Criticism 4: The SGP restricts Growth.
104. The Stability and Growth Pact has come under
heavy criticism that its rules do not sufficiently encourage growth
and that it is therefore a constraint on Member States implementing
the Lisbon agenda for the EU to become the most competitive and
dynamic knowledge-based economy in the world. The TUC explained
that a "key problem" had been that the Pact had put
"too much emphasis on stability and not enough on growth"
(p. 62). In its Communication, the Commission admitted that that
one area where the SGP had "struggled" was in developing
a framework for "assuring the long-term sustainability of
public finances while supporting structural reforms that are designed
to enhance employment and growth potential" (op. cit.).
105. Mr Crook said short-term growth had been
constrained by the Pact. This is because, when a country was in
an economic downturn, an increase in its budget deficit (achieved
either through more spending or lower taxes) might have given
aggregate demand a short-term boost. Mr Crook also considered
that the Pact created a "deflationary bias" in the
longer term (Q 144).
106. The Commission did not accept, however,
that sustainable growth could be stimulated through deficits.
Director General Regling said that to argue that increasing deficits
automatically lead to more growth was "a very dubious proposition."
He cited the recent examples of Japan, Germany and Portugal as
evidence of this and argued that experience showed "quite
clearly" that a government could not stimulate sustainable
growth through increasing deficits (Q 258). Mr Weale agreed that,
on a trend basis, high government borrowing did not help economies
to grow faster; he concluded that the Pact was not proving to
be a particular constraint on growth or the economy, as did Professor
Begg (QQ 55, 78, 106, 116). Whilst questioning whether the Pact
might have "a bias against growth", Mr Walton firmly
agreed that fiscal policy was not "a particularly good instrument
for affecting the long-term growth rate of the economy (Q 55).
107. The Commission further argued that it was
"too simplistic an approach" to claim that because according
to the Pact deficits should be reduced, this meant less growth.
Not every fiscal consolidation necessarily led to less growth;
it always depended on the circumstances. If consolidation was
done mainly through cutting expenditures and not through raising
revenue, then under those circumstances the growth impact was
much more favourable (Q 277). Indeed, the Commission considered
that, in the medium term, the Pact encouraged growth. The restriction
on public borrowing was intended to ensure that the 'policy mix'
in the Euro zone was a tight fiscal policy (i.e., budget balances
'close to balance or in surplus' in the medium term) combined
with a less tight monetary policy, that would lead to price stability
at low interest rates which would encourage private investment,
and thus growth.
108. The Commission also pointed out that increasing
the potential growth rate in Europe would require structural reforms;
an increase in growth could not be achieved simply through macro-economic
policies. The role of the SGP was to co-ordinate fiscal policy;
it was the Broad Economic Policy Guidelines that went beyond budgetary
issues to deal with the full range of economic policiesincluding
labour markets, product market reform, research and development,
education and training systems. The Commission concluded that
whilst the Stability and Growth Pact was "very important
] it should not be overburdened with these other considerations"
(QQ 258, 274).
109. Witnesses agreed that there was a limit
as to how much fiscal rules at the EU level could achieve on their
own. They reinforced the Commission's point that Europe's slow
growth was not due to the SGP but rather to structural deficiencies,
such as market rigidities, that held down productivity and employment
growth (QQ 51, 99, 221-22, 244; UNICE q7). This viewthat
the weak economic performance of the EU was not due to the SGPwas
shared by the Greek Minister for Economic Affairs and Finance,
who was currently chaired the Ecofin Council.
The Government also maintained that changing the interpretation
of the Pact could not compensate for structural reforms.
110. The Commission's Communication said that,
if possible, the Stability and Growth Pact should "cater
for the inter-temporal budgetary impact of large structural reforms
(such as productive investment or tax reforms) that raise employment
or growth potential in line with the Lisbon strategy and/or which
in the long-term improve the underlying public finances positions."
