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back to index backEUROtalk March,  2005


Can Europe Find Consensus on Reforming the Stability and Growth Pact?

Reform of the Eurozone's fiscal rulebook has dominated recent discussions of the European Union's regular monthly meetings of the Council of Economics and Finance Ministers (ECOFIN).

This week's council meeting in Brussels (Belgium) was no different, as the 12 finance ministers who govern the Eurozone attempted to devise a new framework for regulating member states' public finances. While all agree on the necessity of reform, the manner by which it can be achieved is still uncertain. With hindsight, it could be argued that the Stability and Growth Pact (SGP) was ill-conceived. The pact was designed to ensure that all member states involved in the Economic and Monetary Union (EMU) maintained fiscal discipline, which would reduce the risk of profligate member states undermining the single currency through inflationary deficit spending. This limited states to a deficit of no more than 3% of GDP, and limited public debt to within 60% of GDP.

The implementation of the pact coincided with the beginning of a period of economic upswing, as the global economy emerged from the economic dislocation resulting from the Asian crisis. With the deadlines for balancing the books some way off and fiscal pressures relatively light, there was little cause for concern, as fiscal deficits in the key economies generally fell into line with accelerating GDP growth. But the sudden downturn in 2001 caused a rapid reversal of the pattern of improving growth and fiscal balances seen in the late 1990s and into 2000.

As the figures for 2001 slowly began to emerge from around the Eurozone, it quickly became clear that things were not going according to plan, although much of the concern over fiscal slippage was lost in the excitement surrounding the buildup to the physical launch of the euro. Only after the launch was it realized that member states—with their hands tied on monetary policy and little political will behind structural reform—found the desire to spend their way out of a downturn too great. Faced with very weak, or even negative growth, Portugal was soon followed by France and Germany in breaching the terms of the SGP. Others soon followed.

But doomsayers' worst predictions of the EMU's total collapse and plunging confidence failed to materialize. Indeed, with the euro clearly soaring, fiscal indiscipline within the Eurozone has arguably failed to cast lasting doubt over the euro's relative attractiveness. Neither has long-feared inflation been ignited. Furthermore, following three consecutive quarters of decelerating growth, the case for continuing fiscal stimulus is not without merit.

But while markets appear to have ignored the squabbles of Eurozone finance ministers, the SGP's failure has solidified skepticism that it can be a successful project. First, the episode has demonstrated the excessive restrictions placed on governments' abilities for fiscal pump priming. Second, it highlights the difficulties of coordinating policy across 12 nation-states. Moreover, in the longer term, a rule-less approach is clearly unsustainable, since monetary union has not encouraged fiscal responsibility. Evidently, when granted latitude, member states take advantage of a "free ride," knowing that the inflationary impetus (and other costs) of debt financing will be spread more widely across other member states.

To some degree, these deficits were structural in nature, although exacerbated by cyclical factors. This was critical in exposing the SGP's core weakness—namely, its failure to account for cyclical developments. Its Achilles' heel is an overreliance on a form of annual reporting that takes little or no real account of the business cycle. The November 2003 collapse of the pact also highlighted the weakness of the European Commission's role in policing the SGP. The Franco-German alliance that ultimately resulted in the collapse further underlined both the weakness of the rulebook, as well as the hegemony over the ECOFIN that the larger states possessed. Furthermore, in the SGP's current form, no account is taken of public debt ratios and the capacity for states to absorb deficit spending in the longer term. Neither is there sufficient emphasis on the need for growth and pro-cyclical investment and employment policies.

With the pact's failures readily apparent, there is agreement that some kind of fiscal restraint is necessary, but that limited flexibility is not optimal. Consequently, the basis for a new fiscal architecture is taking shape, mirroring the U.K. approach to some degree by accepting that fiscal performance should be measured in structural rather than in nominal terms. This being the European Union, however, squabbles still abound over the finer points. Smaller nations fear that a case-by-case approach, which would account for cyclical developments, risks entrenching the power of large nations to conduct economic policy outside of the rulebook. Meanwhile, larger states, with the capacity to absorb higher levels of debt and deficits, eschew accepting another fiscal straightjacket such as the SGP's one-size-fits-all approach. As a result, there is significant divergence on the extent of the powers that the European Commission should be granted to enforce or police the pact. Complicating matters further, individual countries have put forward their own specific policy tweaks.

The conundrum of course is to find consensus for a SGP to which member states will comply. Given that both France and Germany have already proved their recidivist tendencies during three consecutive years in which they have breached the collective rules of monetary union, the omens are not good. Nevertheless, although negotiations this week failed, the finance ministers have resolved to meet again later this month to thrash out a final agreement. Underestimate the potential for agreement at your peril. The European Union has proved in the past that it is very good at finding common ground for seemingly disparate member states. Whether such an agreement would stand the test of time and economic cycles, however, remains anybody's guess.

Source: Global Insight - GAI


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