Fiscal Policy without a State in EMU?

Fiscal Policy without a State in EMU?

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Fiscal Policy without a State in EMU? Germany, the Stability and Growth Pact and Policy Coordination Jani Kaarlejärvi

Jani Kaarlejärvi 2007 Softcover reprint of the hardcover 1st edition 2007 978-0-230-54275-4 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2007 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin s Press, LLC and of Palgrave Macmillan Ltd. Macmillan is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN 978-1-349-36030-7 ISBN 978-0-230-59010-6 (ebook) DOI 10.1057/9780230590106 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. A catalogue record for this book is available from the Library of Congress. 10 9 8 7 6 5 4 3 2 1 16 15 14 13 12 11 10 09 08 07

Contents List of Figures and Tables Acknowledgements x xii Introduction Part I Germany, the Stability and Growth Pact and Policy Coordination on the Political and Economic Agenda in Europe 1 1 The Europeanisation of Fiscal Policy Coordination 3 1.1 Europeanisation and European economic integration 3 Europeanisation and European integration 5 Europeanisation as a two-way process 6 Europeanisation and European institutionalism 8 The timing element of Europeanisation 9 Europeanisation and national adjustments in fiscal policy coordination 11 1.2 EMU and fiscal policy coordination 12 Institutionalising fiscal policy coordination in EMU 12 Fiscal policy coordination in practice 15 1.3 Outline of the book 17 Part II Fiscal Policy Coordination under the Stability and Growth Pact in Economic and Monetary Union 21 2 The Institutional System of Fiscal Policy Coordination 23 2.1 Theory of institutional fiscal policy coordination 23 Rationales for fiscal policy coordination in EMU 23 Institutional design, adjustments and risks in theory 26 2.2 Formal rules of fiscal policy coordination 30 Forms of economic policy coordination 30 Binding rules of fiscal policy coordination 33 2.3 Institutional procedures in fiscal policy coordination 37 Institutional system of fiscal policy coordination 37 Broad economic policy guidelines 38 Stability and convergence programmes 40 Excessive deficit procedure 41 v xiv

vi Contents 2.4 Adaptation pressures of the Stability Pact in EMU 43 Implementing the institutional system of fiscal policy coordination 43 Criticism of fiscal policy coordination under the Stability Pact 46 Institutional fiscal policy coordination still in progress in EMU 52 3 The German Dynamics of Uploading the Stability Pact 53 3.1 German fiscal challenges in the post-reunification era 53 German reunification and challenges in national adjustments 53 Public debt before and after German reunification 55 Budgetary deficit in transition 57 Public finances in the federal government and the Bundesländer 59 3.2 Stabilisation and/or room for national fiscal flexibility 61 The Bundesbank and monetary discipline 61 The federal government and fiscal discipline 67 The Bundesländer and trade unions and room for national flexibility 71 3.3 Designing and securing national fiscal stability in EMU 74 The need for national adjustments and national economic coordination 74 Designing sustainable public finances in 1996 76 European guidelines for German national economic reforms I 78 Improving growth before the parliamentary elections of 1998 79 3.4 Securing German national fits 1995 1997 80 Fiscal discipline for the EMU era on the German national agenda 80 National economic coordination and increasing adaptation misfits 83 4 Downloading the Stability Pact in Germany 86 4.1 Political changes and refocusing fiscal policy 86 A new government, the same challenges 86 Policy actions and refocusing fiscal policy in 1999 87 European guidelines for German national economic reforms II 91 4.2 Policy adjustments and the financial reality 94 Stabilising public finances at speed in 2000 94 Optimistic European peer pressure on the German economy 97 Introducing future-oriented adjustments in 2001 98 Strengthening national fiscal policy coordination I 100

