Europe's Quest for Fiscal Discipline

• Author: Anthony Annett/Albert Jaeger
• Position: Economist/Division Chief in the IMF's European Department
• Pages: 22-25

Will the Stability and Growth Pact help Europe find the right balance between fiscal discipline and flexibility?

Page 22

While the euro area's monetary policy is conducted by a single institution-the European Central Bank (ECB)-fiscal policy remains decentralized. When Europe's leaders agreed to form the Economic and Monetary Union (EMU) in 1989, they recognized the need for some form of fiscal coordination. Without coordination, the irresponsible policies of one member state could have a negative impact on the entire union, for example, by raising public debt. The Stability and Growth Pact (SGP), setting out regulations for the conduct of fiscal policy that reinforce the provisions of the Maastricht Treaty, was therefore agreed to by member states in 1997, nearly two years before stage three of EMU, when exchange rates were irrevocably locked.

But seven years later, the SGP is mired in controversy. France and Germany-the euro area's largest economies, founding members of the European Union (EU), and the main driving force behind the creation of EMU-are likely to breach the pact's deficit ceiling of 3 percent of GDP for the third year in a row. In November 2003, the European Commission-the official guardian of the EU's treaties- recommended that both France and Germany be placed under enhanced fiscal surveillance, one step short of actual sanctions. However, the Council of Economic and Financial Affairs (ECOFIN)-the decision-making forum for the EU's ministers of finance and economics-suspended the excessive-deficit procedures against the two countries, effectively sidestepping the SGP's rules and leaving the pact in a legal limbo. As it was unclear by what authority the Council acted when it decided not to take action, the European Commission took the case to the European Court of Justice.

Not surprisingly, the SGP is increasingly becoming a lightning rod for pundits debating its economic and political merits. Critics argue that besides being hard to enforce, the pact promotes procyclical fiscal policies (that is, it forces countries to reduce deficits during cyclical downturns) and lacks a rationale for its medium-term goal of bringing the underlying fiscal deficit close to balance or into surplus. Supporters, however, think the pact should be credited with controlling Europe's fiscal deficits. They also point to the countercyclical behavior of fiscal deficits since the introduction of the euro and note that most member countries have managed to live up to their commitments under the pact.

Proposed solutions and blueprints abound, ranging from minor tinkering to completely rewriting the pact. This article tries to shed light on the controversy by reviewing the history of Europe's fiscal policy before and after the pact. It concludes with some thoughts on possible reforms.

Box 1

What is the Stability and Growth Pact?

The SGP consists of two regulations and a resolution agreed by the European Council to underpin the fiscal framework of the Maastricht Treaty. It combines discipline and flexibility by requiring countries to reach fiscal positions "close to balance or in surplus" over the medium term (a reference to the underlying or structural fiscal position) and keep their actual deficits below 3 percent of GDP, except in the case of unusually large shocks. Member states submit annual plans for public finances over the medium term. The Council offers opinions on them and, if necessary, delivers early warnings. Unless exceptional circumstances apply, the excessive-deficit procedure is initiated when a country's deficit exceeds 3 percent of GDP. The procedure starts with a recommendation to reduce the deficit, moves on to enhanced fiscal surveillance, and culminates in the imposition of financial sanctions. If no action is taken along the way, sanctions can be imposed within 10 months of the procedure being initiated. If excessive deficits persist, sanctions can be converted into fines after two years.

Europe's fiscal past

Prior to the signing of the Maastricht Treaty in 1992, fiscal policies in EU member countries were widely divergent. Some countries ran large and persistent deficits that fed into rapid public debt accumulation, while others preserved a remarkable degree of fiscal discipline. By the early 1990s, gross public debts in Belgium, Greece, Ireland, and Italy had spiraled to over 100 percent of GDP, with fiscal policies on a clearly unsustainable path. At the other end of the spectrum, public debt accumulation in Germany and...