The Stability and Growth Pact Status in 2001

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1 4 The Stability and Growth Pact Status in 200 Tina Winther Frandsen, International Relations INTRODUCTION The EU member states' public finances showed remarkable development during the 990s. In 993, the aggregated government deficit of the EU member states totalled 6.2 per cent of GDP. This deficit was reduced continuously, and in 2000, the overall budgetary position was in balance. The improvement should be viewed against the background of the efforts to fulfil the convergence criteria for participation in the Economic and Monetary Union, EMU, and the Stability and Growth Pact. The latter was implemented with effect from 999 as an incentive for sustained fiscal discipline after the transition to EMU. In slightly modified form the Stability and Growth Pact also applies to the EU member states outside EMU. This article examines the practical implementation of the Stability and Growth Pact with focus on the development in 200. THE PROVISIONS OF THE STABILITY AND GROWTH PACT A characteristic feature of EMU is that monetary policy is determined centrally by the European Central Bank, ECB, while fiscal policy is the responsibility of the individual member states. Against the background of the externally determined interest rate the fiscal policies of the euro area member states must ensure an appropriate policy mix (combination of monetary and fiscal policies) at national level, while also contributing to an appropriate policy mix for the euro area as a whole, to avoid overburdening the single monetary policy. The EU Treaty contains a number of provisions on public finances. They are specified further in the Stability and Growth Pact which encourages sustained fiscal discipline after the transition to EMU. The Pact entered into force on the commencement of the third stage of EMU in 999. The Stability and

2 42 Growth Pact consists of a resolution of the European Council and two Council regulations adopted in 997. The central element of the Stability and Growth Pact is that all EU member states must seek to ensure a medium term budgetary position close to balance or in surplus. The Pact's other provisions are of a more technical nature. A schedule is set out for the procedure in the event of non-compliance with the 3 per cent limit for government deficits stipulated in the EU Treaty, and the size of the ultimate sanction of a fine in the event of a sustained budget deficit exceeding 3 per cent is also stipulated. The Stability and Growth Pact applies to all EU member states, although sanctions can only be imposed on euro area member states. The EU member states must prepare stability or convergence programmes each year describing how they intend to comply with the Stability and Growth Pact. The surveillance of public finances is the responsibility of the ECOFIN Council (ministers of economic affairs and finance). The ECOFIN Council therefore assesses whether the member states comply with the Stability and Growth Pact. As the basis for this assessment, the European Commission prepares detailed analyses of the public finances of the member states. The Stability and Growth Pact is the principal instrument in the surveillance of the public finances of the EU member states, but the ECOFIN Council also has other instruments at its disposal, as described in Box. Interpretation of the concept of "close to balance or in surplus" As stated above, the central element of the Stability and Growth Pact is that the EU member states must seek a "medium term budgetary position close to balance or in surplus". This is not a very specific wording, and gives ample scope for interpretation. Over the first 3 years of the Pact's lifetime this objective has in practice been interpreted to mean that the government budgetary position should give sufficient scope for the member state to avoid an excessive government budget deficit (the 3 per cent limit) during a cyclical downturn which is "normal" for that member state. The member state's economic activity has a direct impact on the government budget via the so-called automatic stabilisers. During a boom, higher tax revenue and lower expenditure on unemployment benefits, etc. will automatically improve the government budget. At the same time, fluctuations in growth are dampened. During an economic slowdown, by the same analogy, the automatic stabilisers lead to a deterioration of the budget, which again contributes to dampening the slowdown. It is there- Resolution of the European Council: Official Journal C 236, 2 August 997. The two Council regulations: Official Journal L 209, 2 August 997.

