of the country in question and the effects would possibly spread more widely. This raises the possibility that the ECB would have to bail out the financial system of some or possibly all Eurozone members, in order to prevent systemic collapse; and witnesses agreed that bailout would impose costs on all Eurozone members. The so-called 'no-bail out' clause (Article 103) of the EC Treaty is supposed to prevent the ECB being forced to bail out an insolvent Member State and to ensure that Member States are not liable for the commitments of other Member States. But some witnesses questioned whether, in this crisis situation, the ECB would be able to resist the pressures to monetise the defaulting country's debt. These witnesses, such as Mr Crook, thought that it was "difficult to imagine the ECB would be able to stand entirely aside […] the political pressure for some pooling of the cost of the default would be very hard to resist" (Q 139). For Professor Begg, the ECB's credibility rested in part on its ability to resist these pressures; but if the central bank's credibility was damaged, then "the whole Euro area (indeed EU)" would be "the loser" (p. 24).

40.  For Mr Crook, the default problem offered a "persuasive rationale" for some measures to increase the fiscal discipline of Member States (Q 139; p. 94). The TUC argued though that the danger of bail-outs in the Eurozone appeared to have receded (p. 58).

4.The economic consquences of demographic changes in the EU

41.  When the Pact was agreed in 1997 it was in part to avert the two problems above. It is now necessary to append a third problem, which was not widely envisaged at the outset of EMU, but which adds a further rationale for Member States to control their debt and deficits through the Pact. Abiding by the rules of the Pact will help all EU Member States to deal with the economic effects of their ageing populations.

42.  UNICE pointed out that one benefit of the SGP was that it prepared national budgets for "the threatening time bomb of an ageing population" (p. 69; Q 238). The TUC also mentioned the need to keep down the level of debt in the EU, in order to anticipate the burden on public finances of an ageing population (p. 61). For the President of the ECB, this was "the basic long-term justification of the Stability and Growth Pact." He held that sticking to the Pact would "over time, maybe decades, create the room in budgets to cope with the costs of the ageing of the population which are expected to rise over a 30-year period by something in the neighbourhood of 5 to 6 % [of] GDP." (op.cit.)

7   For example, the Heads of State or Government reconfirmed their commitment to the Stability and Growth Pact once again at their informal meeting in Ghent on 19 October 2001. Back

8   Annex to Council press release 262 of 10 July 2001, 10240/01. Back

9   'Budgetary Challenges in the euro area', Communication of Commissioner Solbes in agreement with President Prodi, SEC(2002) 1009/6, Brussels, 25 September 2002. Back

10  Back

11   The Presidency Conclusions of the Barcelona Council (15 and 16 March 2002) stated: "Member States will maintain or respect the medium term budgetary objective of close to balance or in surplus by 2004 at the latest." Back

12   The full text of the relevant Eurogroup press release is available online at: Back

13   'Strengthening the co-ordination of budgetary policies', Communication from the Commission to the Council and the European Parliament (ECFIN/581/02-EN REV 3), 27 November 2002. Back

14   In their Explanatory Memorandum to Parliament on 16 December 2002 about the Commission's Communication, the Government called the Commission's proposals "a useful contribution to the debate on the reform of the SGP." Wim Duisenberg, the President of the European Central Bank, said that the ECB considered the Communication "a good starting-point for rebuilding confidence in the budgetary policy framework." (Testimony before the Committee on Economic and Monetary Affairs of the European Parliament, Brussels, 3 December 2002). The TUC expressed "broad support" for the proposals (Q 213). Back

15   Testimony before the Committee on Economic and Monetary Affairs of the European Parliament, Brussels, 3 December 2002. Back

16   'Co-ordination of economic policies in the EU: a presentation of key features of the main procedrues', Euro Papers, No 45. Back

17   Speech 'Macroeconomic stability and growth in the European Monetary Union', delivered at The Economist Conference: Portugal and the European Union, Lisbon, 16 December 2002. Back

18   UNICE pointed out that this scenario reflects the 'prisoner's dilemma' in Game theory: "By damaging the other players, one 'free rider' profits more from a situation than he would profit by being cooperative" (q 13). Back

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