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The most acute macroeconomic policy challenge relates to fiscal consolidation and co- ordination, which is vital for the single currency, but currently under stress. The Stability and Growth Pact (SGP), which is the backbone of the co ordination framework, commits governments to reduce budget deficits to close to balance or move to surplus and then let automatic stabilisers play unfettered while respecting the 3 per cent of gross domestic product (GDP) ceiling for the budget deficit stipulated in the Treaty. The experience with this framework is mixed, at best. In part reflecting the unexpected depth and duration of the downturn, balancing the overall budget has been put off by about five years compared with the “stability programmes” submitted by the governments to the Commission and the Council of Ministers at the eve of the downturn. At present six euro area countries (France, Germany, Italy, Greece, the Netherlands and Portugal) are, or are projected to be, experiencing deficits above 3 per cent of GDP. Several countries were already subject to an Excessive Deficit Procedure under the Treaty rules. In November 2003, the Council decided to "hold in abeyance" the procedure in two cases, which resulted in uncertainty regarding the implementation of budgetary surveillance.
The proximate cause of the successive breaches of the fiscal rules lies in the underestimation of the depth and duration of the economic downturn. However, the deeper cause lies somewhere else. Most countries that are likely to experience deficits above the 3 per cent threshold eased fiscal policy in the economic upswing of 1999-2000 and then found it hard to reverse this in the downswing. In particular, some member states implemented tax cuts that were based on the then prevailing strong growth assumptions. At that time they were considered to be in line with the requirements of the SGP but in an ex post perspective they added to the deterioration in the fiscal balances. The impressive fiscal consolidation in the run up to the single currency to meet the Maastricht Treaty convergence criteria apparently stalled as soon as the currency was created. The support for the SGP has been diluted, and the credibility of enforcement has suffered. This is of concern because the fiscal rules are essential for the macroeconomic management of the euro area. They are necessary to avoid lack of fiscal discipline in one or several member countries spilling over into the financial conditions facing the others. The rules had also established a medium term anchor for fiscal policy, thereby creating room for the automatic stabilisers to smooth country specific cyclical swings following the loss of national monetary policy instruments. More fundamentally, and even on an optimistic assessment of the fiscal impact of population ageing, the close to balance or in surplus rule is the minimum required in the next two decades to underpin fiscal sustainability beyond this horizon. Work should continue to assess the impact of ageing on longer term fiscal sustainability on a comparable basis across countries.
With ageing related fiscal pressures building up, a repeat of past policy errors - a weakening or reversal of consolidation efforts amid buoyant cyclical conditions - would be even more costly than they recently have been. Against this backdrop, it would be wise to strengthen the surveillance and enforcement of the rules during cyclical upswings and to take into account more explicitly countries’ indebtedness. Specifically:
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Countries should ensure that their budgetary procedures stem the inherent dynamics towards spending rising faster than GDP, in line with the OECD Best Practices for Budget Transparency. Fiscal policy should be rooted in medium term frameworks that act as a hard budget constraint, based on prudent macroeconomic projections. Budgeting should be top down, with new expenditure funded, a fortiori, by reallocation within or across spending ministries.
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The adoption of such Best Practices is needed irrespective of the Union’s fiscal rules, but the rules could act as a catalyst for change if fiscal surveillance and enforcement could be strengthened, including during cyclical upswings. The Commission should dispose of the resources needed to see to it that the stability programmes are implemented. The Early Warning Procedure should become an effective preventive instrument in the hands of the Commission - rather than in the hands of the Council who is party and judge.
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Stronger surveillance and enforcement may create room for building more flexibility into the Pact. It could help to raise the countries’ ownership of, and commitment to, the rules. Already in 2002, the Council endorsed the principle that the close to balance or in surplus rule should apply in cyclically adjusted rather than in nominal terms. For instance, increased flexibility could be considered for countries that have achieved sound public finance and low levels of debt, to allow for financing possible upfront costs of pension reform (e.g. a move towards funded private pension schemes, while desirable for efficiency reasons, may lead to deficits in public pension schemes) or other structural reforms.
Moving targets 1
General government balance in the euro area as a per cent of GDP 2
1. The various vintages of the Stability Programmes were released over the following periods: 1st 1998/99, 2nd 1999/2000, 3rd 2000/01, 4th 2001/02, 5th 2002/03, 6th 2003/04.
2. Excluding Universal Mobile Telephone System (UMTS) licence proceeds.
Source: European Commission/Eurostat and OECD.
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