PART 3:criticisms of the Stability
and Growth Pact
Criticism 1: The SGP does not take
account of underlying economic conditions
70. In their stability and convergence programmes,
Member States stated their budget targets in actual or nominal
terms. However, our witnesses unanimously agreed that, in assessing
compliance with budgetary commitments, it was necessary to consider
the effects of the economic cycle on the budget position.
They argued that countries' fiscal balances should vary between
the years in accordance with their cyclical position. This would
allow the automatic stabilisers to operate fully and so help to
smooth the fluctuations in the economy in the face of varying
levels of demand.
Box 4 Automatic Stabilisers
|The Government explain the role of the automatic stabilisers as follows:
"Several features of the taxation and spending regime help to stabilise the economy over the economic cycle. As the economy strengthens, incomes tend to rise, resulting in higher income and corporation tax receipts. At the same time, lower unemployment rates reduce social security spending. As the economy weakens, the opposite effects occur. This means that government borrowing tends to fall when growth is relatively high, and rises when growth is relatively low. These 'automatic' effects help to reduce volatility in output over the cycle, by boosting aggregate demand when the economy is below trend, and reducing aggregate demand when the economy is above trend."
Source: HM Treasury, Sustainability for the Long Term: Convergence Programme for the United Kingdom, submitted in line with the Stability and Growth Pact, December 2002
71. The Commission has continually stressed that
the norm for budgetary behaviour in the EU should be that of relying
on automatic stabilisers. The Commission has also implicitly recognised
that this model may only function without a fear of Member States
breaching the 3 % deficit criterion once they have attained their
medium-term targets of budgets 'close to balance or in surplus'.
The medium-term targets are set so as to provide a safety margin
for Member States during cyclical developments:
"If countries abide by the SGP's fiscal philosophy,
they will choose a broadly balanced budget in structural terms
and let automatic stabilisers play freely over the cycle. [
Meeting these [medium-term] targets will allow all Member States
to let automatic stabilisers operate freely during future cyclical
] By attaining this budgetary target, countries
have sufficient room for the automatic stabilisers to operate
freely during normal cyclical downturn without breaching the 3
% of GDP reference value."
72. Under the Pact, the 3% of GDP reference value
has become a hard ceiling to be breached only in exceptional circumstances
and for a limited period of time. In order to create sufficient
room for manoeuvre within this limit, however, a rapid transition
to broadly balanced budgets in structural terms is required.
The Commission's proposal
73. In order to take account of underlying economic
conditions, the Commission proposed establishing budgetary objectives
that take account of the cycle. In its Communication, the Commission
suggested that this development would involve "setting the
requirement that budgets be 'close to balance or in surplus' in
terms of the cyclically-adjusted or underlying budget balance,
not the current value." (op. cit.)
74. In the words of French Bank BNP Paribas,
however, this represented "more a change in emphasis [in
the Pact] rather than of content" (op. cit.). The
Amsterdam Resolution already stressed that achieving a balanced
budget was a medium-term objective, and this was widely interpreted
as meaning that the underlying, structural budget position should
be in balance, rather than the current or nominal value.
Professor Buiter certainly interpreted the medium-term target
in this way (Q 9); as indeed had the Commission itself. The Commission
spelt out this understanding of the 'close to balance or surplus'
rule in its own publications, saying quite clearly, for example,
that "the cyclical adjustment of budget balances is used
when evaluating [
] the respect of the 'close to balance
or in surplus' target of the Stability and Growth Pact."
However, as noted in last year's report from the European Economic
the Stability and Growth Pact did not state explicitly that the
medium-term target refers to the cyclically-adjusted balance.
For our witnesses, however, the medium-term target was not the
major issue; they were more concerned about how the 3 % limit
should be calculated.
Should the excessive deficit criterion
be recast in cyclically-adjusted terms?
