Introduction. The Stability and Growth Pact. The Fiscal Compact and Fiscal Policy

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3 Introduction The proposed 'Fiscal Compact' Treaty 1 is but a step on the road to fiscal union. It aims to incorporate significant parts, but by no means all, of the Stability and Growth Pact (SGP) into primary national legislation, preferably at constitutional level. To this end, it seeks to introduce some new terms, notably that of an annual structural balance of general government, into constitutional law. Like so much of the proposed Treaty, this provision merely reflects what is already in operation in practice but it has been widely misinterpreted as a new fiscal limit that is more restrictive than the long-standing Maastricht 3% ceiling on budget deficits. In fact, the two budgetary limits complement each other and the, apparently more restrictive, structural budget limits of 0.5% or 1% are designed to ensure that the 3% overall budget limit is respected throughout the economic cycle. In practice, this means that there should be sufficient room for manoeuvre to ensure that the 3% deficit ceiling is not breached even in an economic downturn that curtails revenues and boosts spending via the automatic stabilisers 2. The Stability and Growth Pact From the outset, it was recognised that the single currency was incomplete in that it lacked a common fiscal policy. To guard against fiscal profligacy, Germany insisted on a Stability and Growth Pact (SGP) which was agreed in Dublin in 1996 and came into force on 1 January To qualify for membership of the euro, candidates had to meet the so-called Maastricht convergence criteria. These included deficit and debt limits, similar to those in the SGP. The SGP, in turn, was designed to maintain and enforce these limits after the launch of the euro. It was a signal failure. First, Germany, which had insisted on it in the first place, openly flouted the pact when its budget went into substantial deficit, breaking the 3% limit. Second, the design of the SGP proved to be defective in that it missed the build-up of large private sector liabilities in countries like Ireland and Spain which ultimately affected both debt and deficits, causing them to exceed the SGP limits. The key criteria in the SGP were and remain: 1 References throughout this document are to the fourth leaked draft of the treaty, dated 19 January 2012 and available here: 2 This is without prejudice to the usual clause which permits temporary deviations from the medium-term objective or the adjustment path towards it in exceptional circumstances which are defined as an unusual event outside the control of the country concerned which has a major impact on the financial position of the general government or to periods of severe economic downturn as defined in the revised Stability and Growth Pact, provided that the temporary deviation of the Contracting Party concerned does not endanger fiscal sustainability in the medium term.

4 an annual budget deficit no higher than 3% of GDP a national debt below 60% of GDP or sufficiently declining towards that value. Adherence to the terms of the SGP proved difficult from the outset. It is now clear that a number of countries used rather dubious strategies to meet the debt requirement for entry to EMU and the 60% debt ratio was generally ignored once the euro was up and running. The 3% deficit threshold was also exceeded, first by Portugal in 2001, followed by the Germany and France in 2002, the Netherlands and Greece in 2003, and Italy in The ECJ ruling In 2003 a decision not to implement the excessive deficit procedures for Germany and France led to a major dispute between the Council and the Commission. The Commission challenged the decision in the European Court of Justice (ECJ) and asked it to rule on whether the ECOFIN Council of Finance Ministers was legally entitled to disregard the SGP given that it agreed that Germany and France were in breach of their Treaty obligations. The ECJ s ruling favoured the Commission and annulled the Council s conclusions on France and Germany but did not fundamentally change the situation, as it found that the Council could not be forced to take a decision against its will, a ruling that was generally interpreted as telling the Commission and the Council to find a sensible way forward. 3 The 2005 revision of the SGP This led to significant reforms being introduced in The 3 per cent deficit and the 60 per cent debt thresholds remained but the changes allowed for a greater degree of economic judgement and introduced more flexibility. Each member state was required to develop medium term objectives (MTOs) for fiscal policy. These MTOs could vary depending on a member state s initial debt level and growth potential. The revised SGP outlined how adjustments were to be made to reach the MTOs. The revisions provided a less stringent definition of exceptional circumstances under which it was permissible to 3 European Court Case C-27/04, Commission v. Council.