For this reason, the Commission proposed tolerating "a small
deviation" from the 'close to balance or in surplus' requirement
for Member States with an underlying debt of less than the 60
% of GDP reference value who have already made substantial progress
towards the 'close to balance or in surplus' requirement. An adequate
safety margin would also have to be provided at all times to prevent
nominal deficits from breaching the 3 % of GDP reference value
111. Professor Begg's analysis was that, despite
the proposals, stability remained the focus, "with little
concession to growth imperatives such as the acknowledged need
to accelerate and support structural reforms" (p. 26). He
concluded that the Commission's proposals on growth were "far
too half-hearted" because they did not "allow for the
possibility that a Member State could sustain public investment
over several years justified on the golden rule principle"
(Q 120). In its Communication, however, the Commission was sceptical
about deficit-financed public investment:
"Investment in physical (infrastructures), human
(education, training) and knowledge (R&D, innovation) capital,
if well designed, can improve long run output and growth potential,
above all through their beneficial impact effect on productivity
and employment. However, if higher productive public spending
is financed though a rise in taxes or increased deficits and consequently
higher public debt, private investment may be crowded out thus
offsetting any potential beneficial effect on growth and employment."
112. The TUC said that the Commission's proposal
would make the Pact more supportive of growth and employment;
it was "a timely and sensible initiative" (p. 63). UNICE
also welcomed this proposal "in principle", as long
as it was closely monitored. Together with Mr Crook, UNICE was
concerned that the proposal inevitably involved problems of definition.
Mr Crook cautioned that it was "the easiest thing in the
world" to define vast parts of public accounts as public
investment. He considered that defining public investment for
the purposes of framing fiscal discipline was "virtually
impossible" (QQ 164-66). UNICE was also worried about policy
makers "selling" new public expenditures as public investments.
Consequently, UNICE said the proposal should not be extended:
"Any further loosening of budget consolidation would have
adverse effects by letting deficits get out of control and thus
hampering the long term growth potential of the GDP" (q7).
113. The Commission, however, said that it was
not an issue of classifying some types of expenditure as better
than others. In any case, it was very clear about the particular
policy initiatives, such as pension reform, that it would accept
as having long-term benefits for the economy.
The Commission said that, in fact, the issue when considering
whether to allow the proposed deviation was the public finance
situation in the Member State. Director General Regling explained
this as follows:
"Italy would not be allowed, according to our
proposal, to deviate from the balanced budget rule, and the UK
would be allowed to deviate from the balanced budget rule, but
it is because the underlying fiscal situation is so much better
in the UK, not because certain expenditures are now more important
in the budget as such. Italy also has public investment, but they
have such high debt levels and such an ageing and pension problem
that they should run a balanced budget; it is good for their economy.
It is really a question of how you look at the problem: it is
not the question of good versus bad expenditures; it is more where
the public finance situation is." (QQ 260-61)
114. Whilst it may be true that a rigid implementation
of the Pact restricts short-term growth, we accept the argument
that fiscal policy is not a good instrument for affecting the
sustainable long-term growth rate of the economy. We conclude
that the current slow rate of growth in Europe is not due to the
Stability and Growth Pact but is more a consequence of some Member
States' failure to implement structural reforms. A much broader
range of economic policy issues than those relevant to the SGP
will be needed to stimulate growth across the EU.
115. We welcome the Commission's proposal
to relax slightly the 'close to balance or in surplus' rule in
certain circumstances. We agree that Member States with a low
level of underlying debt should be allowed "a small deviation"
from the medium-term target of a budget that is 'close to balance
or in surplus' in order to invest in physical and human capital.
We support the fact that only countries with a low level of underlying
debt will benefit from this additional flexibility, as this places
a greater emphasis on debt and signals a move towards a more country-specific
interpretation of the Pact. As such, this proposal provides an
incentive to countries to lower their debt levels, which helps
to address the criticism that the Pact's incentive structure is
We believe that the Government should also welcome this move to
a more country-specific interpretation of the Pact as it would
allow them to target the UK national priorities of public investment
in physical and human capital (Q 74).
Criticism 5: The SGP does not put
enough emphasis on debt and the sustainability of public finances.
116. It was generally accepted by the Commission
and our witnesses that underlying debt was the key factor to the
sustainability of public finances. In particular, they were concerned
about the situation where the interest burden on a country's debt
could become so high that a government might default on its debt
obligations, especially in light of the consequences of the predicted
117. The debt criterion, cited in Article 104(2)
of the EC Treaty, states that if the government debt to GDP ratio
exceeds 60 % it should diminish at "a satisfactory pace".