75. Some witnesses argued that the 3 % figure
was rigid in circumstances where the automatic stabilisers operated
in a recession. They were concerned that, in a situation of subdued
growth, a quick transition to a balanced underlying
budget would require pro-cyclical policies
that might worsen the cyclical conditions. These witnesses claimed
that the current problems, where certain Member Statesparticularly
France, Germany and Portugalwere breaking the terms of
the Pact, came from the difficulties that these countries were
experiencing in coping with a cyclical slowdown before having
reached their targets of underlying
budgets close-to-balance. Mr Crook argued
that, as these countries could not let their deficits rise naturally
with their automatic stabilisers for fear of being sanctioned
under the excessive deficit procedure, they were being obliged,
to varying degrees, to tighten fiscal policy in the teeth of a
recession. This situation was something that he described as "very,
very bad policy." Mr Walton agreed that in Germany, at a
time when the economy was weak, the Government was being forced
to tighten fiscal policy "quite sharply". He said that
it would seem "much more sensible" to allow Germany
that "extra bit of flexibility" to reduce its deficits
more slowly. Professor Begg agreed that, in "a recession
or a slowdown", it made no sense to compel a country to reduce
its deficit rapidly, because that was "just going to aggravate
the problem" that was causing the downturn. In order to tackle
this transition problem, these witnesses suggested that the 3%
limit should be removed or at least recast in cyclically-adjusted
terms (QQ 42, 118-19, 144).
76. The Commission recognised that this was a
criticism that had been levelled at the Pact (Q 253), but it was
completely against such amendments. The Commission said that any
change in the 3% reference value, even moving from a nominal 3%
limit to a cyclically-adjusted limit, would require a change in
the Treaty. So, first of all, it was against amending the deficit
criterion for this legal reason. But it was also against such
a change on economic grounds, arguing that the Pact provided enough
room for the Member States to let their automatic stabilisers
to work so that the 3 % nominal ceiling was never breached. It
was also concerned that if the 3 % ceiling were expressed in cyclically-adjusted
rather than nominal terms, and if countries took advantage of
that change, then "countries would run significantly higher
deficits over time". This increase in the Member States'
deficits would mean that the problems mentioned above in the introductionfree
riders, countries with a high level of debt defaulting of that
debt, and ageing populations"would be no nearer a
solution." Director General Regling said that
"the effect would be higher deficits everywhere,
debt levels would not come down as quickly as otherwise, or they
could even go up, because in the end, it would mean if countries
wanted to take full advantage of such a rule, that they would
run a 3 per cent deficit over the cycle on average, so that would
be a significant weakening of the Pact, it would mean you would
not need a Pact any longer, because it would not be a constraint
on public finance."
Commission and the Government also pointed out that
the 3 % ceiling was not an absolute, because, in exceptional circumstancessuch
as natural disasters or the collapse of the banking systemMember
States could let their deficits go above 3 per cent (QQ 177, 257).
Problems with cyclical measurements
78. While many witnesses agreed that greater
use of cyclically-adjusted measures was conceptually a good thing,
there were some strong reservations about how they could be implemented
in practice, because of the difficulties of agreeing upon how
they should be measured and disagreement over methodologies for
working them out. Professor Sibert, for example, was concerned
that introducing cyclical measurements would introduce "endless
scope for squabbling over the proper methodology. (p. 110) Any
attempt to actually punish a deviation [would] lead to interminable
arguing about calculations and measurements." Professor Fitz
Gerald and Dr Scott agreed that whilst cyclical measurements appeared
in theory to be "a sensible way to proceed", in practice,
"most cyclical adjusted deficit series do not convince as
a reliable adjustment." Given this problem, they thought
that it was "undesirable to place too much weight on them
or use them to construct the deficit targets." (pp. 96,
108) Other witnesses said that whilst there would be difficulties
over implementation, these were not "insuperable difficulties";
what were needed were "firm accountancy standards or analytic
procedures." (pp. 26, 62) Mr Weale suggested that such an
approach could be achieved if a technical, independent, apolitical
body was established to judge what constituted the cycle (Q 76).
79. For the Commission, these concerns over the
question of methodology were not a problem, as last year it developed
with the Council an agreed method to calculate cyclically-adjusted
budget balances. The principle tool for assessing underlying budget
positions would be "the common methodology to measure cyclically-adjusted
budget balances which [had] been agreed by Member States and the
Commission." This common methodology was proposed by the
advisory Economic Policy Committee, who had set up a Sub-Committee
that had carried out an inquiry into the question of how it was
best to calculate such figures. The resultant proposal had been
agreed and adopted by the Commission and Ecofin.
