Select Committee on European Union Thirteenth Report

Why not leave it to market discipline to ensure the sustainability of public finances?

43.  There is general agreement that the four problems summarized above provide some justification for the EU Member States co-ordinating their fiscal policies. Where there is less agreement, is over the extent to which such co-ordination is necessary.

44.  At one end of the spectrum of thought on fiscal co-ordination, some people, such as Professor Fitz Gerald, suggested that, with the integration of the EU economy, "there may be a need to extend co-ordination of policy in this area." The European Economic and Social Committee (EESC) went further, considering that there was "a strong need" for a more coordinated economic policy across the EU (CES 361/2002, p.12).

45.  At the other end of the spectrum, it was proposed that there should be no attempt to achieve such formal co-ordination; instead, it should be left to market discipline to ensure the sustainability of Member States' finances. Mr Crook argued that the markets automatically applied a special risk premium to the interest rates in countries that face a risk of insolvency. This premium would have the effect of the market applying a sanction on the individual country that was over borrowing. As such, this regime would more directly affect the Member States that over borrowed. Mr Crook therefore claimed that a Pact was not needed, for the disincentive to a Member States increasing its level of debt was supplied by the market, and in a way that only discriminated against the country with an excessive deficit. Indeed, Mr Crook would prefer it if there were no regime at all to the current Pact, which he saw as positively damaging (Q 139). We noted that there have been some indications that the market does exert an influence on Member States: on 15 January 2003 the rating agency Standard & Poor lowered the outlook on Italy's AA debt rating from stable to negative, and another rating agency, Fitch, said that even the AAA rating for Germany could not be taken for granted (Financial Times, 13 December 2002, p.23).

46.  However, UNICE pointed out that such moves, which might eventually prevent a Member States from becoming insolvent, were not enough for the stability of the Eurozone: a country could "accumulate deficits and debt a long time before actually facing insolvency." (q13) Therefore, leaving the market to regulate on Member States' debt would do nothing to counter the threat of a country 'free riding'. The TUC agreed that it was "very important" to have such a Pact, or the free-rider problem would not be addressed and "some countries could bask in the financial rectitude of others and act irresponsibly" (Q 214). Furthermore, abolishing the Pact could prove an incentive for individual EU governments to adopt divergent approaches, which would lead to difficulties for the ECB. The Government concluded that leaving the markets to regulate the debt of Member States was not "the right way to go." (Q 194) The Commission agreed that it was "wrong" to think that the markets could "take care of everything." Even if the market could exercise an influence on the level of Member States' debt, it was the deficit levels that were important for the conduct of monetary policy and so affected the ECB and the consequent policy mix. It was therefore "important to have a co-ordination mechanism." Moreover, the Commission rejected the argument that the market could exert pressure on governments to control their debt and implement sound fiscal policies. This was because, as an effect of monetary union, the interest rate spreads had "come down tremendously". Where previously the spreads might have gone up by between 100 and 500 percentage points in reaction to fiscal policies that the market saw as profligate or unsustainable, today in the Eurozone the spreads were "down to below 50 basis points," which was "not surprising" because of the absence in the Eurozone of exchange rate risk that would need to be reflected in the interest rate spreads (QQ 253, 255, 271-72).

47.  However, the fact that spreads are low currently merely indicates that there is currently no differential default risk between different Member States. That may reflect a market belief that any Eurozone member that did default on its debt would be bailed out by the ECB and, effectively, by other members of the Eurozone. Or the low spreads may simply reflect a current absence of default risk. They need not necessarily indicate that if one country were to experience an increase in default risk its interest rate would not rise relative to the rest.

48.  Another argument against leaving the markets to regulate the debt of the Member States was that the markets liked the sense of certainty and stability that the Pact provided. Professor Zank argued that the current pact, by limiting deficits and debt, reassured financial markets, by communicating to them Member States' commitment to fiscal probity (p. 110). UNICE warned that the size of Member States' budget deficits was "a factor directly influencing" market confidence. A "strong SGP" sent "a signal to the markets that no excessive budget deficits" would emerge in the Euro-area "thus also providing room for manoeuvre for the ECB". For the sake of "keeping the confidence of market participants, the EU should refrain from any watering down of the deficit criteria"[19] (q2; 12; p. 69). If the EU announced that the Pact was dead this would probably have a seismic effect on the markets. Mr Crook contended that the markets regarded the Stability and Growth Pact "as dead already, to all intents and purposes […] the markets will take the view that not much has changed if the EU simply acknowledged that the Pact was defunct" (Q 142). Professor Persaud, however, produced compelling evidence to refute this claim. He demonstrated that the market was concerned about the free-rider problem and that it would appear that the Stability Pact had "served its purpose in reassuring the markets on this point." He added that the market appeared to be "particularly concerned" about attempts to make the Pact looser when the limits were being threatened, because this smacked of "moving the goal posts to where the ball is and the markets do not like that."[20]