Originally, this debt criterion was interpreted very loosely by
the Commission, so that even Belgium and Italy, with ratios over
120 % of GDP, qualified for Stage Three of EMU. The Commission
justified this decision on the grounds that the two countries'
debt levels were declining because of primary surpluses.
The European Monetary Institute noted, however, that even if these
surpluses were maintained over the long term, Belgium and Italian
debt levels could remain above the 60 % reference value for as
long as 15 to 20 years.
118. Since the Helsinki European Council in December
1999, there had been continued calls for greater emphasis on medium
to longer-term sustainability of public finances. The Stockholm
Council in March 2001, which noted with particular concern unfunded
future public liabilities, instructed the Ecofin Council "regularly"
to review "the long-term sustainability of public finances
in the context of both the BEPGs and the SGP." In the light
of these instructions, the Commission carried out its first systematic
assessment of the sustainability of public finances on the basis
of the 2001 stability and convergence programmes. Subsequently,
the Barcelona European Council, in March 2002, asked the Commission
and the Council to continue to examine the long-term sustainability
of public finances as part of the annual surveillance exercise,
"particularly in the light of the budgetary challenges of
119. Nonetheless, the Commission still recognised
that the "framework of the SGP, with its focus on national
account definitions of government deficits and debt," did
not provide "a complete picture of the financial positions
of governments, especially as regards the long-term implication
of budgetary policies."
Many witnesses asserted that this was because, when assessing
Member States' compliance with the SGP, the Commission still had
not paid sufficient attention to the debt criterion. Italy and
Greece, with debt ratios in 2002 of well over 100 %, caused most
concern, particularly as they had made very little progress to
reduce their debt levels towards the 60 % of GDP reference value
since the implementation of the Pact in 1999 (pp. 95, 108; QQ
50, 116, 134-40).
120. In its Communication, the Commission acknowledged
that this situation had created a difficulty in implementing the
Pact. The Commission proposed that "greater weight must be
attached to government debt ratios in the budgetary surveillance
process" and that the SGP requirement for debt/GDP ratios
above 60 % to fall towards that level at a "satisfactory
pace" should be put into practice. The Commission suggested
that this could be achieved in a number of ways. First, countries
with debt levels well above the 60 % reference value should be
obliged to outline a detailed strategy in their stability and
convergence programmes for reducing their debt level to below
60 %. This proposal includes activating the excessive deficits
procedure for countries whose debt does not fall fast enough.
Secondly, as part of the Commission's analysis of each country's
stability and convergence programme, the sustainability of public
finances should be assessed more closely with firm conclusions
on whether the country's budgetary policies were sufficient to
meet future liabilities such as pensions (op. cit.). The
Commission suggested that this development could strengthen the
credibility of the 'no bail-out' clause in the Treaty.
121. The Commission recognised that it needed
to clarify what would constitute a "satisfactory pace"
of underlying debt reduction towards 60 % of GDP. The Communication
proposed that an appropriate pace of debt reduction would result
from compliance with the 'close to balance or in surplus' deficit
requirement, but it did not provide more specific details about
how this would be applied (op. cit.). Under these conditions,
and assuming optimistic growth rates, it was estimated that it
would still take those Member States with debt-to-GDP ratios of
more than 100 % around 10 years to get down to the reference value
of 60 % of GDP (Q 50).
