Select Committee on European Union Thirteenth Report

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.[48]

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 policies—including 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 view—that the weak economic performance of the EU was not due to the SGP—was shared by the Greek Minister for Economic Affairs and Finance, who was currently chaired the Ecofin Council.[49] The Government also maintained that changing the interpretation of the Pact could not compensate for structural reforms.[50]

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 (op. cit.).

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." (op. cit.)

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.[51] 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.[52]

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 asymmetrical.[53] 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).[54]

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 demographic changes.[55]

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.[56] 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.[57]

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 ageing".

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."[58] 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).[59]

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.[60]

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" (Q 117).

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 bargaining" (q3).

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 balance—even if it was in the medium term—would 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 EMU—2002, 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

49   See his address to the congress of "Economic Policy and the New Sources of Growth in Europe", 08 February 2003, available online at . Back

50   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

51   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

52   This was recognised by the Government in their recent White Paper Meeting the Challenge: Economic Reform in Europe, February 2003. Back

53   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

54   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

55   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

56   Convergence Report 1998, Brussels, March 1998. Back

57   Convergence Report, Frankfurt am Main, March 1998. Back

58   Public Finances-2002, European Economy No.3, 2002, p.62. Back

59   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

60   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

previous page contents next page

House of Lords home page Parliament home page House of Commons home page search page enquiries index

© Parliamentary copyright 2003