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Does the European Stability and Growth Pact (SGP) need to be reformed? Fiorella Kostoris University of Rome “La Sapienza” Cyprus,September 2010 Index I. WHAT IS SGP II. THE RATIONALE OF SGP III. THE MAIN CURRENT CRITIQUES AND REFORM PROPOSALS OF SGP IV. MY REFORM PROPOSAL OF SGP 1 I. WHAT IS SGP SGP is an instrument of coordination in Member States’ (MS) fiscal policy within the European Union. It takes the form of reference values for important fiscal parameters and it includes various rules for the short- and medium-term budgetary decisions of the main (national and European) stakeholders involved. 2 SGP is a written pact. Basic principles are set in the primary norms of the European Treaties since 1992 without any later change (nowadays Art. 126 of last year’s Lisbon Treaty plus Protocol defining the reference values for deficit/GDP = 3% and debt/GDP = 60%). 3 Derogations to these numerical rules exist, according to Art. 126: compliance exists • even if deficit/GDP > 3%, if “the ratio has declined substantially and continuously and…comes close” “or the excess… is only exceptional and temporary and the ratio remains close” • even if debt/GDP > 60%, if “the ratio is sufficiently diminishing and approaching the reference value at a satisfactory pace” 4 Otherwise, the excessive deficit procedure (EDP) has to be started by a Commission Report, a Commission Recommendation and possibly a Council Decision, ultimately leading to sanctions of MS. 5 Primary norms do not specify whether reference values have to be treated as short run or as structural constraints. But logically they correspond to steady growth solutions, with a golden rule. Primary norms are important, because it is very difficult to modify European Treaties. However, SGP was officially born only in 1997 with 2 Council Regulations (SGP1) and was reformed in 2005 with 2 additional Council Regulations (SGP2). Table 1 shows “innovations/specifications” of secondary norms relative to primary ones: 3 are particularly important in 1997; 4 in 2005. The debt constraint is ignored in both. 6 Main changes to the Stability and Growth Pact following the Council Agreement of March 20, 2005 Original (1997): SGP1 Revised (2005): SGP2 1.Main changes in the preventive arm Medium-term objective (MTO) All Member States (MS) have a medium-term budgetary objective of ‘close to balance or in surplus’. Country-specific differentiation of MTOs according to stock of public debt and potential growth. MTOs for euro-area MS are set between -1% of GDP and balance or in surplus (in cyclically adjusted terms and net of one-offs). Adjustment path towards the MTO No specific provisions. Annual minimum adjustment for MS of the euro area of 0.5% of GDP in their structural balance. The effort shoud be higher in ‘good times’, identified as periods where output exceeds its potential level. Structural reforms No specifi provisions. Reforms will be taken into account when defining the adjustment path to the MTO and may allow a deviation from it under the following conditions: only major reforms (direct/indirect impact on sustainability); safety margin to the 3% reference value is guaranteed; the deficit returns to the MTO within the programme period. Special attention to systemic pension reforms. 7 Original (1997): SGP1 Revised (2005):SGP2 1. Main changes in the corrective arm Severe economic downturn ‘Severe economic downturn’ if there is an annual fall in real GDP of al least 2%. An economic downturn may be considered ‘severe’ in cases of a negative growth rate or accumulated loss of output during a protracted period of very low growth relative to potential growth. ‘Other relevant factors’ (ORFs) No specific definition of ‘ORFs’ and their role in the excessive deficit procedure. The Commission report will take into account: developments in the medium-term economic and budgetary position (potential growth, cyclical conditions, implementation of policies, public investment, quality of public finances, fiscal consolidation in ‘good times’, debt sustainability). Increasing the focus on debt and sustainability No specific provision. The debt criterion, and in particular the concept of a debt ratio ‘sufficiently diminishing and approaching the reference value at a satisfactory pace’, will be applied in qualitative terms. Initial deadline for correcting the excessive deficit The excessive deficit has to be corrected in the year following its identification, unless there are ‘special circumstances’. The rule remains: possible extension by one year based on ORFs and on the condition that minimum fiscal efforts have been taken. 