3 43 INSTRUMENTS IN THE SURVEILLANCE OF PUBLIC FINANCES IN THE EU MEMBER STATES Box The member states shall each year prepare a programme outlining their measures to comply with the Stability and Growth Pact. For the euro area member states, these are designated as stability programmes, and for non-euro area member states they are designated as convergence programmes. Against the background of these programmes the ECOFIN Council adopts opinions that present an assessment of the member states' compliance with the Stability and Growth Pact (published on which also includes links to the member states' programmes). The EU Treaty (Article 04) allows the ECOFIN Council to impose sanctions, possibly as a fine, should a member state exceed the 3 per cent limit for its government deficit. The imposition of a fine on a member state is specified in the Stability and Growth Pact. Under the EU Treaty (Article 99) the EU member states each year, on the basis of a draft from the European Commission, shall reach agreement on the Broad Economic Policy Guidelines, including for instance fiscal policy. Each year, the European Commission publishes a report which evaluates the implementation of the Broad Economic Policy Guidelines for the previous year. This report, as well as the Broad Economic Policy Guidelines, are published on According to the EU Treaty (Article 99 (4)) the ECOFIN Council may make a critical recommendation to a member state if the member state's economic policy is not consistent with the Broad Economic Policy Guidelines, or if there is a risk that the economic policy will jeopardise the proper functioning of EMU. The conclusions of the European Council may also relate to public finances, such as the European Council in Stockholm in March 200. These conclusions are published on fore important to allow the automatic stabilisers to take effect during a slowdown without the risk of an excessive budget deficit. Member states should therefore on average keep their budget deficits considerably below the 3 per cent limit (i.e. close to balance or in surplus). With a view to its analyses of the stability and convergence programmes the European Commission has calculated benchmarks for the cyclically-adjusted budget deficits, cf. Box 2. These benchmarks reflect how far the individual member states' cyclically-adjusted budget deficits should be from the 3 per cent limit. Recently, the assessment of the programmes has also begun to take account of other factors, including the quality and long-term sustainability of public finances. THE STABILITY AND GROWTH PACT IN PRACTICE STATUS IN 200 In March 200, the ECOFIN Council completed its assessments of the member states' latest updated stability and convergence programmes.

4 44 CALCULATION OF CYCLICALLY-ADJUSTED BUDGET BALANCE AND BENCHMARK Box 2 The cyclically-adjusted budget balance and the European Commission's benchmark are two central concepts in the ECOFIN Council's assessment of the stability and convergence programmes of the EU member states. Cyclically-adjusted budget balance The course of the budget balance can be seen as a summary measure of the development in fiscal policy. A higher balance (lower budget deficit) reflects a tightening of fiscal policy, and a lower balance (higher budget deficit) reflects an expansionary fiscal policy. However, it is well-known that the budget balance is affected by factors that are not directly related to the fiscal-policy measures. This applies especially to the cyclical position. An adjustment of the budget balance in this respect will therefore give a more accurate picture of the actual fiscal policy pursued, and thereby of the underlying pressure on public finances. However, calculation of a budget balance adjusted for the cyclical development, i.e. a cyclically-adjusted budget balance, will always involve elements of conjecture, and thus be subject to some uncertainty. The European Commission's compilation of the cyclically-adjusted budget balance is based on a calculation of the cyclical component of the balance. The cyclicallyadjusted balance can be calculated as the actual budget balance less the cyclical component. The cyclical component is the product of the cyclical sensitivity of the budget balance and the output gap, whereby the cyclical sensitivity expresses the effect on the budget balance (as a percentage of GDP) of a per cent increase in GDP, while the output gap expresses the percentage deviation of GDP from its potential. The European Commission applies a filter-based approach in the calculation of potential GDP. In practice, weighted moving averages are applied to actual GDP in order to estimate potential GDP. The OECD and the IMF apply a similar method to calculate the cyclically-adjusted budget balance, although potential GDP is calculated as the output of a production function with the normal contribution by the production factors. The European Commission's benchmark for the budget balance The European Commission has calculated a benchmark for the budget balance of each member state as a tool in the assessment of the member states' compliance with the objective in the Stability and Growth Pact of a budgetary position "close to balance or in surplus". The benchmark can be interpreted as the minimum value of the cyclically-adjusted budget balance which ensures compliance with the requirement in the EU Treaty of a budget deficit not exceeding 3 per cent of GDP during a "normal" economic slowdown for the member state. Table shows the benchmark for the individual EU member states, as well as the sub-components of its calculation, cf. the section above on the cyclically-adjusted budget balance. The ECOFIN Council's opinions show that all EU member states, except Germany and Portugal, comply with the Stability and Growth Pact in 200. The ECOFIN Council nevertheless criticised several member states for lack of ambition in their programmes. Germany complies with the Stability and Growth Pact as from 2002, while Portugal will not reach compliance until after 2002.