122. Professor Begg explained that picking an
appropriate pace for debt reduction was not easy, because it should
"be fast enough so that it is not some very distant manana
and slow enough so that it is not disruptive to the particular
Member State" (Q 117). There was general agreement among
our witnesses that the Commission should not develop another numerical
target that did not take account of the circumstances of the particular
country, such as stipulating there had always to be a 3 %
reduction per annum by all Member States, for instance. Rather,
the Council should, where necessary, set out with each Member
State a specific "credible trajectory towards getting debt
down"; this type of country-specific approach could be adaptable
and provide flexibility for changes in economic circumstances,
where necessary. This method could be based on the annual stability
and convergence programmes, as the Commission proposed. Witnesses
said that it was important that flexible interpretation should
be possible, because for a Member State during a recession to
continue reducing its underlying debt ratio would only aggravate
the problems, resulting in a further slow-down and making it more
difficult to consolidate finances (p. 109; QQ 117, 118). Mr Crook
agreed that the pace of adjustment to the lower debt ratio ought
to be very sensitive to the country's economic environment (Q
173). As Professor Begg pointed out, however, it was in the interest
of the Member States themselves to reduce their underlying debt:
"Even Greece, with 100 % is still paying 4 %
of GDP on average for debt financing, if it is paying slightly
above the ECB interest rate, and that is a very heavy burden on
Greek tax payers or a very heavy loss to mounting public expenditure"
123. Mr Crook suggested that if the Commission
focused sufficiently on the debt criterion, it would be possible
to abandon the deficit criterion in the Pact (Q 136). Yet,
although the Commission accepted that greater emphasis should
be placed on underlying debt, it did not accept that this should
mean a weakening of the deficit criterion. Director General Regling
told the Committee: "Debt is very important and we will try
to take it more into account now than we used to in the past,
but the deficit is important for the conduct of monetary policy"
(Q 255). Although Mr Crook argued for debt to be the headline
criterion of a revised SGP (Q 137), the majority of our witnesses
agreed that it should not totally replace the existing deficit
focus of the Pact (e.g. Q 49).
124. Taking into consideration underlying
debt levels as well as budget deficits provides a more coherent
basis for analysing the sustainability of Member States' public
finances. We therefore welcome the Commission's proposal to focus
more on debt. Furthermore, we agree with the Commission that focusing
on debt should not detract from the need for Member States to
keep their deficits under control, for the two elements are clearly
connected, as a country running high deficits will accumulate
a high level of debt.
125. The stability and convergence programmes
of Member States with particularly high debt ratios should contain
a clear commitment to an agreed trajectory of reducing debt. In
the light of these commitments, the Council opinions on the stability
and growth programmes should include guidelines for reducing debt.
If necessary, these guidelines should be enforced through a strong
process of peer pressure after an early warning sent by the Commission
direct to the Member State.
126. Whilst we are in favour of those Member
States with high levels of underlying debt working out a plan
for reducing their debt, we would not wish to see these governments
penalised for not being able to meet their plans in the event
of an economic downturn. The Commission should not stipulate a
uniform rate of date reduction that does not take account of the
circumstances of each particular country. The plans for debt reduction
should not be the same for all countries irrespective of their
starting point or expected future growth rate; they should offer
Member States discretion to respond to changed economic circumstances.
Therefore, we do not accept the Commission proposal that a failure
on the part of a Member State to achieve the established pace
of debt reduction should lead to sanctions. As we have already
stated (see above, paragraphs 90 and 102), we do not wish to see
an extension of the number of situations that lead to the formal
sanction of the excessive deficit procedure.
Criticism 6: The SGP's rigid rules
do not allow for differences between countries.
127. A recurring theme among the five criticisms
of the SGP examined above was that the Pact did not sufficiently
recognise the differences between the circumstances of Member
States when reviewing their budgetary policies. Dr Scott, for
example, complained that the Pact's rigid rules allowed no discrimination
"between countries who should be allowed flexibility and
those who need to reform" (p. 107). He considered it important
to discriminate between governments who had been adversely affected
by unforeseen shocks and needed to be flexible in their response
and governments who had been pursuing excessive deficits relative
to their long run plans (p. 108). This was illustrated by the
fact that the excessive deficit procedure had been launched against
Germany for coming perilously close to the 3 % deficit ceiling,
despite the fact that its underlying debt position was healthy.
Italy, on the other hand, had not been cautioned for failing to
bring down its debt from a very high level of over 100 % of GDP.
Both countries had large future pension liabilities looming, but
Germany's lower level of debt meant that at present it was in
a better position to meet these than Italy. Another reason given
to demonstrate the desirability of country-specific targets was
that the demographic profiles of the different Member States were
very different and would lead to very different demands on their
pension systems. Sweden had already opted voluntarily for a 2
% surplus and was discussing a 2.2 % to 2.75 % surplus for their
medium-term target, because they recognised that they would have
a significant pension burden in the future.