80. It should be made explicit that the medium-term
target of budgets 'close to balance or in surplus' is to be measured
in terms of the cyclically-adjusted budget balance. The common
methodology agreed and adopted by the Commission and Ecofin should
be used to calculate the underlying budget balances for this target;
this means that an extra body of experts is not needed to calculate
81. Conversely, the Commission should continue
to use the nominal ratio when monitoring Member States' compliance
with the deficit criterion as part of the surveillance procedure.
The actual 3% deficit-to-GDP ratio should continue to be treated
by the Commission as a trigger. Early warnings should be sent
to Member States whose nominal deficits approach this figure.
82. However, when deciding how the Pact is
to be enforced, the Council should not treat the actual 3 % figure
by as an absolute limit, never to be breached. The 3 % reference
value is a precise figure that sets a clear benchmark against
which peer pressure can be applied within the Council. But the
Council's enforcement of the deficit criterion should nonetheless
involve a degree of flexibility. The Council's decision whether
or not to implement the excessive deficit procedure, once a country
has breached the 3 % reference value, should take account of the
underlying economic situation, including the Member State's position
in the economic cycle and possibly its level of debt.
flexible interpretation of the Pact, which we believe could be
achieved without changing the Treaty, should help to tackle the
problems that countries still in transition towards lower underlying
deficits face in the event of a cyclical downturn.
As such, it would help countries that have high underlying deficits
but which are taking appropriate steps to reduce them gradually.
This proposal would thereby provide additional flexibility for
those countries that need it. It could also be used to allow greater
short-term flexibility to low-debt countries with sound public
finances and so provide an incentive for countries to reduce their
level of debt.
84. It is also important to recognise that
the current difficulties experienced by France, Germany and Portugal
demonstrate that the Pact functions asymmetrically over the economic
cyclethese countries did not previously make use of better
cyclical conditions to reduce their structural deficits. This
is a problem that needs to be addressed (see below, paragraphs
Criticism 2: Too many countries
have underlying budget balances that exceed the 'close to balance
or in surplus' requirement.
85. In its Communication, the Commission proposed
establishing a general principle requiring countries with underlying
deficits exceeding the 'close to balance or in surplus' rule to
improve these deficits by 0.5% of GDP each year until they reach
the medium-term target. Furthermore, the rate of improvement in
the underlying budget position should be higher in countries with
high deficits or debt. The Commission also envisaged a more ambitious
rate of annual improvement in underlying budget positions in periods
of favourable growth conditions.
86. A number of witnesses questioned the thinking
behind this figure of 0.5 % of GDP. Mr Walton, for example, said
bluntly that there was "no particular economic rationale"
for the proposal. These witnesses were concerned that the figure
was arbitrary and inflexible. Furthermore, the inflexibility of
adding to the SGP another figure that was not contingent on the
circumstances of the particular country would inevitably mean
that some countries would follow "sub-optimal policies".
For example, in a period of recession, improving the underlying
budget was bound to imply fiscal tightening, which could reduce
aggregate demand and worsen unemployment (Q 38; pp. 10, 108, 62).
87. Other witnesses, however, defended the proposed
rule as both justified and achievable. Both the Commission and
UNICE stated that achieving a 0.5% of GDP improvement in a country's
underlying deficit was "more than feasible"; this was
demonstrated by the fact that it had been achieved by many countries
in the past.
Although the Commission's Communication did not include the possibility
of exceptions to this rule in difficult economic circumstances,
Director General Regling conceded that, if there were "a
real crisis situation, a recession", the rule might need
to be revisited (QQ 238, 278; q6).