5 45 CONTINUED Box 2 The product of the largest output gap which is considered likely with normal cyclical fluctuations (column ) and the cyclical sensitivity of the budget balance (column 2) is the cyclical safety margin in the European Commission's calculation. It is calculated on the basis of data from the period The benchmark (column 3) is calculated by deducting 3, which is the limit for excessive budget deficits, from the cyclical safety margin. In general, the benchmark, and thereby the requirement of the budget balance, will be high for member states whose budgets are highly cyclically sensitive (e.g. Sweden), as well as for member states with traditionally large fluctuations in economic activity (e.g. Finland). BENCHMARK OF THE EUROPEAN COMMISSION Table Member state Largest likely output gap Cyclical sensitivity of the budget balance 2 Benchmark 3 Austria Belgium Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain Euro Denmark Sweden UK EU Source: The European Commission and own calculations. The largest output gap which is considered likely with normal cyclical fluctuations. 2 Effect on the budget balance (as a percentage of GDP) of a per cent increase in GDP. 3 Value of the cyclically-adjusted budget balance as a percentage of GDP which ensures that the actual balance does not fall below 3 per cent of GDP with normal cyclical fluctuations. See also chapter 3 of European Economy, Reports and Studies No. 3, 2000 "Public Finances in EMU 2000" published by the European Commission. The development in public finances is indeed somewhat mixed. On the one hand, the government deficit for the EU as a whole decreased from 0.7 per cent of GDP in 999 to 0.0 in On the other hand, the total budget deficit of the EU member states is expected to increase to 0.3 per cent of GDP in 200, according to the member states' stability and convergence programmes. A further contributing factor is weaker economic growth than expected when the programmes were prepared. If the out-

6 46 GOVERNMENT BUDGETS IN THE EU MEMBER STATES Table 2 Budget balance as a percentage of GDP Euro area member states, according to their stability programmes Austria Belgium Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain Euro Non-euro area member states, according to their convergence programmes Denmark Sweden UK EU Source: The member states' second updated version of their stability and convergence programmes and the European Commission. The figure indicates the favourable scenario. There is no corresponding figure indicating the conservative scenario. 2 The figure indicates the favourable scenario. The corresponding figure for the conservative scenario is The figure indicates the favourable scenario and provided the margins are used for tax cuts and/or increase in costs. If the margins had instead been used to reduce deficit or debt, the figure is.. The corresponding figure for the conservative scenario is 0.3 in both situations. come, as expected, is a deterioration of the total budgetary position, this will be the first since 993. As stated in the member states' stability and convergence programmes, the deterioration in 200 is only expected to be of a temporary nature, and a balanced position is expected in A temporary reversal of the favourable course of public finances is not unnatural, considering the remarkable fiscal development during most of the 990s. A large proportion of the budget-deficit reductions since 993 can be attributed to declining interest expenditure as a consequence of the strong decrease in interest rates in many member states up to the commencement of the third stage of EMU in 999. Table 2 shows historical data and projections of the budgetary position in accordance with the stability and convergence programmes. The expected slight deterioration in the total budgetary position in 200 is attributable to such factors as the significant tax cuts in several member states. Any dynamic effects of the tax reforms are not expected to be sufficient to offset a short-term decrease in budgeted revenue. Member states therefore have to exercise government spending restraint in order

