IMPLEMENTATION

  1.    The Stability Pact consists of two Council Regulations, which have the force of law: one on the Excessive Deficit Procedure and one on surveillance, together with a European Council resolution which provides guidance to the Council and Member States on the application of the Pact. The Regulations clarify the meaning of the clauses in the Maastricht Treaty regarding "excessive" deficits, and in particular what constitutes an exceptional or temporary deficit justifying a deficit in excess of 3 per cent of GDP. A deficit is automatically considered exceptional if output fell by at least 2 per cent in the year in question. A deficit may be considered exceptional by the Council if output fell by ¾-2 per cent; in this case a country will presumably have to point to unusual features of the recession in order to make its case. Where there is discretion in the application of the pact, then decisions are by a variant[28] of qualified majority. Under the pact, members of MU also commit to a medium-term budgetary objective of "close to balance" or surplus.

  2.    Countries are obliged to correct excessive deficits "as quickly as possible after their emergence" and to "launch the corrective budgetary adjustments they deem necessary without delay". In practice countries will probably be able to run excessive deficits for two years before incurring fines. The Commission will not receive definitive data concerning the previous year's outturn till about March of the following year, so it is unlikely that corrective action could be ordered until around May. Effectively, given the lags in implementing fiscal policy action, this means that the country cannot be expected to have corrected the excessive deficit until the following year, ie the next year but one after the excessive deficit originally appeared. Finally if there are "special circumstances" a country might be allowed longer than two years to comply; an example would presumably be Finland in the early 1990s.

  3.    Presumably if action is being taken, then the fines provided for under the pact will not be imposed. If action is not taken, then fines will be levied in the form of non-interest-bearing deposits starting at 0.2 per cent of GDP and rising by 1/10th of the excessive deficit up to a maximum of ½ per cent of GDP (which is therefore reached when the deficit hits 6 per cent). Additional deposits are required each year until the excessive deficit is corrected. If the excess deficit is not corrected within two years, the deposit is converted into a fine; otherwise it is returned, in which case the country has effectively been fined merely the interest rate times the size of the deposit.

  4.    Nothing is said about how these deposits/fines will be collected. Presumably if a country refused to make them and were a net recipient of funds from Brussels, these could be withheld (in fact this provision already holds in the Cohesion Funds). If it were a net supplier to Brussels, it might be more difficult to enforce, but presumably sanctions could be applied in other areas if a country got really difficult.

THE ECONOMIC ARGUMENTS FOR THE PACT

  5.    There are a number of rationales that have been advanced for the pact (many of which have surfaced in the Committee's interrogation of the various witnesses):

  (i)  As an extra buttress against countries running up large debit obligations, upon which they then decide/are forced to default, pressuring other countries into bailing them out and generating systemic financial problems, particularly if default by one country leads investors to question the soundness of other countries public debt ("contagion"). Bail outs are prohibited by the Treaty, but some people have questioned how credible this is. There are also worries that the ECB will have to pump liquidity into the system if there is a financial crisis, and that this could lead to inflation. However, this need not follow—the key is for the ECB to mop up the extra liquidity through open market operations as soon as financial stability is restored. This, in my view, is the most convincing argument for the pact, but the risk of systemic financial instability could also be reduced by restricting financial intermediaries from large holdings of the debt of high-debt countries.

  (ii)  To discourage high debt countries from pressing for more inflationary monetary policies in order to reduce the real value of their debt obligations. However, given the constitution of the ECB/ESCB it seems rather unlikely that a high debt country would be able to manipulate Euro monetary policy in this way.

  (iii)  To offset a political bias to high deficits ("live now, pay later"). This is really a case of tackling the symptoms, rather than the disease, and there may be better ways of tackling the problem, such as the Code for Fiscal Stability announced by the UK Chancellor, or relating contributions to the EU budget to debt/deficits as well as GDP, etc.

  (iv)  To prevent interest-rate spillovers. The argument runs that previously countries were discouraged from running up high debt because of the threat of the exchange rate collapsing. Under MU this discipline is no longer there, and countries will thus borrow more. This will drive up interest rates for everyone else. In fact the evidence suggests that such effects are in practice likely to be negligible, since the general level of (long-term) real interest rates is determined in a global capital market. Furthermore, it is not clear that an increase in real interest rates is necessarily bad—if a country is a net creditor vis-a-vis the rest of the world (which the United Kingdom presently is) then it is actually made better off by the increase in real interest rates!

  (v)  The previous argument relates to medium/long-term spillovers. There is also an argument for the pact based on facilitating short-term macroeconomic policy co-ordination. Here it is argued that expansionary fiscal policy by one country, say to fight unemployment, raises aggregate demand in the Euro area, and will lead the ESCB to tighten monetary policy, resulting in a bad fiscal/monetary policy mix, and possibly also an imbalance in policies across countries. However, it is not necessarily the case from this perspective that fiscal policy will be too expansionary in the first place—countries tend to ignore the "locomotive" effects of fiscal expansion on their neighbours, so fiscal policy may well be too contractionary during generalised recessions. In any case the pact is a rather crude weapon for trying to improve co-ordination.

  6.    The main concern with the pact is that it will force governments to tighten the fiscal stance during recessions and thus lead to a pro- rather than counter-cyclical fiscal policy, leading to an increase in the volatility of output and unemployment. This should not happen if governments are far-sighted and run a budget surplus during booms, so that the budget roughly balances over the business cycle (as intended by the "close to balance" medium-term commitment); in that case an excessive deficit should only be triggered in the case of a fairly deep recession, in which case the exemption clauses kick in.

  7.    The worry, of course, is that governments won't be this farsighted, as the pact offers no "carrot" for good behaviour in booms, only a "stick" against bad behaviour and one which moreover is more likely to be applied during recessions. Counterfactual simulations over the past by Eichengreen and Wyplosz[29] suggest that if EU governments fiscal policies do not change in the way envisaged, then excessive deficits (ie ones without an exemption) would be triggered about a third of the time! Obviously, it is reasonable to expect some change in behaviour in the new "stability-oriented" world, but the question remains whether it will be large enough to make excessive deficits a rarity. If not, then we may see fines being triggered—most likely when economic circumstances are in any case unfavourable—which will no doubt cause friction between the member countries.

8 April 1998

29   The Stability Pact:"More than a Minor Nuisance?", Economic Policy, April 1998, Vol. 26, pp 65-114. Back