EURO-AREA: Crisis response challenges SGP rationale

Analysis

The EU's Stability and Growth Pact (SGP) was adopted in 1997 in the run-up to the completion of Economic and Monetary Union (EMU), at the instigation of the then German finance minister, Theo Waigel, and of Germany's Bundesbank as a fiscal framework for supporting monetary policy within the euro-area. It was envisaged as a means of maintaining budgetary discipline within the member states after they had qualified for EMU, by achieving the Maastricht 'convergence criteria'. The SGP maintains the Maastricht ceilings for annual public sector borrowing (3% of GDP) and for overall state debt (60% of GDP), while introducing provisions for policing and reducing excessive deficits on the part of individual member states -- the so-called 'excessive deficit procedures' managed by the Council of Finance Ministers (ECOFIN).

Against the background of this year's global financial crisis and the likelihood that a number of member states will have public sector borrowing requirements of considerably more than 3%, the summit of EU heads of state on December 11-12 agreed to accept ECOFIN's recommendation to relax excessive deficit procedures (see INTERNATIONAL: Stimulus plans pose long-term risks - December 11, 2008). Nevertheless, at the insistence of the German, Dutch and Swedish governments, the summit press release still underscored the need for a rapid return to budgetary discipline (see EUROPEAN UNION: Agreement reached but at a cost - December 16, 2008).

Starting assumptions. Budgetary discipline is a self-evident virtue, in the same way that budgetary indiscipline is a self-evident deficiency. However, the way that it is enshrined in the SGP raises a number of critical questions about the pact and its founding assumptions:

• The theoretical foundations of the SGP are strongly monetarist and neo-liberal in nature; they ascribe primary importance to the maintenance of price stability in terms of low inflation, supporting in turn the maintenance of a stable real exchange rate. The ambition of the SGP has been to promote the reduction of borrowing and debt to an average of zero over the business cycle (see EUROPEAN UNION: ECB Politics - October 22, 1997).
• One of the core stated purposes of the SGP is to reduce the 'crowding-out' effects of state borrowing -- to reduce the pressure of state demand for credit on financial markets, and thus on market rates of interest. This should allow private sector agents to deploy credit more effectively according to the competitive conditions of the capital market and according to market-determined investment strategies.
• The reduction of state borrowing as a proportion of GDP was intended to go hand-in-hand with the reduction of the overall state ratio, i.e. the overall proportion of GDP deployed by the state, most notably through the privatisation or part-privatisation of state enterprises.
• In its original form, the SGP permitted defection from budget deficit ceilings in the case of annual recessions of the order of a 2% contraction in GDP -- an exceptionally rare phenomenon in recent economic history. This was relaxed in 2005 to permit defection in the case of negative growth.
• The framing of the SGP (by its German authors) took no account of the abnormal and continuing fiscal problems associated with German unification. Rather, the pact was informed by the political motivation of the German state to reassure a German electorate that remained strongly sceptical of the EMU project.
• A further motivation informing the SGP was the perceived need to satisfy international financial markets of the fiscal probity of EMU member states to avoid exchange rate volatility.

Poor record. The history of the SGP has witnessed repeated breaches of the Pact's rules. These breaches have been consistently tolerated, primarily because the euro area's core economies -- Germany, France and Italy -- were unable themselves to stay below the 3% ceiling.

Excessive deficit procedures have been applied to Greece and Portugal, but not to the major economies; the swingeing fines envisaged (0.2-0.5% of GDP) have never been used. While the state debt ratio has fallen within the euro-area since 1998, the SGP ceiling remains breached by an average of 66.4% (figures for 2007), and in some cases (Italy, Greece, Belgium) it is significantly higher than the 60% 'reference value'.

The objective of a lower state ratio has also been achieved, as revealed by figures published in the ECB's special issue of its Monthly Bulletin in May 2008, marking ten years of the Bank's existence. Government expenditure in the euro-area as a percentage of GDP has accordingly fallen, from 48.6% in 1998 to just 46.3% in 2007.

Dysfunctional effects.The struggle against crowding-out effects, which still features on the Commission's SGP website, has thus far been highly successful, and ECB data on capital market loans to the private sector in the same period show average annual growth of 8.2%, with particularly strong surges in 2006 (10.9%) and 2007 (10.8%). However, the expected 'crowding-in' effects of reduced government expenditure on private sector investment have not occurred. In fact, overall investment ratios for euro members have continued to fall.

The virtuous circle of crowding-in failed to materialise because credit was deployed to fund two large waves of global M&A activity (in 1999-2000 and 2005-06) and speculation in the financial markets, the results of which have become evident this year (see PROSPECTS 2009: Euro-area recession set to endure - November 17, 2008). The 'stability' and 'growth' effects of the state fiscal forbearance represented by the SGP are arguably of limited value, set against the damage currently being inflicted on European economies, arising out of the approach to lending embodied by the SGP. Growth has been weaker within the euro-area than in all other regions of the world. Together with the relative stagnation of household demand in the core economies of the euro-area, the demonisation of (in part credit-financed) state expenditure has shifted the balance of domestic demand in favour of over-leveraged speculation.

Outlook. Given the new state responsibilities in counter-cyclical economic stimulation and long-term environmental planning, the time is ripe for a recasting of the SGP which emphasises sustainable social and environmental development alongside the proper concern for monetary stability, and where the current regional and international coordination of monetary and fiscal policy is institutionalised (see INTERNATIONAL: Heterodox policies may gain traction - December 9, 2008). However, such demands for change must overcome the suspicions of fiscally cautious member states (especially the pact's author, Germany) -- a difficult, if not impossible, task.