How Should the Stability and Growth Pact Be Reformed?
| Author | David Walton/Angel Ubide/Mark Hallerberg |
| Position | Chief European Economist, Goldman Sachs/Director of Global Economics, Tudor Investment Corporation/University of Pittsburgh |
| Pages | 26-28 |
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Three points of view on the future of Europe's fiscal pact
Page 26
Consensus that the Stability and Growth Pact (SGP) will need some adjustment appears to be growing. The recent failure of the European Union's (EU's) Council of Economic and Financial Affairs (ECOFIN) to follow the pact's prescriptions for addressing excessive fiscal deficits in several member countries has only added to already urgent calls for reform. But how far should reform go? Should the pact be completely rewritten, as some have argued? Or is it basically sound, making the problem one of enforcement rather than structure? Below, F&D presents the views of two private sector economists-David Walton and Angel Ubide-and a political scientist-Mark Hallerberg.
The SGP was flawed from the start and needs to be reformed to provide the euro area with a durable fiscal framework built on solid economic foundations.
France and Germany may have breached the rules of the pact, but fiscal policy has not been conducted irresponsibly. The rise in the euro area's budget deficit in the past couple of years has been mostly due to the effects of the economic cycle. By allowing the automatic stabilizers to work in full, governments have helped cushion the downturn in economic activity rather than exacerbate it. Unlike the United States, France and Germany do not have "twin deficit" (fiscal and current account) problems. If the deficit limit of 3 percent of GDP had been strictly enforced, a much greater burden would have been placed on the European Central Bank to use monetary policy to support the economy. This would hardly have been sensible, given that interest rates are already at historic lows.
It is no good resurrecting the pact in its existing form. Without credible reforms, further breaches are inevitable. Other countries could invoke France and Germany as precedents.
Several flaws in the original design of the pact need to be addressed.
* By requiring each country to achieve cyclically adjusted budgets "close to balance or in surplus," the pact treats each country the same despite very different ratios of government debt to GDP across the euro area.
* The balanced budget rule implies a decline in debt ratios toward zero. This makes little economic sense and even less political sense. The rule takes no account of the fact that public investment can add to a country's assets as well as its debts.
* The pact is asymmetric: it does not make proper allowance for cyclical effects. Once the deficit breaches 3 percent of GDP, member states are expected to eliminate the "excessive deficit" the year after it is identified, with little regard for the stage of the economic cycle. Conversely, the pact is not forceful enough in requiring fiscal consolidation during good times.
* The sanctions mechanism lacks credibility. Sanctions are unlikely to be applied when they run against what governments regard as their sovereign decisions, particularly when deficits are the consequence of weakness in economic activity.
Thus, the time has come to create a new pact that takes account of the experience of the past couple of years. A new pact should be geared to the following six principles:
First, all member states should reaffirm the need to adhere to a fiscal framework that guarantees the...
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