Note on the Stability and Growth Pact
Specialist Adviser, Professor Charlie
1. The Stability Pact consists of two
Council Regulations, which have the force of law: one on the Excessive
Deficit Procedure and one on surveillance, together with a European
Council resolution which provides guidance to the Council and
Member States on the application of the Pact. The Regulations
clarify the meaning of the clauses in the Maastricht Treaty regarding
"excessive" deficits, and in particular what constitutes
an exceptional or temporary deficit justifying a deficit in excess
of 3 per cent of GDP. A deficit is automatically considered exceptional
if output fell by at least 2 per cent in the year in question.
A deficit may be considered exceptional by the Council
if output fell by ¾-2 per cent; in this case a country will
presumably have to point to unusual features of the recession
in order to make its case. Where there is discretion in the application
of the pact, then decisions are by a variant
of qualified majority. Under the pact, members of MU also commit
to a medium-term budgetary objective of "close to balance"
2. Countries are obliged to correct
excessive deficits "as quickly as possible after their emergence"
and to "launch the corrective budgetary adjustments they
deem necessary without delay". In practice countries will
probably be able to run excessive deficits for two years before
incurring fines. The Commission will not receive definitive data
concerning the previous year's outturn till about March of the
following year, so it is unlikely that corrective action could
be ordered until around May. Effectively, given the lags in implementing
fiscal policy action, this means that the country cannot be expected
to have corrected the excessive deficit until the following year,
ie the next year but one after the excessive deficit originally
appeared. Finally if there are "special circumstances"
a country might be allowed longer than two years to comply; an
example would presumably be Finland in the early 1990s.
3. Presumably if action is being taken,
then the fines provided for under the pact will not be imposed.
If action is not taken, then fines will be levied in the form
of non-interest-bearing deposits starting at 0.2 per cent of GDP
and rising by 1/10th of the excessive deficit up to a maximum
of ½ per cent of GDP (which is therefore reached when the
deficit hits 6 per cent). Additional deposits are required each
year until the excessive deficit is corrected. If the excess deficit
is not corrected within two years, the deposit is converted into
a fine; otherwise it is returned, in which case the country has
effectively been fined merely the interest rate times the size
of the deposit.
4. Nothing is said about how these
deposits/fines will be collected. Presumably if a country refused
to make them and were a net recipient of funds from Brussels,
these could be withheld (in fact this provision already holds
in the Cohesion Funds). If it were a net supplier to Brussels,
it might be more difficult to enforce, but presumably sanctions
could be applied in other areas if a country got really difficult.
5. There are a number of rationales
that have been advanced for the pact (many of which have surfaced
in the Committee's interrogation of the various witnesses):
(i) As an extra buttress against countries
running up large debit obligations, upon which they then decide/are
forced to default, pressuring other countries into bailing them
out and generating systemic financial problems, particularly if
default by one country leads investors to question the soundness
of other countries public debt ("contagion"). Bail outs
are prohibited by the Treaty, but some people have questioned
how credible this is. There are also worries that the ECB will
have to pump liquidity into the system if there is a financial
crisis, and that this could lead to inflation. However, this need
not followthe key is for the ECB to mop up the extra liquidity
through open market operations as soon as financial stability
is restored. This, in my view, is the most convincing argument
for the pact, but the risk of systemic financial instability could
also be reduced by restricting financial intermediaries from large
holdings of the debt of high-debt countries.
(ii) To discourage high debt countries from
pressing for more inflationary monetary policies in order to reduce
the real value of their debt obligations. However, given the constitution
of the ECB/ESCB it seems rather unlikely that a high debt country
would be able to manipulate Euro monetary policy in this way.
(iii) To offset a political bias to high
deficits ("live now, pay later"). This is really a case
of tackling the symptoms, rather than the disease, and there may
be better ways of tackling the problem, such as the Code for Fiscal
Stability announced by the UK Chancellor, or relating contributions
to the EU budget to debt/deficits as well as GDP, etc.
(iv) To prevent interest-rate spillovers.
The argument runs that previously countries were discouraged from
running up high debt because of the threat of the exchange rate
collapsing. Under MU this discipline is no longer there, and countries
will thus borrow more. This will drive up interest rates for everyone
else. In fact the evidence suggests that such effects are in practice
likely to be negligible, since the general level of (long-term)
real interest rates is determined in a global capital market.
Furthermore, it is not clear that an increase in real interest
rates is necessarily badif a country is a net creditor
vis-a-vis the rest of the world (which the United Kingdom
presently is) then it is actually made better off by the increase
in real interest rates!
(v) The previous argument relates to medium/long-term
spillovers. There is also an argument for the pact based on facilitating
short-term macroeconomic policy co-ordination. Here it is argued
that expansionary fiscal policy by one country, say to fight unemployment,
raises aggregate demand in the Euro area, and will lead the ESCB
to tighten monetary policy, resulting in a bad fiscal/monetary
policy mix, and possibly also an imbalance in policies across
countries. However, it is not necessarily the case from this perspective
that fiscal policy will be too expansionary in the first placecountries
tend to ignore the "locomotive" effects of fiscal expansion
on their neighbours, so fiscal policy may well be too contractionary
during generalised recessions. In any case the pact is a rather
crude weapon for trying to improve co-ordination.
6. The main concern with the pact is
that it will force governments to tighten the fiscal stance during
recessions and thus lead to a pro- rather than counter-cyclical
fiscal policy, leading to an increase in the volatility of output
and unemployment. This should not happen if governments are far-sighted
and run a budget surplus during booms, so that the budget roughly
balances over the business cycle (as intended by the "close
to balance" medium-term commitment); in that case an excessive
deficit should only be triggered in the case of a fairly deep
recession, in which case the exemption clauses kick in.
7. The worry, of course, is that governments
won't be this farsighted, as the pact offers no "carrot"
for good behaviour in booms, only a "stick" against
bad behaviour and one which moreover is more likely to be applied
during recessions. Counterfactual simulations over the past by
Eichengreen and Wyplosz
suggest that if EU governments fiscal policies do not change in
the way envisaged, then excessive deficits (ie ones without an
exemption) would be triggered about a third of the time! Obviously,
it is reasonable to expect some change in behaviour in the new
"stability-oriented" world, but the question remains
whether it will be large enough to make excessive deficits a rarity.
If not, then we may see fines being triggeredmost likely
when economic circumstances are in any case unfavourablewhich
will no doubt cause friction between the member countries.
8 April 1998
28 A two-thirds weighted majority of EMU members only,
excluding the country or countries whose deficits are deemed excessive.
The weights for each country eligible to vote are the usual weighting
factors used in the qualified majority voting procedure (Article
The Stability Pact:"More than a Minor Nuisance?", Economic
Policy, April 1998, Vol. 26, pp 65-114. Back