5 exceed the 3 per cent deficit target. Under the revised rules, negative growth (or very slow growth) relative to potential growth could be considered exceptional. Moreover, other relevant factors could be taken into account in determining whether a deficit was excessive. The design flaws in the SGP However, the flaws in the design of the SGP meant that some member states had little need to avail of this greater flexibility. Countries like Ireland and Spain easily satisfied the terms of the SGP while their property markets were booming and yielding buoyant tax revenues. In the case of Greece, the European Commission has since found persistent failures in the quality of the data submitted under the SGP statistical reporting procedure. In effect, the Greek data were erroneous and Greece should never have qualified for membership of the euro. Once the economic tide turned, the weak structural position of several countries was exposed as the crisis intensified. The SGP failed to protect the public finances from very large deficits and mushrooming debt levels in the vast bulk of the member states.

6 The 'six pack' reforms These events demonstrated that members of a common currency area have a shared interest in the viability of their partners public finances. Given the potential implications of the public finances of one member state, e.g. Greece, for the euro as a whole, there was a clear case for greater EU involvement in, and a stepping up of, ongoing surveillance of member states. This led to a very comprehensive set of proposals by the Commission in early 2010 designed to improve the economic governance of the SGP and prevent a repeat of the earlier experience. These proposals, known as the 'six pack' five regulations and one directive 4 - came into force on 13 December 2011, having been approved by all 27 member states and the European Parliament in a remarkably short period of time by EU standards. Amongst the other elements, notably stricter enforcement of the rules and enhanced penalties in the form of deposits and fines, three key reforms stand out: Reverse Qualified Majority Voting (RQMV) financial sanctions can be imposed by the Council on a recommendation from the Commission unless a qualified majority 5 votes against it. Previously, a qualified majority was necessary to approve sanctions which meant that a few large states could easily block them. The debt criterion, which had been ignored, was made operational and put on a par with the deficit limit. Henceforth, a debt ratio above 60% will trigger an excessive deficit procedure if the excess (after taking account of exceptional factors) is not reduced by 1/20 th annually. An early warning system based on a scoreboard of ten macroeconomic indicators is designed to trigger in-depth studies and 'deep-dive analyses' to identify potential imbalances economies, thereby avoiding a repetition of the Irish and Spanish experiences where property bubbles temporarily boosted revenues which were used to finance long-term spending commitments. 4 Regulations supersede domestic law and are effective immediately on adoption whereas a Directive has to be transposed into national law. 5 A weighted majority of approximately 75% of votes is required.

7 The Fiscal Compact Just when it appeared that the EU at last had an effective SGP, Germany again intervened to insist on more reforms, this time in the form of a 'Fiscal Compact'. In large measure, this proposed treaty is designed to mollify domestic political opinion 6 but it also reflects a German view that the crisis is essentially fiscal in nature. The idea is to replicate EU legislation in national constitutions or the equivalent, thereby giving it greater weight and authority and making it more difficult for governments to change the law and/or ignore the SGP when circumstances deteriorate. The Fiscal Compact deals extensively with the debt and deficit criteria but, strangely, ignores the early warning system and the scoreboard designed to prevent the emergence of imbalances elsewhere in the economy again, this may reflect a German pre-occupation with deficits and debt. The Fiscal Compact provisions in the draft treaty provide that budgetary position of the general government shall be balanced or in surplus as opposed to the SGP wording of close to balance or in surplus. However, this apparently slightly more restrictive provision is immediately deemed to be satisfied if the annual structural balance of the general government is at its country-specific mediumterm objective as defined in the revised Stability and Growth Pact with the annual structural deficit not exceeding 0.5% of the gross domestic product at market prices 8. This is virtually identical to the provisions of the SGP as revised by the six pack. The original SGP stated that adherence to the objective of sound budgetary positions close to balance or in surplus will allow all Member States to deal with normal cyclical fluctuations while keeping the government deficit within the value of 3% of GDP. In practice, structural deficits of up to one per cent have been permitted since The updated version of the SGP introduced last December 9 reads the countryspecific medium-term budgetary objectives shall be specified within a defined range between minus 1% of GDP and balance or surplus, in cyclically adjusted terms, net of one-off and temporary measures. The one innovation in the Fiscal Compact is the reference to a structural budget not exceeding 0.5% but this is within the range in the revised SGP and the Compact also foresees a range of up to minus one per cent for those with low debt burdens. 6 There is a great deal of concern about the potential cost to Germany of the various bailouts which is constraining the Merkel Government from agreeing to the more decisive measures that are necessary to boost confidence and combat speculation in the bond markets. The ECB have a similar perspective. 8 Where the ratio of government debt to gross domestic product at market prices is significantly below 60 % and where risks in terms of long-term sustainability of public finances are low, a structural deficit of at most 1.0 % is permitted. 9 Contained in Regulation 1175.