49.  The Committee supports the co-ordination of national fiscal policies across the EU with a view to maintaining sound public finances. Market discipline alone cannot be guaranteed to ensure the sustainability of public finances. Consequently, the Committee considers that a co-ordinating pact or other method of co-ordination between the Member States is necessary to deal with the 'free rider' problem and the risk of default. Such a pact can help Member States to control their debt and deficits, which should also contribute to their preparations for the economic effects of ageing populations, while providing stability for the ECB and the market. It is extremely important that Member States are free to structure the expenditure and the revenue side of their budgets according to their own national preferences. This is not in question in any of the discussions on the Stability and Growth Pact, which deals only with levels of government debt and deficit.

Problems affecting the operation of the SGP

50.  Before examining how to change the SGP, we must first analyse how it has performed since it came into force at the start of 1999. These first four years have seen the Pact face various challenges, which are briefly summarised below.[21]

The global economic slowdown

51.  Apart from Germany, all EU countries had a positive output gap in 2001 following several years of higher-than-potential growth. In spite of the positive output gaps, however, a number of euro-area countries loosened their stance in 2001 (particularly Ireland, but also Finland, Germany, Greece, Holland, Luxembourg and Portugal), with some of these countries making large tax reductions (Germany, Holland and Ireland).[22] Given the level of the output gap, the fiscal stance in these countries appeared to be pro-cyclical. This lack of fiscal consolidation in 2000 when economic growth was buoyant proved to be short-sighted and was to contribute to the constraints facing high-deficit countries during the subsequent economic slowdown.

52.  2001 saw the sharpest slowdown in world growth for close to thirty years (with the rate of GDP growth falling from 4.7 % to 2.2 %). Moreover, at the same time, world trade declined from a growth rate of 12 % to a position of almost no growth at all. These global slowdowns were due to a range of factors, including: the rise in oil prices, the economic effects of the terrorist attacks of September 11th 2001, corporate accounting scandals and rapid falls on the stock markets.

53.  2001 thus proved to be the most challenging period for fiscal policy since the launch of EMU. One of the consequences of this was that the budget deficit for the euro area reached 1.3 % of GDP in 2001, up from 0.7 % in 2000; this represented the first reversal in the process of budgetary consolidation since 1993.[23] The estimated cyclically-adjusted budget deficit for the euro area increased slightly to 1.5 % of GDP, up from 1.3 % of GDP in 2000.

54.  In 2002, output growth in the euro area was on average 0.75 % (after 1.4 % in 2001). Thus, for the second consecutive year, it was significantly below potential (or trend) growth, so that the output gap—a measure of the under-utilisation of resources—moved from positive in 2001 to negative in 2002. The political situation in the Middle East and the threat of war with Iraq have since created further uncertainty, posing a further risk to the economic outlook in Europe.

The increasing financial impact of ageing populations in the EU

55.  The demographic changes in the EU over the coming decades are expected to place a large strain on European public finances. The ageing populations across Member States will have a considerable budgetary impact, which may, in turn, have serious repercussions for Member States' adherence to the Stability and Growth Pact. According to the Commission:

"Public spending is projected to rise by between 4 % and 8 % of GDP in the coming four decades, although much higher increases are projected in several Member States. Increases in public spending due to ageing population will start as of 2010 in some countries as the baby-boom generation enter into retirement, and the steepest rise will occur between 2020 and 2035 in most Member States." (Public Finances in EMU—2002, European Economy No.3, 2002, p.5)

56.  The Commission has called on all Member States to achieve and sustain the medium-term target of budgets 'close to balance or in surplus', in order to meet these costs by lowering the future interest burden on debt. Furthermore, those countries most affected by the economic impact of ageing populations should run budget surpluses up to 2010 and beyond so as to achieve a large reduction in public-debt levels prior to taking hold. According to the Commission's calculations, six Member States (Germany, Spain, Greece, France, Austria and Portugal), that is, half of the Eurozone membership, risk budgetary imbalances that would breach the Stability and Growth Pact, based on their current policies. Two further countries (Belgium and Italy) with high levels of public debt will need to maintain high primary surpluses over the very long term to cope with the budgetary impact of their ageing populations.

57.  The Commission explains that the ageing population is projected to have "only a minimal impact on public spending in the UK. This largely stems from the strategy of limiting the role of the State to providing a minimum flat-rate pension (that is indexed to prices), while ensuring a legislative and fiscal framework that enables individuals to save for their own retirement income." (ibid., p.35)

The Council did not send 'early warnings' to Germany or Portugal

58.  These problems were thrown into sharp focus when, early in 2002, the Commission judged that the budget deficits of two Member States were in danger of breaching the 3 % of GDP reference value. Germany and Portugal had missed the deficit targets for 2001 set down in their 2000 stability programmes by a wide margin of over 1 % of GDP. The Commission considered that there was a clear risk of the countries' deficits approaching the 3 % reference value in 2002.[24] In line with the Treaty, the Commission therefore recommended that the Council issue early warnings to the two Member States. This was the first time that these preventive elements of the SGP had been activated.