7 47 GOVERNMENT DEBT OF THE EU MEMBER STATES Table 3 Percentage of GDP Euro area member states, according to their stability programmes Austria Belgium Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain Euro Non-euro area member states, according to their convergence programmes Denmark Sweden UK EU Source: The member states' second updated version of their stability and convergence programmes and the European Commission. The figures indicate the favourable scenario. The corresponding figures for the conservative scenario are 55.7 and The figures indicate the favourable scenario. The corresponding figures for the conservative scenario are 50.3, 48.7 and 46.7, respectively. 3 Calculated on the basis of an expected budget surplus of 2 per cent of GDP. to avoid a large budget deterioration. This is emphasised in many opinions from the ECOFIN Council. However, tax cuts in most member states are not financed initially, since the expenditure side of the budget will not be adjusted until According to the European Commission, placing a large share of the adjustment burden at the end of the projection period might be a source of concern. Most member states are already expected to achieve budget surpluses in 200. It is noteworthy that these are mainly the small euro area member states and the non-euro area member states. Indeed, these member states receive most praise in the opinions of the ECOFIN Council. On the other hand, progress is slower in several of the large euro area member states which are not expected to approach balance or a budget surplus until The Stability and Growth Pact does not stipulate direct requirements of the size of the government debt, but indirectly government debt still plays a role, since a large government debt is naturally a burden on the current budget, in view of the substantial interest expenditure. Table 3 shows projections of the government debt as a percentage of GDP. The

8 48 CYCLICALLY-ADJUSTED BUDGET BALANCE AND BENCHMARK Table 4 Per cent of GDP Benchmark Euro area member states Austria Belgium Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain Non-euro area member states Denmark Sweden UK Source: The European Commission. See the explanation in Box 2. Table shows that the expected fiscal consolidation and economic growth ensure a considerable decline in the debt ratios of most member states. In 2003, only Belgium, Italy and Greece are expected to have debt ratios exceeding 60 per cent of GDP. According to Table 4, the majority of the member states can now allow the automatic stabilisers to operate fully without any risk of exceeding the 3 per cent limit during a "normal" cyclical downturn. This is shown by the fact that the member states' cyclically-adjusted budget balances are on the right side of the European Commission's benchmark. However, it also appears that a cyclically-adjusted budget deficit of at least per cent of GDP is expected in three member states in 200. Germany and Portugal are even expected to exceed the European Commission's benchmark, while France is on the right side of it. Germany and Portugal in particular therefore need to reduce their cyclically-adjusted budget deficits further, before they can allow the automatic stabilisers to take full effect. This increases their vulnerability to unexpected cyclical set-backs. This is emphasised in the ECOFIN Council's opinions and in the European Commission's latest report on public finances in EMU, which concludes that Germany and Portugal only comply with the Stability and Growth Pact in the medium term, and not in 200. European Economy, Reports and Studies No. 3, 200 "Public Finances in EMU 200".

9 49 Austria's cyclically-adjusted budget deficit is also expected to be close to per cent of GDP in 200. Austria's budgetary course is still favourable, however, since it has reduced its budget deficit significantly after the ECOFIN Council's criticism of Austria's stability programme for The deficit is now on the right side of the European Commission's benchmark. Austria's stability programme for 200 was relatively easily accepted, which reflects that the peer pressure of the Stability and Growth Pact has taken effect in this case. The UK complies with the provisions of the Stability and Growth Pact in 200. In accordance with the UK's convergence programme, a cyclically-adjusted budget deficit of per cent of GDP is expected to be sustained for the period This brings the UK on the verge of non-compliance with the Stability and Growth Pact. However, the ECOFIN Council states that this is due to a very conservative estimate of the trend growth. The primary objective of the ongoing surveillance of the EU member states' economies is that the member states comply with the Stability and Growth Pact. Ireland complies fully, but was nevertheless criticised by the ECOFIN Council in the spring of 200. The cyclically-adjusted budget surplus accounts for 2-4 per cent of Ireland's GDP, which is considerably above the European Commission's benchmark. However, the budget for 200 contains several expansionary measures which were regarded as procyclical in view of the overheating of the Irish economy. Ireland's fiscal policy is thus not in compliance with the Broad Economic Policy Guidelines for 2000 in which Ireland was recommended not to pursue an expansionary fiscal policy. Ireland was the first member state to receive a critical recommendation from the ECOFIN Council in accordance with Article 99 (4) of the EU Treaty. The projections in the member states' stability and convergence programmes show that the general fiscal consolidation will continue until 2004, despite the expected temporary deterioration in the EU member states' total budgetary position in 200. A welcome scenario would be for the member states to continue their fiscal consolidation, while simultaneously implementing tax cuts. However, it is uncertain whether all member states in 200 will be able to fulfil the budget deficits projected in Table 2, since the current macroeconomic environment is less favourable than when the stability and convergence programmes were prepared at the beginning of 200. Cf. the description of this article of the EU Treaty in Box.