8 The net point is that, to all intents and purposes, the provisions of the Fiscal Compact are the same as those in the revised SGP and the revised SGP, in turn, reflects the practice since 2005 where structural budget deficits are concerned 10. The major innovation in the Compact lies in the proposal to enshrine these provisions in national law, preferably at constitutional level, rather than in any greater restriction on the deficit limits, per se. Structural budget balance definition and concerns The concept of structural balance is easy to understand but the associated calculation problems are formidable. The Bundesbank, for example, has described it as relatively complex, opaque and elastic on account of the numerous discretionary modelling options 11. The Irish Department of Finance is even more sceptical. The 2001 Budget stated that Estimations of the structural budget balance and other such measures of the appropriateness of budgetary stance require to be treated with caution. Much more important in terms of evaluating the appropriateness of policy are the real measures of the general government surplus and the general government debt level 12. It went on to list the problems with the cyclically-adjusted budget balance (CABB) measure as it saw them: First, with large structural changes having taken place, it is difficult to establish that there is currently an identifiable Irish economic cycle. Second, it is currently difficult to reliably establish what is the sustainable trend rate of economic growth in Ireland, because of shifts in productivity, labour force participation and migration patterns. Third, there is a large degree of uncertainty regarding trend growth estimates generally. Fourth, there is a weak correlation between measures of the output gap and inflation in Ireland given the importance of external factors in determining price developments. Fifth, the CABB indicator is a backward looking rather than a forward looking indicator of the budgetary position. The key issue in terms of the sustainability of fiscal policy is where a country is expected to be over, say, three years ahead, not some notional trend estimate. Sixth, the CABB does not take into account the impact of changes in EU funding on national budgets. 10 Of course, all these limits have been repeatedly broken and 23 of the 27 member states are in the excessive deficits procedure with budget deficits above the 3% limit

9 Subsequent budgets contained less extensive but broadly similar reservations. The EU, on the other hand, is quite enthusiastic, believing that splitting budget deficits into their cyclical and structural components is a critical piece of analysis which determines how much of the deficit is cyclical and will be unwound when the economy recovers and how much is structural and must be eliminated by discretionary fiscal measures such as tax increases and spending cuts. Calculating the cyclical component of the budget deficit necessitates forming estimates of (a) current and historic growth rates 13, (b) potential growth rates, (c) output gaps, that is (b) (a), and (d) the impact of the output gap (the extent to which the economy is under or overheating) on the budget, to get the cyclical component of the deficit. The structural component is the residual when temporary or one-off factors are excluded. Medium-term budgetary objectives Prior to 2005 the SGP adopted a one-rule-fits-all approach which focused on a medium-term structural budgetary position close to balance or in surplus regardless of member states specific economic conditions. The reform of the SGP in March 2005 introduced the concept of medium-term objectives (MTOs) into the Stability and Convergence Programmes (SCPs) and their assessment by the European Commission 14. The MTOs allow the structural budget balances to be country-specific and to take into account differences across countries in their economic fundamentals and risks to public-finance sustainability, albeit within narrowly-defined limits. Thus, Member States were requested to declare MTOs in a range between a structural deficit of one per cent of GDP (for low debt/high potential growth countries) and a balanced or in-surplus structural budgetary position (for high debt/low potential growth countries). This is similar to the provisions of the draft Fiscal Compact which also envisages marginally less restrictive structural deficit ranges of 0.5 to one per cent. Initially, the revised SGP did not include a well-defined methodology for calculating the MTOs. This was rectified in 2009 and the revised methodology now encompasses not only public debt, potential growth, and budgetary safety margins, but also the implicit government liabilities associated with rising 13 Preliminary growth data are subject to revision for several years after the event. 14