88. As mentioned above (paragraph 21), this proposalthat
countries with underlying deficits exceeding the 'close to balance
or in surplus' rule should improve these deficits by 0.5% of GDP
each year until they reach the medium-term targetwas not
new to the Commission's Communication of November 2002; it had
already appeared in the Communication of Commissioners Prodi and
Solbes in September 2002. Moreover, it had already been agreed
by the Eurozone countries. At the Eurogroup meeting on 7 October
2002, the Eurozone Member States concurred with the Commission
that those countries which had not yet reached the medium-term
objective, needed "to pursue continuous adjustment of the
underlying balance by at least 0.5% of GDP per year."
Why then should the Commission suggest this proposal anew? It
could be so that the principle applies to all EU Member States
and not just those in the Eurozone. Also, the Commission could
want the principle to be more clearly established as a rule that
is both "strict and enforceable" (SEC(2002) 1009/6).
89. The Committee accepts that the 'close
to balance or in surplus' requirement is a sound medium-term objective;
it can act both as a useful guideline for Member States and as
an effective benchmark for peer pressure. Member States should
be encouraged to achieve this aim as soon as it is economically
sensible for them to do so, because it will give them sufficient
room to allow the automatic stabilisers to work fully across the
cycle (see above, paragraphs 70-76). Some flexibility in enforcing
how Member States attain this target may be required, however.
90. The Commission's proposal that Member
States should set an adjustment path towards the medium-term target
of budgets 'close to balance or in surplus' of 0.5 % GDP per year
should not be treated by the Council as an enforceable rule, any
breach of which would activate the excessive deficit procedure.
Such a proposal would reinforce and tighten the conditions of
the Pact, rather than allowing the Council to interpret it flexibly.
It would increase the complication of the Pact and could lead
to the Commission having to intervene more often, since the more
complicated the rules become, the greater the danger that the
Member States will transgress them. This would have as a consequence
that the rules' credibility would be undermined. Furthermore,
strictly enforcing a proposed adjustment path that is not country-specific
could require Member States in a downturn to adopt pro-cyclical
policies that might worsen the cyclical conditions (see above,
91. Nonetheless, the Commission's proposal
does have the advantage that, even if its economic logic is questionable,
it is easy to monitor. For this reason, the figure of 0.5 % could
act as an effective benchmark around which peer pressure could
be mobilised in the Council. The Commission proposal is a sensible
one if it is treated as a guideline for the Member States; it
should not be interpreted as a rule.
Criticism 3: The SGP does not function
symmetrically across the cycle.
92. Our witnesses unanimously agreed that one
of the Pact's main weaknesses was that it did not work symmetrically
over the economic cycle. The rules provided insufficient incentives
for fiscal restraint during periods of high growth by not rewarding
such policies enough. The risk of fines for breaking the deficit
rule in a down turn would not influence government behaviour in
economic good times, since at that time the next recession could
seem a long way off and might even occur under another government.
Indeed, some said that the Pact encouraged pro-cyclical fiscal
policies as the rules put pressure on governments to engage in
fiscal tightening in an economic downturn but did not oblige them
to pursue counter-cyclical policies in times of economic boom
(see, for example, p. 108; QQ 42, 118, 144, 189).
93. The problems of the last two years, and particularly
the difficulties that Germany and France were experiencing in
meeting the deficit rule, were said to have their roots in the
missed opportunities of the high-growth period of 1998-2000. The
Communication noted that a "failure to pursue budgetary consolidation
in 1999 and 2000 when growth conditions were favourable led to
a deterioration in underlying budget positions and inadequate
room for the automatic stabilisers to operate in the subsequent
economic slowdown" (op. cit.). The implication, with
which our witnesses agreed, is that had the Pact worked symmetrically
across the cycle and obliged these countries to apply counter-cyclical
fiscal policies in 1999 and 2000, their deficits would not have
risen so much subsequently (p. 69; QQ 9, 78, 189, 253).
94. As indicated in the previous paragraph, the
Commission was aware of this weakness in the SGP. It recognised
that preventing structural budget balances from deteriorating
during upturns was one of the most important challenges for the
Pact. The Commission "wanted to eliminate this asymmetry"
(Q 253), and the Communication proposed that Member States should
not implement expansionary, pro-cyclical policies in the good
times but should run surpluses instead (op. cit.). The
vast majority of witnesses welcomed this "measure of providence",
which would represent a move to "a more 'symmetric' approach"
(see, for example, pp. 62, 70). Professor Buiter thought that
the SGP should send a clear instruction to countries: "make
hay while the sun shines, do not wait for winter" (Q 18).