10 50 NEW PERSPECTIVES IN THE STABILITY AND GROWTH PACT The nature of the surveillance of public finances in the EU is gradually changing, now that most member states have achieved sound budgetary positions. The focus is no longer exclusively on fiscal discipline and a medium term budgetary position close to balance or in surplus. It appears from the ECOFIN Council's opinions concerning the individual member states in 200 that other factors are also beginning to play a role, naturally subject to the assumption that fiscal discipline is still maintained. The ECOFIN Council thus seems to be moving away from a "mechanical" assessment based on the European Commission's benchmarks, which can now be regarded more as a necessary, but not exhaustive, condition in connection with the assessment of the stability and convergence programmes. The focus is now also on such issues as creating an additional safety margin in the budget, to accommodate unexpected non-cyclical fluctuations. This is pointed out particularly in the opinions concerning Belgium, Italy and Greece, which all have high debt ratios and are thus more vulnerable to possible interest-rate shocks. Furthermore, fiscal policy is now viewed in a broader context in conjunction with other economic policies. The joint report from the ECOFIN Council and the European Commission to the European Council in Stockholm in March 200 stipulates as a central element that the assessments should include the contribution of public finances to growth and employment. For example, it is important that the tax burden does not dampen growth. The report also pointed out that the quality and sustainability of public finances should be improved. Sustainability in the long term now plays a greater role, given the ageing population, as the labour force will decline significantly, bringing the pension burden to twice the current level by The Economic Policy Committee (EPC) has calculated that this will lead to an increase in expenditure on public pensions by 3-5 per cent of GDP in most member states. It is therefore necessary to implement measures already at this stage to counter these effects so as to ensure continued compliance with the Stability and Growth Pact in the future. This was emphasised in the ECOFIN Council's opinions on most member states' stability and convergence programmes. Based on experience from the 3 years with the Stability and Growh Pact, on 0 July 200, the ECOFIN Council adopted an updated version of Another contributing factor is the methodological problems related to calculation of cyclicallyadjusted budget balances and the European Commission's benchmarks.

11 5 the code of conduct on the content and format of the stability and convergence programmes. The updated code of conduct focuses on the relation between the Stability and Growth Pact and other economic policies. The code of conduct also refers to the need to ensure the quality and long-term sustainability of public finances, and the standardisation of the procedure provides for more uniform treatment of the member states. The updating of the code of conduct does not affect the principles of the Stability and Growth Pact. CONCLUDING REMARKS In recent years, the surveillance of public finances in the EU has become more sophisticated, and thereby also more complex. It started out as surveillance based on simple key indicators, initially the 3 per cent limit for government deficits, and subsequently the European Commission's benchmark for the cyclically-adjusted budget balance. However, now the objectives are becoming more broadbased, and it will be more and more difficult to assess compliance by the member states. This applies e.g. to the objective that public finances support growth and employment, and the objective of increased focus on the quality and sustainability of public finances. The indications for 200 point to significantly lower economic growth in the EU member states than expected when the stability and convergence programmes were prepared. Several member states must be expected to encounter problems with compliance with the projected budgetary positions. This may give rise to renewed debate on the exact interpretation of the provisions of the Stability and Growth Pact.