Evolution of the Stability and Growth Pact

A Perspective on the Current Reform Agenda

Rodney ThomPaschal Donohoe

“Economic prosperity and the viability of the monetary union cannot be sustained without tackling past fiscal failures - a trend towards

increasing government expenditure and taxation levels combined with high structural budget

deficits and government debt accumulation.”

The European Commission (2001)

“I know very well that the Stability Pact is stupid, like all decisions

which are rigid.”Romano Prodi, EU Commission President (2002)

Agenda• Key Features of the SGP

• Operation of Pact

• Reform Agenda

• Perspectives on Reform

• Different Model

• Conclusion

SGP – Key Features

Pact

SGP I(1997 – 2005)

• Member States deliver budget deficits below 3%/GDP.• Debt/GDP ratios at most 60% or moving to this target.• Excessive Development Procedure (EDP) for Member States outside target levels.

SGP II(2005 – current)

• Exception to fiscal rules allowed based on economic circumstances.• Permits consideration of ‘relevant factors’ – pension, R&D spend + investment programmes.• Council given additional power to determine time frame for corrective action.

Pact breaks into two distinct periods.

SGP – Key Features

• Definition of excessive deficit• Preventive Arm – designed to stop excessive

deficits developing.• Corrective Arm – what Member States should

do.• Sanction Procedure – if corrective action is not

taken.

Operation of PactEvaluate Pact based on key reference points • Deficit Levels

• Debt Levels

• EDP

• Macroeconomic Stability

Deficit/GDP Levels – Euro Average

-6.00%

-5.00%

-4.00%

-3.00%

-2.00%

-1.00%

0.00%

1.00%

1998 '00 '02 '04 '06 '08

% Deficit/GDP

Euro average only breached target deficit levels twice since Pact foundation.

Source : Eurostat

Deficit/GDP Levels – Member States

‘00 ‘01 ’02 ‘03 ‘04 ‘05 ’06 ‘07 ’08

Euro-zone(#)

11 12 12 12 12 12 12 13 14

Breach(#)

0 3 3 4 6 4 3 1 5

Member States

PortugalItaly

Greece

FranceGreece

Germany

N’landsItaly

FranceGermany

PortugalAustria

ItalyFranceGreece

Germany

PortugalItaly

GreeceGermany

PortugalItaly

Greece

Greece MaltaFranceSpain

GreeceItaly

Consistent breaching of 3% reference level by mixture of Member States.

Debt/GDP Levels – Euro Average

58%

60%

62%64%

66%

68%

70%

72%74%

76%

78%

80%

1998 '00 '02 '04 '06 '08

% Debt /GDP Ratio

Source : Eurostat

Continual breaching of Debt/GDP Target across Eurozone.

Debt/GDP Levels – Member States

40

50

60

70

80

90

100

110

120

130

2000 - 08

%D

ebt/

GD

P Germany

Spain

France

Italy

Portugal

Key economies began to breach 60% reference from 03/04. Exception was Spain…..

Use of EDP

• Triggered 14 times between 2001 and 2008.• Did not lead to sanction implementation on a

single occasion.• First Country to be warned was Ireland.

– Target budget surplus of +4.3% in ’01.– Delievered surplus of +1.7%.– Commission warned that budget was pro cyclical

across period of rising inflation.– No action taken.

Use of EDP – France and Germany• Both France and Germany received Commission warnings between 2002

and 2003.

• In 2003 both Member States breached 3% deficit target.

– France – lower income tax receipts due to policy changes.

– Germany – floods in East Germany.

• By November ’03 neither country delivering ECOFIN recommendations.

• ECOFIN then decided (via QMV) to suspend EDP.

• This decision subsequently rejected by the ECJ.

Macroeconomic Stability- Ireland and Spain -

2007(Eurostat)

Ireland Spain

%Government Deficit +0.1% +1.9%

%Debt/GDP 25% 36%

EDP Use

Both economies delivering Pact commitments.