10 expenditure due to ageing populations. Two novel features were incorporated: a supplementary debtreduction effort where debt exceeded the Maastricht 60 per cent reference value; and a partial frontloading of the cost of ageing to cover part of the future increases in age-related spending. The first of these was subsequently incorporated into EU law via the six pack regulations and is repeated in the Fiscal Compact. MTOs have a triple aim. First, the MTO is intended to provide a safety margin against the possibility that, given an unexpected worsening of economic conditions, the nominal budget deficit suddenly rises and exceeds the Maastricht 3 percent of GDP reference value. This notion underpins the countryspecific MTO minimum benchmark. Thus, a country whose budget balance is more sensitive to cyclical fluctuations should be committed to a more demanding MTO and therefore to a tighter medium-term target for the structural budget balance. A similar commitment is expected from a country exhibiting a business cycle with large output movements since an unexpected, large drop in economic activity is more likely to occur, dragging down the budget balance. Second, the MTO aims to ensure progress towards sustainability of public finances, defined broadly to include both the explicit liabilities corresponding to the current stock of debt and the implicit liabilities associated with the expected deterioration of fiscal balances due to rising age-related expenditure (i.e. the cost of ageing). As far as sustainability of explicit liabilities is concerned, the MTO seeks convergence of high debt levels towards the Maastricht 60 percent of GDP reference value. Thus, a country whose debt-to-gdp ratio is above that threshold should pursue a more demanding MTO, as well as a country having low prospective growth rates of potential GDP. High-debt and low-growth countries would then seek to achieve a stronger fiscal position leading to debt growth below nominal GDP growth, eventually converging to the Maastricht reference value. Third, the MTO allows room for manoeuvre by a country that chooses to undertake public investment as a means to support aggregate demand or to promote economic growth. In particular, a low-debt country is granted a less demanding MTO so that its fiscal budget can accommodate additional investment spending. In their 2009 updates of their stability and convergence programmes, 15 EU countries declared MTOs calculated using the new methodology. The range was from +1% to -1% 15 with eight countries falling between +0.5 and -0.5%. 15 Excluding Hungary which declared a MTO of minus 1.5%.

11 Irish MTOs In its Stability Programme Update in October 2008 and in its 2009 Stability and Convergence Programme, Ireland declared a structural Medium Term Budgetary Objective of close to balance (i.e. in the range of 0 to minus 0.5% of GDP) 16. It is clear that a structural deficit of minus 0.5% was regarded as close to balance. Viewed in this light, the Fiscal Compact 0.5% structural deficit provision is no different from the original SGP requirement of close to balance or in surplus. The April 2011 Stability Programme Update 17 noted that in October 2007: the ECOFIN Council agreed that long-term fiscal sustainability, notably the future impact of ageing, should be better taken into account when Member States are determining their medium-term budgetary objectives (MTOs). The subsequent EU Commission document Modalities for the implementation of the new MTOs set out the methodology for doing so. In the Irish case, the findings suggest an MTO of -½ per cent of GDP, which allows for 33 per cent of the likely cost of ageing to be covered. These considerations, together with the updated long-term spending projections of the Economic Policy Committee and the European Commission, will inform the revision of Ireland s MTO in due course. In the meantime, the focus is on reducing the General Government Deficit to below 3% of GDP by 2015 in the manner set out in this Stability Programme Update. In reality, however, MTOs of 0.5% and structural budget deficits in the range minus one per cent to zero are irrelevant for member states which have debt ratios above the 60% reference level. This is particularly so in the case of countries which are in bailout programmes where the terms of the programme supersede all else and make the minimum criteria irrelevant. Ireland, for example, is likely to have to run substantial budget surpluses for the next quarter century in order to comply with the requirement to get its debt ratio back to 60%. Article 5 of the draft Fiscal Compact provides that: The Contracting Parties that are subject to an excessive deficit procedure under the European Union Treaties shall put in place a budgetary and economic partnership programme including a detailed description of the

12 structural reforms which must be put in place and implemented to ensure an effective and durable correction of their excessive deficits. The content and format of these programmes shall be defined in European Union law. Their submission to the European Commission and the Council for endorsement and their monitoring will take place within the context of the existing surveillance procedures of the Stability and Growth Pact. The implementation of the programme, and the yearly budgetary plans consistent with it, will be monitored by the Commission and by the Council. We can get an idea of what this is likely to entail from the 2012 Irish Budget documentation 18. The target is to get the General Government Deficit down to 2.9% by 2015 item 4 in the accompanying Table. To do this, a primary budget surplus, i.e. the deficit excluding interest payments, of 2.8% of GDP is required item 5a. An accompanying chart in the Budget documentation shows that maintaining a primary surplus of close to 3% between 2015 and 2039 would lower the debt to GDP ratio to 60%. This would occur despite the assumed interest rate on government borrowing being above the growth rate of the economy (5.2% versus 4.5%). This makes the structural budget balance well-nigh irrelevant though it will inevitably be associated with significant structural surpluses rather than deficits and Ireland s MTO is likely to be revised significantly. In this context, the structural budget balance item 8 in the Table looks implausible at minus 3.7%. 18