Contents vii Facing European economic monitoring I 101 Strengthening national fiscal policy coordination II 103 4.3 Unforeseen changes in the German economic environment 105 Changes in the trends in the German economic environment 105 Early challenges in the common monetary policy 107 Deteriorating budgetary policy in Germany 111 A widening gap in the public finances 114 Sluggish trends in labour policy and employment 118 4.4 Dealing with German national misfits 1998 2002 120 Refocusing German national fiscal policy in EMU 120 Declining national economy and striking financial reality 122 Increasing economic monitoring and national fiscal flexibility 124 5 Reuploading Fiscal Policy Coordination in EMU 127 5.1 Adjusting to European economic authority and monitoring 127 German fiscal policy after the parliamentary elections of 2002 127 Facing European economic monitoring II 131 Strengthening national fiscal policy coordination III 133 European guidelines for German national economic reforms III 134 5.2 Frozen and softened European fiscal policy coordination 135 Tackling structural problems radically through Agenda 2010 in 2003 135 Facing European economic monitoring III 137 European guidelines for German national economic reforms IV 140 Institutional power struggle over European economic monitoring 142 Furthering structural reforms for a better national outlook in 2004 143 Preparing for the softening of the European fiscal rules 146 The rules were reformed in March 2005, long live the new rules! 149 5.3 Economic developments and room for national fiscal flexibility 152 Recovering exports improving the German economic environment 152 Common monetary policy and (in)stability 153 German budgetary policy on the edge 157 Challenging trends in the public finances 159

viii Contents Improvements in the economy of the Bundesländer 161 Stagnation on the national labour market 162 5.4 Reuploading German national fits 2003 2005 164 National economic realities in reuploading 164 Much at stake in Germany as the engine of the whole E(M)U economy 166 Part III Germany, the Stability and Growth Pact and Policy Coordination: Institutional Capacity for Effective Fiscal Policy Coordination in EMU 169 6 Reviewing the Institutional System of Fiscal Policy Coordination 171 6.1 Institutional system of the Stability and Growth Pact 171 Methodology of the review of the Stability Pact 171 Institutional system of the Stability Pact 173 Institutional duties in economic monitoring and implementation 178 Reinterpreting the fiscal rules of the Stability Pact 182 6.2 National adjustments, political commitments and economic coordination 189 National adjustments and political commitments 189 National stability programmes in fiscal policy coordination 194 National economic coordination under the Stability Pact 197 6.3 Fiscal policy coordination under the coming fiscal challenges in Europe 201 The European Central Bank and European policy mix 201 Population ageing and sustainable public finances in EMU 204 7 Challenging the Existing Understanding of Europeanisation in the Study of Germany, the Stability and Growth Pact and Policy Coordination 209 7.1 Uploading, downloading and reuploading of Europeanisation 209 Securing German adaptation fits in fiscal policy coordination 209 Three dimensions of Europeanisation in fiscal policy coordination 212 The timing element in the Europeanisation of fiscal policy coordination 215 Which Europeanisation matters in fiscal policy coordination? 219

Contents ix 7.2 Fiscal policy without a state in EMU? 222 National fiscal authority in practice in EMU 222 Supranational institutions in fiscal policy coordination 225 Reuploading as the first signal of too fast integration in fiscal policy? 230 How to get back to a win-win situation under the Stability Pact in EMU? 233 Appendix 235 Notes 236 Bibliography 262 Index 289

