The global crisis has laid bare the inadequacy of the European surveillance procedures. Enshrined in the Stability and Growth Pact, the idea was to prevent fiscal ill-discipline, the explosion of domestic and foreign debt, trade imbalances, as well as competitiveness gaps in the Eurozone. It didn’t work. On 29 July the European Commission adopted an ambitious reform of the pact. The reform does present some positive innovations, but many new features appear unrealistic or even harmful.
The proposals harden the Stability and Growth Pact and extend surveillance to macroeconomic and “structural” policies.
- The first novelty concerns the prevention of fiscal ill-discipline.
All Eurozone members will specify medium-term budget objectives, and will contain the growth in public spending below the medium-term growth of GDP, until the target is met. Also, they will be required to implement “best practice” budgetary procedures, such as medium-term planning, fiscal rules, transparency in the statistics and possibly the institution of councils of independent advisors.
These innovations are important and can contribute to financial stability in the Eurozone. The main changes, however, lie in the corrective part of the imbalances.
- In addition to the deficit limit (3% of GDP), a target for public debt, 60% of GDP, will be explicitly introduced.
All countries that exceed the debt limit (currently all the Eurozone members, except Luxembourg, Slovenia, Slovakia and Finland, see Table 1) will be required to reduce it every year, at a rate of one twentieth of the excess debt. For example, a country with a debt ratio of 120%, and thus a distance of 60% from the target, needs to cut the debt by 3 points (=60/20) of GDP every year.
Violation of either the deficit or debt requirements will lead to the opening of an infringement procedure and a fine of 0.2% of GDP if the country does not comply. The sanction process will be sped up and made more certain. Rejecting a penalty proposed by the Commission would need a qualified majority in the Council of Ministers – that is to say, over-ruling the penalty could be blocked by a minority of nations (see Baldwin and Widgren 2007 for a discussion of EU decision-making).
Table 1. Economic indicators in the Eurozone plus UK
Source: OECD, Eurostat
Finally, the Commission envisages monitoring a series of vulnerability indicators pointing to dangerous imbalances in the Eurozone. These include private and public, debt, competitiveness, the current account, credit expansion, the growth in property prices, productivity growth.
Again, the Commission will open another infringement procedure, this for "excessive imbalances", if the country fails to introduce corrective measures, possibly resulting in a fine of 0.1% of GDP.
The introduction of the debt/GDP criterion involves at least four difficulties.
1) The reform exacerbates the problem of pro-cyclical adjustment: the debt rule, similarly to the deficit rule, requires tougher budget cuts, the deeper the recession.
Yet we know that in order to minimise tax distortions over time and maximise welfare, tax rates should be approximately constant over the business cycle, which suggest that fiscal policy should be mildly counter-cyclical (see Barro 1979).
2) The system continues to be based on the idea that “virtuous” behaviour is obtained by credible "punishment" threats.
There is no incentive for countries to reduce the deficit or the debt during “good times”, the real factor behind the rise in public debt before the crisis. A more flexible system would avoid such problems. One example is a “point” system akin to the one implemented in many countries for driving licenses: “credits” are gained when (debt) targets are met, and lost when they are not, (see Manasse 2007).
3) Since the debt ratios exceed 60% of GDP almost everywhere in Europe, every country will simultaneously need to reduce its budget deficits, regardless of its economic conditions.
This will impart a very strong recessive bias to Europe as a whole. The size of the cuts for high-debt countries may be so high that the credibility of the adjustment may be compromised.
Figure 1 shows the path of the primary surplus needed to reduce the debt GDP ratio in Italy according to the Commission proposal. The figure shows two scenarios (both assume an initial debt ratio of 118% of GDP). In the first scenario, the real interest rate exceeds the growth rate by about one and a half points (as in Italy today). In this case, the adjustment requires primary surplus of around 5% slowly declining to 3% of GDP in the next 10 years, see the red line in Figure 1.
Figure 1. Primary balance adjustment with the new debt rule
Source: Author’s calculations
Even in the very optimistic scenario where the difference between the growth rate and real interest rate is zero, the blue line in the Figure, the adjustment remains substantial and prolonged. Now imagine such a high debt country facing the option of squeezing the primary balance at this pace for sure, or facing a 0.2% fine with some positive probability, three years from now (when the adjustment progress is reviewed). What will it choose? Recall that the “ultimate threat”, the expulsion from the euro, is not contemplated in the proposal.
4) Privatisations and securitisations proceeds reduce the public debt, but not the deficit. Thus the new debt rule could pave the way to a new wave of creative finance measures and fire sales of public assets in order to meet the debt targets.
While monitoring vulnerability indicators is part of the standard surveillance activity by international institutions, the proposed system of “scoreboards” looks quite rudimentary in the light of the recent literature (see Manasse and Roubini 2009). More importantly, the idea that the Commission may open infringement procedure on this basis is unrealistic. Countries cannot be forced to adopt specific structural reforms such as liberalisation of goods and labour markets, or specific tax measures (disincentives to investment in real estate), all of which fall within their competences; governments cannot directly control the growth of productivity, nor the real exchange rates, house prices or the current account. At most they can pass reforms that, with long and unpredictable lags, may affect these measures. Other suggested indicators, such as the expansion of credit or the indicators of the quality of credit in the real estate sector, either fall within the ECB responsibility, or should be addressed by a European-wide regulation and supervision of the financial sector (see Spaventa 2010).
In short, while a reform of the Stability and Growth Pact is clearly urgent at this juncture, the naivety of the Commission’s proposals, with the exception of those concerning budgetary institutions, risk being counterproductive.
Baldwin, Richard and Mika Widgrén (2007), “Is a new treaty needed”, VoxEU.org, 11 May.
Barro RJ (1979), “On the Determination of the Public Debt”, Journal of Political Economy, 64:93-110.
Manasse, P (2007), "Deficit Limits and Fiscal Rules for Dummies", IMF Staff Papers, 54:3
Manasse, P and N Roubini (2009), “'Rules of Thumb' for Sovereign Debt Crises”, Journal of International Economics, 78(2):192-205
Spaventa, L (2010), “How to prevent excessive current account imbalances”, Eurointelligence.