128. In order to avoid such anomalies, a number
of our witnesses wanted the Pact to adopt customised, country-specific
targets. Professor Sibert was adamant that, unlike the uniform,
'one size fits all' approach of the SGP as currently designed,
"sensible budgetary policies ought to vary across countries
and across time". This would involve scrapping the 3 % and
60 % reference values for deficits and debt, which were applied
uniformly between Member States, and instead setting different
targets for debt and deficit for each Member State according to
its economic circumstances (p. 108, 110; QQ 104, 109, 140).
129. The Commission and UNICE, however, argued
against any such move. The BEPGs already contained country-specific
targets, and they did so in their recommendations not only on
fiscal policy, but also for labour markets, product markets and
education systems. In addition to the BEPGs, however, it was important
to have a rule-based framework for fiscal policy, in order to
guard against the problems outlined above in our introduction
(see Part Two). A further danger was that changing the targets
in the Pact would fudge the issues. The beauty of the SGP was
its simplicity. A shift to customised targets would make it less
clear which Member States were following sensible economic policies
and which were not. The process of surveillance would become a
lot more complex, and discipline would become harder to enforce.
Along with UNICE and the Commission, the TUC therefore concluded
that the need for simple, clear, easily enforceable rules was
"overwhelming" (Q 214). UNICE also raised the concern
that the introduction of country-specific targets would lead to
horse trading and Member States conducting deals with one another
within the Council over each other's targets. This would be extremely
damaging; fiscal policy "must not become subject to political
130. Director General Regling also pointed out
the proposals in its Communication already had the aim of introducing
a degree of flexibility into the Pact. The Commission was proposing
that countries with low levels of government debt should be allowed
a small deviation from the medium-term balanced budget rule. It
was also proposing that, until they reached the medium-term target,
heavily-indebted countries would have to improve their underlying
deficits by more than the 0.5 % of GDP each year that the Commission
proposed stipulating for other Member States. These two changes
would bring some country-specific targets into the SGP, making
it more customised (Q 275).
Box 5 Accession Countries
|Some witnesses pointed out that one rationale for having customised targets was the enlargement of the Union in 2004 (QQ 104, 109). A number of the accession countries had made considerable efforts to control their fiscal policies, but all the medium-sized and large countries already had what Professor Buiter described as "worryingly large" fiscal imbalances (Q 29). He explained that these countries were going to be "very, very hard pressed to keep their fiscal house in order." For a number of these countries, the reality of having to cope with deficits above 6 % would come home, regardless of the Pact. If the Pact were to be enforced at all tightly on them, it would be "the most severe fiscal impact faced since the transition began." (Q 30)
As soon as they joined the EU, the accession countries would formally become subject to the rule requiring Member States to have budgets 'close to balance or in surplus' in the medium term. To make the transition from a deficit of around 6 % to close to balanceeven if it was in the medium termwould be "wrenching, especially with the additional demands of the environmental and infrastructure fields coming on top of current spending needs and given the fact that the net transfer from Brussels, while mitigating the problem, will not eliminate it; it will not finance the full required increase in expenditures." Consequently, these countries were going to be under "very severe" fiscal pressure. Most of them, with the exception of one or two of the Baltic States, had continental western European levels of public spending-to-GDP ratios but with much lower levels of income per capita. These were much poorer countries supporting very ambitious welfare states. What is more, they would have to make the transition from a command to a market economy. They would need to upgrade their public infrastructures and prepare for the liberalisation effects which EU membership would entail.
The implied question behind these facts was how the SGP could take into account that the accession countries were undergoing tremendous structural and institutional changes without moving to customised targets.
