Select Committee on European Union Thirteenth Report

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.[31] 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 downturns. […] 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."[32]

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.[33] 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."[34] However, as noted in last year's report from the European Economic Advisory Group,[35] 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 States—particularly France, Germany and Portugal—were 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 introduction—free 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." (Q 255)

77.  The Commission and the Government also pointed out that the 3 % ceiling was not an absolute, because, in exceptional circumstances—such as natural disasters or the collapse of the banking system—Member States could let their deficits go above 3 per cent (QQ 177, 257).[36]

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.[37]

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 the cycle.

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.[38]

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.[39]

83.  This 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.[40] 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.[41]

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 cycle—these 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 92-103).

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.[42] 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 proposal—that 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 target—was 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."[43] 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, paragraph 75).

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.[44] 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".[45]

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 %.[46] 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. cit.).

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 desirable […] 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.[47] 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 the Council.

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

32   Public Finances in EMU-2002, European Economy No.3, 2002, pp.3, 9, 45. Back

33   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

34   Public Finances in EMU-2002, European Economy No.3, 2002, p.2. Back

35   Report on the European Economy 2002, European Economic Advisory Group at CESifo, Munich. Back

36   For details of the exceptional circumstances under which this is possible, see above, paragraph 13. Back

37   Council press release 198 of 12 July 2002, 10668/02; Public Finances in EMU-2002, European Economy No.3, 2002, pp.54-61. Back

38   We discuss the early-warning system below, see paragraphs 132-45. Back

39   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

40   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

41   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

42   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

43   The full text of the Eurogroup press release is available online at  Back

44   Report on the European Economy, European Economic Advisory Group at CESifo, Munich.  Back

45   Press release 100/1/02 REV 1. Back

46   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

47   This commitment should be part of a new Resolution of the European Council and of a revised Code of Conduct (see below, paragraph 162). Back

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