List of Figures and Tables Figures 1.1 The three-step approach from the formation of European coordination systems via adaptation pressures to changes in national policy-making 8 1.2 Timing in the uploading and downloading of the Stability Pact 10 2.1 Broad economic policy guidelines and multilateral surveillance 39 2.2 Procedure of stability and convergence programmes 40 2.3 Sanction procedure within the excessive deficit procedure 42 3.1 Public debt 1989 1997 56 3.2 Budgetary deficit 1989 1997 57 3.3 The financial position of Old and New Länder 1993 1997 59 3.4 Public finance and annual growth 1989 1997 60 3.5 Long-term interest rate 1989 1997 64 3.6 Exchange rate 1989 1997 65 3.7 Inflation rate 1990 1997 65 3.8 Public debt and budgetary deficit in Germany 1990 1997 70 3.9 Labour productivity, labour costs and unemployment rate 1991 1997 72 3.10 Summary: Securing German national fits 1995 1997 81 4.1 Contribution to real domestic GDP in Germany 1998 2002 106 4.2 Exchange rate of the Euro 1999 2002 108 4.3 Long-term interest and inflation rates 1998 2002 110 4.4 Public debt 1998 2002 112 4.5 Budgetary deficit 1998 2002 113 4.6 Public finance and annual growth 1998 2002 115 4.7 Tax revenue and public expenditure in Germany 1998 2002 116 4.8 The financial position of Old and New Länder 1998 2002 117 4.9 Labour productivity and unemployment rate 1998 2002 119 4.10 Real wages and real unit labour costs 1998 2002 119 4.11 Summary: Dealing with German national misfits 1998 2002 121 5.1 Contribution to real GDP in the Euro area 2003 2004 154 5.2 Exchange rate of the Euro 2003 2004 155 5.3 Long-term interest and inflation rates 2003 2004 156 5.4 Public debt 2003 2006 157 5.5 Budgetary deficit 2003 2006 158 5.6 Public finance and annual growth 2003 2006 160 5.7 Tax revenue and public expenditure in Germany 2003 2006 161 5.8 The financial position of Old and New Länder 2003 2006 162 5.9 Summary: Reuploading German national fits 2003 2005 164 x

List of Figures and Tables xi 6.1 The golden rule in German fiscal policy 1998 2006 185 6.2 Public debt in the Euro area 1998 2006 207 6.3 Budgetary deficit in the Euro area 1998 2006 207 7.1 The three -loading phases of Europeanisation in fiscal policy coordination under the Stability Pact in EMU 212 7.2 Timing element in the formation and implementation of common European fiscal and monetary policies 216 7.3 Timing events in fiscal policy coordination 2002 2005 218 7.4 Reformed dynamics of Europeanisation in fiscal policy coordination 220 7.5 Multi-level authority in European fiscal policy coordination 228 7.6 Evolution of the authority struggle in fiscal policy coordination 231 A.1 Eleven Years of the Stability Pact in the European Union 1995 2005 235 Tables 2.1 Forms of economic policy coordination in EMU 31 3.1 Expected budgetary balance in Germany 1995 2002 83 4.1 National adjustments and European economic policy coordination in Schröder s first government 1998 2002 88 5.1 National adjustments and European economic policy coordination in Schröder s second government 2002 2005 129 5.2 Labour market indicators in Germany and EMU 2003 2004 163 6.1 Comparison of the estimated economic factors to actual reported economic statistics 2000 2006 195

Acknowledgements This book is based on my doctoral dissertation reviewed in the University of Sheffield in Britain. I am really happy to say that the choice of the topic could have not been more interesting. In fact, this was the primary reason why I have managed to work so effectively with my own strict timetable. The empirical and theoretical timing and contribution of the research to the understanding of the system of fiscal policy coordination could not either have been more appropriate because the Stability Pact lived its own fascinating life with major downturns and upturns throughout this whole research process from 2002 to 2005. To present and analyse the continually changing dynamic of the Stability Pact in the EMU environment with its entire complex political, economic, institutional and legal dimensions has been a major work but a highly rewarding one. Although this project has been entirely my own, it has still required cooperation and networking with leading academics and experts in this research field: EU/EMU studies. I would like to thank Prof. Andrew Gamble at the Department of Politics in the University of Sheffield for making our cooperation work so effectively. I am also grateful for the facilities and the encouraging environment for academic research that I experienced at the Max-Planck Institute in Cologne in Germany in 2004. I have also benefited greatly from thought-provoking suggestions from and discussions with Prof. Pertti Ahonen (University of Tampere), Prof. Paul De Grauwe (University of Leuven), Prof. Knud Erik Jørgensen (University of A[o]rhus), Prof. Veli Karhu (University of Tampere), Dr Susan Marton (University of Gothenburg), Mrs Virginia Mattila (University of Tampere), Prof. Vivien Schmidt (University of Boston) and Prof. Amy Verdun (University of Victoria). I also want to thank those EMU experts in the European Central Bank, the European Commission, the German Bundesbank, the German Bundesländer, the German Federal Ministry of Finance and leading German research institutions with whom I was in close cooperation during the research process for their cooperation and information. Most sections of the book have been presented at a number of leading international and European conferences and workshops on EU/EMU studies, and the study has benefited from the comments and views evinced on those occasions: 1 The European International Relations Summer School on The EU Facing Eastern Enlargement in Jena, Germany and in Prague, Czech Republic in July 2002; xii