13 Problems with structural budget indicators This brings us back to the deficiencies of structural budget indicators. Not alone are they difficult to calculate, they are also prone to revision and different agencies such as the IMF, the OECD and the EU Commission regularly arrive at different figures. As noted earlier, the peculiarities of the Irish economy render the exercise particularly difficult. Some idea of the scale of potential revisions can be gleaned from the following Table. The first column shows output gaps for Ireland as calculated by the EU Commission in real time i.e. in their autumn forecasts immediately preceding the year in question and as they are in their latest forecasts produced in November Recall that the output gap is the difference between actual and potential growth and it is a stock rather than a flow concept. Thus, in late 2008, the EU believed that the Irish economy was roughly in equilibrium with an output gap of only 0.2%. Now, it has revised this to minus 4%, i.e. there was significant slack in the economy in However, the 2009 Budget would have been prepared and assessed on the basis of the former figure. It is also noteworthy that the European Commission estimated that the output gap was negative all through the bubble era until 2008 and that its revisions do not radically alter this picture this is equally implausible. As 40% of the output gap is deemed to be reflected in the cyclical component of the budget deficit, the impact of revisions on both the cyclical and structural components of the budget

14 deficit is considerable, with the potential to affect the size of the adjustment required to get back to balance or surplus. External advice Both the IMF and the OECD advocated modest fiscal tightening during the boom years but the overall tone of their assessments was positive. The IMF s 2007 overview of the Irish economy found that fiscal policy had been prudent, with a medium-term fiscal objective of close to balance or surplus, in line with Fund advice 19. In so concluding, they would have relied on their estimates of the output gap and the cyclical position of the economy. All of the bodies undertaking external surveillance of the Irish economy produced regular estimates of the structural budget balance; i.e., the budget balance adjusted for the economic cycle. During the boom, these estimates failed to reveal the underlying deficits that were emerging. In its 2007 report the IMF estimated that the structural budget balance for 2007 was a surplus of 0.7 per cent of GDP, implying healthy public finances. However, by 2009 the picture looked very different. The IMF s 2009 review revised its estimate for 2007's structural budget deficit to 8.7 per cent of GDP. This implied that, allowing for the effects of the boom, there was a large deficit in the public finances in 2007, notwithstanding the actual small surplus recorded in that year. This, somewhat extreme, example illustrates the dangers of relying on structural fiscal indicators. It is perhaps fortunate that the Irish structural indicators will take a back seat for the next quarter century. Conclusion The Fiscal Compact does not involve any significant new fiscal limits though the failure to adhere to the existing wording of the SGP introduces an element of confusion. Rather, it seeks to incorporate existing provisions into national law, preferably at constitutional level. The references in the Compact to structural deficits of 0.5% and 1%, respectively, should not be interpreted as more restrictive than the original 3% deficit. In fact, they are already in use and are designed to ensure that the 3% limit is respected even in times of an economic downturn when the cyclical component of the deficit turns negative. 19

15 The implications for Ireland are lesser still given that it already has a medium-term objective of minus 0.5%. However, this objective is completely unrealistic in current circumstances. Instead, fiscal policy in Ireland over the next quarter century will be driven by other provisions of the Fiscal Compact and the revised SGP. By 2015, Ireland is likely to have a debt ratio of the order of 120% of GDP. The requirement to reduce this by one-twentieth per annum will dominate fiscal policy in the 20 years after This will necessitate running primary budget surpluses, i.e. nominal surpluses as distinct from structural surpluses, of the order of 3% per annum for an extended period. This is a requirement of the revised SGP which is already part of Irish law as it was adopted by regulation last year. The Fiscal Compact seeks to copper-fasten this requirement by giving it constitutional or near constitutional status with the intent of making it much more difficult to repeal or evade.