The decision of
EU finance ministers in February 2002 to ignore a Commission proposal to warn
Germany and Portugal over the level of their budget deficits has jeopardised
the credibility of the Stability and Growth Pact. But Ecofin's inaction does
not mean, as some have suggested, that the Pact has been fatally undermined.
Indeed, the dispute could provide a much-needed opportunity to refine the workings
of this key institutional feature of economic and monetary union.
The political sensitivities that drove European finance ministers to reject
the Commission's proposal are easy to understand. For the German government,
which faces an election in September, the Commission's stance was an unwelcome
criticism of its economic management record. Other major euro-zone countries
such as Italy, France and Spain were prepared to support the German position,
aware that they could be in the dock in the future. Only a number of smaller
EU countries - including Belgium, the Netherlands and Austria - objected. These
countries claimed that Germany was being accorded a special status as a large
country.
However, these short-term political factors conceal a more fundamental philosophical
debate about the structuring of the Pact. Several EU governments, led by France
but with strong backing from the UK, have long claimed that the Pact is too
mechanistic and fiscally restrictive. They argue that the Pact as it currently
stands fails to take fully into accord other important budgetary factors such
as government investment, overall debt levels and the position of the economic
cycle.
Even those who support a rigid interpretation of the Pact accept it possesses
flaws. The 3 per cent deficit figure, which triggers punitive action, is arbitrary.
Wim Duisenberg, ECB President, admitted, as much when he told the European Parliament
in January that what should really be assessed is the 'underlying' budget performance
rather than a nominal measure of the deficit. The real divide seems to be between
those such as the Commission and the ECB, which was to uphold the existing Pact
rigorously, and those member-states, which want to adopt a more 'flexible' approach.
However, there is a danger that unless EU finance ministers quickly establish
the parameters of this more flexible approach, the Stability Pact could become
a byword for political opportunism. The finance ministers should consider introducing
a number of straightforward reforms to clarify their future approach to budget
scrutiny.
A relatively simple change, and one that the EU has already agreed to introduce
for its Broad Economic Policy Guidelines, would be to state clearly that the
primary focus of the Stability Pact is the structural - or cyclically adjusted
- measure of the budget deficit. A structural measure of the deficit has the
benefit of being less vulnerable to the whims of the economic cycle. This should
ensure that governments are not penalised for minor breaches of the 3 per cent
ceiling when the underlying budgetary position is improving.
Secondly, finance ministers should make more explicit how they intend to treat
investment expenditure and overall debt levels. The Stability Pact already contains
reference to the need to consider these factors, as well as the nominal budget
deficit. However, there is no indication as to how debt and investment should
be treated in the Stability Pact process. The Commission has narrowly interpreted
the Pact's provision that governments must achieve a 'balanced budget' over
the medium term, precluding any room for borrowing in order to finance investment.
The EU should therefore consider adopting a variation on the 'golden rule' for
public finances employed by Gordon Brown in the UK. This rule states that over
the course of the economic cycle, current revenues should match current expenditure.
Furthermore, borrowing for investment should be permitted, provided overall
government debt levels remain at a 'stable and prudent level' - currently defined
as around 40 per cent of GDP. This would enable governments with a strong underlying
budgetary position to borrow for investment purposes, without breaching the
terms of the Pact.
Both these sensible refinements of the Stability Pact would enjoy widespread
support in the financial markets. As the suggested changes would only reinterpret
the existing Pact, they require simply the assent of Ecofin and the Commission,
rather than a full-scale treaty change.
Alasdair Murray is director of the economics and social policy unit at the CER.