Acknowledgements xiii 2 The Comparative Summer School on Economic Analysis of Illegal Activities in Oslo, Norway in August 2002; 3 The International Conference on Multilevel and Federal Governance in Victoria, Canada in October 2002; 4 The European Summer School on Theories and Research Design in the Field of EU Studies in A[o]rhus, Denmark in August 2003; 5 The European Economic Workshop on EMU: Current State and Future Prospects in Rethymno, Greece in August 2003; 6 The ECPR Conference on Winners and Losers of EU Decision Making in Marburg, Germany in September 2003; 7 The EUROFRAME Conference on Economic Policy Issues in the European Union in Paris, France in June 2004; 8 The ECPR Conference on Implications of a Wider Europe: Politics, Institutions and Diversity in Bologna, Italy in June 2004; 9 The UACES Research Conference in Birmingham, UK in September 2004; 10 The Research Seminar on The Fiscal Authority of the Member States in EMU at the Department of Economic History in Gothenburg, Sweden in February 2005; and 11 The Research Conference on Is There a Fiscal Policy without a State in EMU? at the Centre For Public Sector Research in Gothenburg, Sweden in February 2005. The importance of my family in Finland: priceless.

Introduction This study focuses on one of the most topical issues on the European political and economic agenda: fiscal policy coordination in Economic and Monetary Union (EMU) and the required adjustments to national fiscal policies by EMU Member States. It presents a single coherent case study of German fiscal policy with the creation of the Stability and Growth Pact (or the Stability Pact) in 1995 1997 and with the implementation of the Stability Pact since 1997. Both the theoretical and empirical contributions of the study are significant. Theoretically, this study shows that in the process of Europeanisation, national interests have had a major impact on the formation (uploading) of fiscal policy coordination. It also shows how European fiscal policy coordination has affected national fiscal policies and policy implementation (downloading) in EMU, and how changes in national interests have finally launched the reform process of the original Stability Pact (reuploading), a new phase of Europeanisation. Empirically, this study demonstrates how the EMU process, originating in the Maastricht Treaty, created a new role for national economic policy with the transfer of monetary authority to an independent European Central Bank. In these circumstances, the second element of economic policy, fiscal policy (including budgetary policy, public finances, taxation and employment policy) has become a significant instrument in effectively adapting national economies to cyclical global and European environments. However, the credibility of fiscal policy coordination under the Stability Pact has, to say the least, been controversial in EMU. Through the main question of how and to what extent the formation of the Stability and Growth Pact has affected the implementation of German national fiscal policy in EMU, the study analyses the German economy under the first and second Schröder governments (1998 2005). The empirical material on the German economy in EMU shows that if it is analysed only through the formal rules of the Stability Pact, Germany has undeniably broken the fiscal rules since 2002. However, the formal rules for assessing the national economy ignore a crucial understanding of the development of the German economy over this period because Germany has sought to promote fiscal stabilisation through major reforms even though they have not yet been fully effective. However, as Germany, like certain other EMU Member States, continually faced major problems with the Stability Pact, the original fiscal rules were finally amended at the Ecofin Council meeting on 20 March 2005. In short, this extensive analysis of the German economy raises four central findings on European fiscal policy coordination. Firstly, the fiscal rules of the Stability Pact and fiscal policy coordination in EMU are as essenxiv

Introduction xv tial as ever in the economic environment of mounting national debt and deficit stocks. Secondly, Member States have to renew and strengthen their political and economic commitments to the common objectives of fiscal policy coordination. Thirdly, the developments in Member States should be assessed from a country-specific approach under the excessive deficit procedure of the Stability Pact. Finally, as shown in this study, the making of a common European fiscal policy through increasing fiscal policy coordination briskly and in a similar way to the common monetary policy has experienced serious difficulties and thus, it is possible to argue that at the moment, there is not yet a common fiscal policy without a state in EMU.