59.  However, Germany and Portugal were not issued with early warnings. Following a discussion in the Eurogroup, political agreement was reached at the Ecofin Council not to endorse the Commission recommendation for early warnings. The reason given by the Council for not issuing early warnings was that both Germany and Portugal had provided firm political commitments which "effectively responded" to the Commission's concerns.[25]

60.  The Council's unexpected decision not to issue the early warnings caused a great deal of unease; questions were asked about the Member States' commitment to the rule-based approach outlined in the SGP. The Committee on Economic and Monetary Affairs of the European Parliament was concerned over the fact that this approach had, "on the one hand, cast doubts on [the Pact's] credibility and, on the other hand, might lead to inequalities in its application." That Committee even saw it necessary to draw Member States' attention to the 2001 code of conduct, which differed from the 1998 code in requiring, inter alia, "equality of treatment among Member States". The Committee said that, following the recommendation sent to Ireland for an economic policy inconsistent with the BEPGs, the Council itself seemed to have "ignored completely" this equality in the decisions over Germany and Portugal.[26] The Commission reported that there was a "widespread perception in the public opinion" that the rules could be "manipulated or disregarded."[27] This perception was reinforced when, later in the year, the deficits of both Germany and Portugal did exceed the 3 % reference value, in line with the Commission's predictions.

Member States are breaking the rules of the SGP

An excessive deficit in Portugal

61.  In September 2002, the Portuguese Government, which had come into office in April 2002, substantially revised the deficit data submitted by the previous Portuguese authorities in February 2002. The new Government notified the Commission that the government deficit in Portugal had increased from 2.4 % in 1999 to 4.1 % of GDP in 2001. Consequently, the Ecofin Council on 5 November 2002 decided that an excessive deficit existed in Portugal in 2001. The Council's Opinion said that part of the deficit increase in 2001 "was due to the rectification of government accounts, the other part to deviations of budget execution from targets planned."[28] The Portuguese government declared its firm commitment to a new deficit target of 2.8 % of GDP for 2002; whether Portugal achieves this target will not be known until the Council considers Portugal's stability programme for 2002 on 7 March 2003.

An excessive deficit in Germany

62.  The German stability programme for 2002 to 2006 said that the government deficit in 2002 was 3.75 % of GDP. Consequently, the Ecofin Council on 21 January 2003 decided that an excessive deficit existed in Germany in 2002. The Council therefore sent a Recommendation to Germany with a view to bringing an end to the excessive government deficit. The Council noted that the rise in Germany's nominal deficit from 2.7 % in 2001 to 3.75 % in 2002 could "only partially be explained" by the unexpected slowdown in growth and that there had once again been "expenditure overruns in the health sector which contributed to a deterioration of the underlying balance." The stability programme said that Germany aimed to reduce the deficit in 2003 to 2.75 %; the Council judged that this forecast was based on an optimistic growth rate of 1.5 % in 2003 and considered that there was "a non-negligible risk" that the general government deficit in 2003 might again exceed the 3 % of GDP reference value. In underlying terms, the government accounts were predicted to be close to balance by 2006. The Council established a deadline of 21 May 2003 for the German Government to take measures that would bring the deficit below 3 % as planned.[29]

A risk of an excessive deficit in France

63.  The Ecofin Council on 21 January 2003 decided to send an early warning to France with a view to preventing an excessive deficit occurring. The Council noted that France's nominal deficit had risen from 1.4 % in 2001 to 2.8 % in 2002 and judged that "a large part of the slippage" in 2002 was due to a deterioration in the underlying balance. France's stability programme for 2003 to 2006 projected that the general government deficit would fall to 2.6 % of GDP in 2003, based on a predicted increase in real GDP of 2.5 % in 2003; the Council considered this forecast to be optimistic and concluded that there was a danger that French government deficit would breach the reference value in 2003.

64.  The macroeconomic projections of France's stability programme were based on two scenarios: a 'cautious' scenario, with real GDP growth at 2.5 % a year over the period, and a 'favourable' scenario, where real GDP growth would reach 3 % per year. The Council was concerned that France would only achieve the medium-term objective—of a budget close to balance by 2006—under the favourable scenario. (ibid.)