95. As with the other proposals examined so far,
the proposition that the SGP should operate symmetrically across
the cycle is not a new idea in itself. Indeed it is already implicit
in the Pact, since it is an integral part of the policy of using
automatic stabilisers to dampen the business cycle (see above
paragraphs 70-71). This point was clarified in the Presidency
Conclusions of the Barcelona European Council (15-16 March 2002),
which stated: "Automatic stabilisers should be allowed to
play symmetrically, provided the 3% of GDP limit is not breached
in downturns. This means, in particular, that in expansionary
phases growth dividends should be fully reaped. Member States
could make use of discretionary fiscal policy only if they have
created the necessary room for manoeuvre".
96. As Director General Regling said, deficits
could help a country to stabilise during an economic downturn,
and the medium-term target of the Pact was designed to allow this.
Professor Buiter confirmed that, "in principle, the Pact
does not rule out the operation of the automatic stabilisers"
(Q 9), but experience has shown that governments do not tend
to take a long-term view of fiscal policy.
97. Where the Commission's proposal is new, perhaps,
is the question of how Member States should be prevented from
inappropriately loosening their fiscal policies in good times.
In the Communication, the Commission stressed that there were
"inadequate surveillance and enforcement mechanisms to deal
with unwarranted pro-cyclical loosening of the fiscal stance"
and said that "effective enforcement procedures" were
required (op. cit.). The Government agreed and underlined
the "need to have credible ways of enforcing" any policy
designed to prevent fiscal loosening during a boom (Q 189).
98. The consideration that enforcement mechanisms
in this area needed to be strengthened was probably a conclusion
drawn from what happened with Ireland when it was judged to have
acted in a pro-cyclical manner during an economic up-turn. In
2001, Ireland was censured by the Council for not running a large
enough budget surplus during its period of boom, when real GDP
growth was above 10 %.
The Council addressed a recommendation to Ireland because it was
not following the guidance laid out in the BEPGs. However, the
BEPGs provide guidelines rather than enforceable rules for Member
States, and therefore there is no sanction that can be applied
against a Member State not doing something that is stipulated
in the BEPG. The Irish government disagreed with the decision
to issue the recommendation, and the Irish Minister for Finance,
Charlie McCreary, refused publicly to countenance the measures
advocated by the Council in the recommendation.
99. In reaction to these events with Ireland
and the expansionary budgetary actions of France and Germany when
growth was high, the Commission Communication proposed penalising
those countries that fail to cut deficits during economic upturns
under the Stability and Growth Pact. The Communication stated
that "an inappropriate pro-cyclical loosening of the budget
in good times should be viewed as a violation of budgetary requirements
at EU level, and should lead to an appropriate and timely response
through the use of instruments provided by the Treaty" (op.
100. It is not clear exactly how this proposal
should be interpreted, as the Treaty provides a variety of instruments
to ensure budgetary discipline, from the sort of recommendation
sent to Ireland in accordance with the BEPGs to the fines that
can be imposed under the excessive deficit procedure. Mr Crook
thought that the situation with Ireland showed that tougher enforcement
measures were needed. He wanted to see "a rule" to oblige
governments to run surpluses in booms. He said:
"I think that would be an improvement, on balance.