Both economies experienced massive and rapid fiscal deterioration.

Focused on health of ‘state’ – ignored private and foreign sectors.

Summary

Performance

Deficit Level Consistent Breaching

Debt LevelLarge Member States > 60% value

EDP Triggered 14 times No sanctions

Macroeconomic Stability

Did not recognise imbalances or risks.

Reform Agenda

• Sanctions for High Levels of Debt - > 60%– “For example, a country would be subject to an excessive

debt procedure even with a deficit below 3% if the debt is above 60% and the path of debt reduction is considered unsatisfactory” (Herman Van Rompuy).

• Extend sanction measures to Debt prevention.– Introduces concept of PFPM (Prudent Fiscal Policy

Making).– Public spending growth should not be faster than expected

GDP growth.

Reform Agenda

• Pursuing Member States that do not address persistently poor competitiveness or macroeconomic imbalances. Rigorous use of score carding systems.

• Changing sanction process. Default is to apply. Can only be overturned by Council via QMV. – ‘Semi-automaticity’.

Pact Evolution

SGP 1 : Corrective

SGP 2: Exceptions to Corrective Arm

SGP 3: Preventative Sanctions Extensions of Sanctions

Semi Automaticity

Perspectives on Reform

1. Centralisation of Decision Making

2. Credibility of Sanction Application

3. Role of Monetary Policy

4. Strengthening the Pro Cyclical Bias

5. Crisis Management and Resolution Framework

Centralisation of Decision Making

Increase in powers of EU Commission.

Spending and taxation remain national

decisions.

“ …the European Commission will be able to impose sanctions on national Governments and Parliaments and force them to lower spending and/or increase taxes, while this institution will not face the political sanction of its decisions..” Paul De Grauwer (2010).

Credibility of Sanction ApplicationWill the Commission

sanction Member States?

Yes No

Small Member States

Larger Member States

Only once for credibility damage

• No successful sanction application in history of Pact.

• Higher frequency of potential sanction due to increase in sanction ‘arsenal’.

• Credibility damage will be greater as ambition is stronger.

Role of Monetary PolicyGrowth in Euro Area Lending for House

Purchase (ECB)

-202468

101214

2000 - 2010

% C

han

ge

vs Y

A

Expansion of lending played a key role in driving asset price inflation.

Strengthening the Pro Cyclical Bias

• Proposals widen debt parameters that tigger sanction.– Pro cyclical bias in place under previous Pacts.– Bias stengthened due to 1) increase in sanction

triggers 2) ‘semi automaticity’– Official fine will be in addition to higher lending

rates on Government Bond Markets.

Crisis Management and Resolution Framework

• Current framework is based on prevention.• Use of sanctions will prevent default.

Crisis Management ≠ Crisis Resolution

• Sovereign defaults happen.• Will creation of resolution framework stimulate

defaults?• Not be better to manage this market ambiguity now

versus height of crisis?

A Different Model ?

• Establishment of national fiscal councils or laws underpinned by a Commission template.

• Acknowledgement that financial markets are a source of sanction through higer costs of lending.

• More focus on surveillance vs additional sanction mechanisms.

• Greater focus on surveillance allows lower grower debt levels to trigger flexibility in deficit levels.

Source of Sanctions• Exchange Rate Mechanism assumed the DM as

system anchor.• Expectation was that a currency would be devalued if

domestic policies were expansionary versus anchor.• Led to higher local interest rates.• Similar trend on sovereign debt markets.

– Sanctions already in existence – current not ‘threatened’ in future.

– Different role for institutions.

Reform Focus

Sanction

START CRISIS END

Reform Focus

START CRISIS END

MARKET

SURVEILLANCE RESOLUTION

Conclusions• Pact must work for future stability of euro.

• Current proposals mark significant development in policy through sanction strengthening.

• Surveillance capacity vital given role of macroeconomic imbalances in causing crisis.

• Could be integrated with more decentralisation and acknowledgement of current sanctions?