In view of these future requirements, and the fact that, once they become EU members, the accession countries would be obliged to maintain budget deficits below 3 % of GDP, the Commission implemented a new initiative called the pre-accession fiscal surveillance procedure (PFSP) in spring 2001. This process was "designed to closely approximate the policy coordination and surveillance mechanisms of the EU while giving due regard to the accession priorities of the candidate countries." (Public Finances in EMU2002, European Economy No.3, 2002, p.133)
131. As Professor Buiter said, the Commission faces the
difficult task of creating rules that are "both simple and
appropriate to a variety of circumstances" (Q 6). The Pact
needs to be clear enough and simple enough to be monitored and
enforced across all of the Member States, whilst providing individual
Member States with the flexibility to react to their own economic
circumstances. Some uniform, firm rules are required to avoid
countries free riding or running up large debts on which they
might default and to enable countries to deal with the economic
effects of their ageing populations. But there is a possibility
that the SGP rules could be interpreted and applied in a way that
does not take sufficient account of the different circumstances
of different countries, especially the accession countries. We
agree with many of the Commission's proposals for improving the
interpretation of the Stability and Growth Pact. As we have made
clear, however, we do not wish to see these proposals interpreted
in an inflexible manner that takes no account of the particularities
of each individual case. The crucial question is how the proposals
are to be enforced, and it is to the issue of enforcement that
we now turn.
48 The Commission has long been concerned that deficit
spending by governments could 'crowd out' private investment.
Conversely, it considers that the SGP is pro-growth, as it 'crowds
in' private investment (see, for example, Public Finances in
EMU-2000, European Economy No.3, 2000, p.33). The point that
the Pact was "conducive to private investment" was reiterated
in the Communication (op. cit.). Back
See his address to the congress of "Economic Policy and the
New Sources of Growth in Europe", 08 February 2003, available
online at http://www.eu2003.gr/en/articles/2003/2/7/1847/index.asp
Evidence of Dr MacShane, MP, to this Committee on 21 January 2003
(published in our 8th Report, Session 2002-03, HL 54: Evidence
by the Greek Ambassador on the Greek Presidency and by the Minister
for Europe, Foreign and Commonwealth Office, on the Copenhagen
European Council, Q 33). This was also the view of Wim Duisenberg,
President of the ECB (op. cit.). Back
Elsewhere, the Commission has recognised "the conceptual
difficulty in defining what 'quality' actually means" (Public
Finances-2002, European Economy No.3, 2002, p.95).
Yet, in its Communication, the Commission has settled on a definition,
saying that a certain composition of public expenditure "could
be considered as 'high quality' if it makes a positive contribution
to the goals of the Lisbon strategy, i.e. making the Union the
most dynamic, competitive, knowledge-based economy, enjoying full
employment, strengthened economic and social cohesion and environmental
sustainability." (op. cit.) Back
This was recognised by the Government in their recent White Paper
Meeting the Challenge: Economic Reform in Europe, February
Witnesses, such as Dr Scott (p. 108), pointed out that the SGP
did not provide Member States with any incentive for good fiscal
behaviour; it focused only on punishing bad fiscal actions. Back
The Government said: "It is also important for the legitimacy
of the arrangements that governments are able to target their
national priorities. In the United Kingdom's case, for example,
it is clear that we have a need for significant public investment
to catch up for a prolonged period of under-investment. Given
the fact that we have very low and sustainable debt levels, we
believe there is a very strong case for enabling us to accommodate
that public investment." (Q 175) This is exactly what the
Commission's proposal seeks to achieve. Back
The European Economic and Social Committee (EESC) also considered
that "an increasing interest" in the objective of Member
States having debt-to-GDP ratios below 60% was "necessary"
as the demographic changes would "among other things require
that the interest burden be as small as possible." (CES 361/2002,
p.2) These concerns, which were shared by our witnesses, refer
to the default problem and the pensions problem that are explained
above (see paragraphs 37-42). Back
Convergence Report 1998, Brussels, March 1998. Back
Convergence Report, Frankfurt am Main, March 1998. Back
Public Finances-2002, European Economy No.3, 2002,
cf. Council Opinions of 21 January 2003 on the updated Stability
Programme presented by Italy (5320/03) and on the updated Stability
Programme presented by Greece (5318/03). The 2001 stability and
convergence programmes for Portugal and Sweden recorded slight
increases in debt levels, although both countries' debt-to-GDP
ratio remained below the 60 % reference value. Back
Public Finances in EMU-2002, European Economy No.3,
2002, p.62. For a discussion of the issue of bail outs, see above,
paragraphs 37-40. Back