I do say it with a heavy heart, because it complicates the regime
and that is a bad thing; but, on balance, I think that would be
] what is missing is something analogous to the
excessive debt criterion that kicks in with a penalty. A dressing
down is easy to bear when you have Ireland's growth rate and Ireland's
budget surplus in unadjusted terms. I do not think a dressing
down from the Commission imposes much of an embarrassment for
the government in those circumstances." (QQ 161-62)
101. Mr Walton, on the other hand, was concerned
that, if the Commission imposed too many conditions on the way
that governments behaved, this would be bound to end in failure,
as there would be too many breaches of the rules, ending up with
too many censures which in the end would become quite meaningless
(Q 72). Mr Weale therefore suggested that the Commission should
say to a Member State acting pro-cyclically during a boom: "Are
you sure you have got enough leeway to cope with a downturn given
these are the rules of the Pact?" (Q 78)
102. It is important to tackle the fact that
the Pact works asymmetrically across the economic cycle. Furthermore,
it would be in the long-term interests of the Member States if
pressure could be brought to prevent them from acting pro-cyclically
in times of boom. The Committee does not, however, consider that
applying the sanction of the excessive deficit procedure in good
times would be the most effective way of achieving these twin
objectives. The Committee shares the concern that the rules of
the Pact should not be complicated. The number of situations that
lead to the formal sanctions of the excessive deficit procedure
being invoked should not be extended, or these measures will lose
their force. The Stability and Growth Pact should not be interpreted
so as to include formal sanctions for Member States pursuing pro-cyclical
actions in good times.
103. Instead, the Member States should commit
themselves to running fiscal policies that function symmetrically
across the economic cycle.
In addition, the BEPGs and the Council Opinions on the stability
and convergence programmes should provide additional explicit
guidance on how such policies are to operate, together with more
consistent instructions from the Council to Member States on how
to implement these policies. The guidelines should be enforced
by the Council through a strengthened process of peer review.
To facilitate the Council's work, a timely surveillance procedure
is needed, which would include sending an early warning to the
Member State concerned during the period of boom, warning it that
if it continues to act pro-cyclically, then it runs a high risk
of subsequently running an excessive deficit. To be effective,
this warning needs to be followed by firm peer pressure within
31 The cycle is generally taken to be the period between
the point where the output gap is zero and when the output gap
returns to zero. Back
Public Finances in EMU-2002, European Economy No.3,
2002, pp.3, 9, 45. Back
See, for instance, 'EMU Fiscal Rules: A New Answer to an Old Question?',
Balassone and Franco, in Fiscal Rules, Banca d'Italia,
Rome, 2001. Back
Public Finances in EMU-2002, European Economy No.3,
2002, p.2. Back
Report on the European Economy 2002, European Economic
Advisory Group at CESifo, Munich. Back
For details of the exceptional circumstances under which this
is possible, see above, paragraph 13. Back
Council press release 198 of 12 July 2002, 10668/02; Public
Finances in EMU-2002, European Economy No.3, 2002,
We discuss the early-warning system below, see paragraphs 132-45. Back
We see the distinction outlined in these two paragraphs between
the surveillance process, conducted by the Commission, and the
enforcement process, administered by the Council, as fundamental.
We return to this division below (see Part Four). Back
Despite supporting the introduction of this additional flexibility
into the enforcement of the Stability and Growth Pact, the Committee
does not believe that fiscal policy is an effective way of stimulating
sustainable growth (see below, paragraphs 104-15). Back
This could help to address the criticism that the Pact's incentive
structure is asymmetrical, as the SGP punishes fiscal indiscipline
but does not recognise or reward those countries who have achieved
sound public finances. On the importance of providing Member States
with an incentive to place a greater emphasis on their level of
debt, see below, paragraph 141. Back
Wim Duisenberg also supported this new rule. He said that the
proposal gave him reason "to express some confidence in the
future" (op cit.). Back
The full text of the Eurogroup press release is available online
at http://www.ypetho.gr/eurogroup/ Back
Report on the European Economy, European Economic Advisory Group
at CESifo, Munich. Back
Press release 100/1/02 REV 1. Back
The Ecofin Council of 12 February 2001, in accordance with Article
99(4) of the EC Treaty, addressed a recommendation to Ireland
concerning the inconsistency of its stability programme with the
BEPGs agreed by the Council on 19 June 2000. The Council judged
that the Irish budget for 2001 was "expansionary and pro-cyclical"
and would "aggravate overheating and inflationary pressures
and widen the positive output gap" (Council press release
35 of 12 February 2001, 5696/01). Back
This commitment should be part of a new Resolution of the European
Council and of a revised Code of Conduct (see below, paragraph