Member States with debt above the 60 % reference value

65.  The EC Treaty requires the ratio of government debt to GDP to be below the 60 % reference value, "unless the ratio is sufficiently diminishing and approaching the reference value at a satisfactory pace." According to the 2001 stability programmes, the gross debt-to-GDP ratio in the euro area is set to fall to 63 % of GDP in 2004. According to these projections, 12 Member States will be below the 60 % of GDP ceiling by that time. The three other countries, however, will remain a long way off this reference value. Belgium is predicting its debt level will be 88.6 % in 2005; Greece predicts a level of 90 % of GDP in 2004; Italy predicts its debt will still be at 95 % of GDP in 2005. The Pact, however, does not explain how the Excessive Deficit Procedure is to be applied when the public debt criterion is violated (the Commission is now planning to change this, see below paragraphs 116-26).

Who is to blame?

66.  Broadly speaking, there are two opposing interpretations of these problems: either the problems are the result of the budgetary actions of the Member States; or the problems are to do with the rules of the SGP.

The problems are the result of Member States' budgetary actions

67.  The Commission firmly backed the former interpretation; it claimed that the Member States were responsible for their budgetary decisions and so for the consequent breaches of the rules of the SGP. The Commission stated that it was clear that in 2001 budget deficits increased "due to tax cuts that were not fully offset by expenditure reductions and the operation of automatic stabilisers in the cyclical downturn."[30] Many of our witnesses supported this position. Professor Buiter, for instance, said that there was "no reason" why France and Germany should be in the budgetary position that they found themselves at the end of 2002. Their excessive deficits were due to the fact that they had not run tighter budgets during the period of higher growth: "If they had done so, they would now not be in that position." (Q 9; p. 109) UNICE agreed that, in contrast to most EU Member States, "the governments of several large Member States applied the Pact selectively and did not conduct prudent fiscal policies during the times of high economic growth." (p. 69)

68.  Mr Solans, Member of the Governing Council and of the Executive Board of the ECB, said that it was important to be clear that "normally, behind the non-fulfilment of the SGP there is a case of bad public administration, either past or present." (op. cit.) Wim Duisenberg concurred that the current fiscal problems had arisen not because the rules were "inflexible," but because countries had "not honoured their commitments to make progress in fiscal consolidation, particularly during good times." He added that it was now "high time" for those countries with deficits approaching or exceeding 3 % of GDP to "honour their commitment to respect the rules". He was concerned by "a certain laxity in living up to the solemn pledges and commitments" that many countries had made (op cit.). French Bank BNP Paribas agreed that the problem was not so much with the Pact, rather it was with the "willingness of the countries to honour their commitments." (Ecoflash, 27 November 2002, #02-530)

The problems are with rules of the SGP

69.  Alternatively, the fact that several Member States are in breach of the Pact could be interpreted as being the fault the rules of the SGP, that is, that the rules of the Pact are badly conceived and 'inflexible'. The Committee heard complaints against the medium-term target and the reference values for deficit and debt in the Pact, how they are interpreted, the fact that they are measured in nominal rather than cyclically-adjusted terms, the uniform way in which the rules are applied to the different Member States, and the enforcement procedures and sanctions. The Commission's Communication aims to address some of these criticisms. We took seriously all of the criticisms of our witnesses. Each of the criticisms, together with the relevant Commission proposal wherever possible, is examined in Part Three below. We reserve our conclusions until we have considered all the sides of the arguments.

19   The European Parliament Committee on Economic and Monetary Affairs also considered that the SGP played "an important role" in "creating European economic confidence" (A5-0161/2002, p.6). Back

20   'Is it Really Stupid? The markets perspective on the Stability & Growth Pact and prospects for its reform', Avinash Persaud and Michael Metcalfe, State Street, January 2003. Back

21   All figures are taken from the Commission document Public Finances in EMU-2002, European Economy No.3, 2002. Back

22   For a short discussion of what happened in reaction to this fiscal loosening by the Irish Government, see below paragraph 98. Back

23   The official deficit figures for 2002 were not available at time of going to print. Back

24   For a full justification of why the Commission decided to recommend early warnings for Germany and Portugal, see Public Finances in EMU-2002, European Economy No.3, 2002, Part II. Back

25   Both countries stated their willingness to implement their new stability programme updates in full so as to avoid a breach of the 3 % of GDP reference value, to resume the process of budgetary consolidation and to reach their medium-term targets of balanced budgets in 2004 (see Council press release 28 of 12 February 2002, 6108/02). Back

26   A5-0145/2002, pp.7-8. Back

27   Public Finances in EMU-2002, European Economy No.3, 2002, p.52. Back

28   Council press release 333 of 5 November 2002, 13490/02. Back

29   Council press release 15 of 21 January 2003, 5506/03. Back

30   Communication form the Commission 'The euro are in the world economy-developments in the first three years', COM(2002) 332 final, 19 June 2002. Back

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