8 The reform of SGP1 was induced by critiques on 4 elements 1.its logical inconsistency, as the deficit reference values are rigidly set independent of the MS’ growth pontential and debt level; 2.its incapability to transform “cigada” MS into “ants”, compliant with fiscal rules; 3.its insufficient ability to induce MS’ countercyclical policies stabilising the real economy in the short run and boost growth in the long run; 4.its inadequate enforceability (see par. IV). 9 II. THE RATIONALE OF SGP The rationale behind SGP is that a sustainable and non-inflationary growth requires nominal stability and the latter requires, particularly in the Eurozone, limits on MS’ deficits and debts: in the single currency area, MS do not fully internalise the inflationary consequences of their fiscal behaviour and, facing an economic downturn, have a deficit bias creating negative spillovers on partners (raising interest rate and inflation), unless they find a binding constraint. 10 Remark that this argument is correct only if shocks are asymmetric and concern the supply side. In the case of common shocks, MS would fully internalise the effects of their deficits; in the presence of negative demand shocks, MS’ expansionary budget policies would create positive spillovers on partners through the import-export channel. 11 III. THE MAIN CURRENT CRITIQUES AND REFORM PROPOSALS OF SGP Current critiques of SGP2 include 2 old critiques of SGP1 for new reasons. 2.Fiscal discipline is inexistent: ongoing excessive deficit procedures concern all the 16 Euro countries (except Luxembourg) and 9 of the remaining 11 EU MS (except Estonia and Sweden). Some MS show non-transitory excessive deficits and debts (Italy); many show rising debts above 60% (including Germany). See Table 2. 12 Deficit and Debt (as a percentage to GDP) in some European areas (1997-2010) European Union Deficit/GDP Debt/GDP 1997 -2.5 71.0 1998 -1.6 68.8 1999 -0.7 67.3 2000 1.1 64.1 2001 -1.3 62.9 2002 -2.3 60.4 2003 -3.0 61.8 2004 -2.6 62.2 2005 -2.5 62.7 2006 -1.4 61.4 2007 -0.8 58.8 2008 -2.3 61.6 2009 -6.8 73.6 2010 -7.2 79.6 13 Deficit and Debt (as a percentage to GDP) in some European areas (1997-2010) Euro Area Deficit/GDP Debt/GDP 1997 -2.6 75.3 1998 -2.2 73.7 1999 -1.3 72.7 2000 0.2 70.2 2001 -1.8 69.2 2002 -2.5 68.0 2003 -3.0 69.1 2004 -2.8 69.5 2005 -2.5 70.1 2006 -1.3 68.3 2007 -0.6 66.0 2008 -2.0 69.4 2009 -6.3 78.7 2010 -6.6 84.7 14 Deficit and Debt (as a percentage to GDP) in some European areas (1997-2010) Italy Deficit/GDP Debt/GDP 1997 -2.7 120.2 1998 -2.8 116.3 1999 -1.8 114.9 2000 -0.5 110.6 2001 -3.1 109.5 2002 -2.9 105.7 2003 -3.4 104.4 2004 -3.4 103.8 2005 -4.3 105.8 2006 -3.3 106.5 2007 -1.5 103.5 2008 -2.7 106.1 2009 -5.3 115.8 2010 -5.3 118.2 15 Deficit and Debt (as a percentage to GDP) in some European areas (1997-2010) France Deficit/GDP Debt/GDP 1997 -3.0 59.3 1998 -2.7 59.5 1999 -1.6 58.5 2000 -1.3 57.2 2001 -1.5 56.8 2002 -3.2 58.8 2003 -4.2 62.9 2004 -3.7 64.9 2005 -2.9 66.4 2006 -2.3 63.7 2007 -2.7 63.8 2008 -3.3 67.5 2009 -7.5 77.6 2010 -8.0 83.6 16 Deficit and Debt (as a percentage to GDP) in some European areas (1997-2010) Germany Deficit/GDP Debt/GDP 1997 -2.7 61.0 1998 -2.2 60.9 1999 -1.6 61.2 2000 1.2 60.2 2001 -2.8 59.5 2002 -3.7 60.4 2003 -4.0 63.9 2004 -3.7 65.7 2005 -3.3 68.0 2006 -1.6 67.6 2007 0.2 65.0 2008 0.0 66.0 2009 -3.3 73.2 2010 -5.0 78.8 17 3.Stabilisation of real economies is obtained far from full employment and growth performance is insufficient in the EU. The Lisbon Agenda, setting 10-year targets for 2010 employment, R & D, etc. was partly unsuccessful. 18 New critiques of SGP2 mainly concern 4 elements (see points 4. 5. 6. 7.) 4.Enforceability is insufficient due to 3 reasons: 4.1. inadequate sanctions: according to Schäuble (March 2010), MS with EDP should not receive EU Cohesion Funds, should not participate to budgetary decisions regarding other MS, should have their voting rights suspended, and as a last resort should exit the monetary union, remaining in the EU; 19 4.2. inadequate surveillance by EU partners on other MS’ public budgets, according to Merkel (May 2010): consequently Van Rompuy (June 2010), chairman of the European Task Force, proposes a “European Semester” every Spring to reinforce ex ante surveillance; the Commission Communication (June 2010) adds that, under the European Semester, complementarity of national economic policies will be ensured at the European level before final decisions on budget are taken in MS; 20 4.3. inadequate involvement of National Parliaments in the compliance with SGP rules. Merkel proposes to include in each MS’ Constitution binding clauses on deficit and debt, as already done by Germany (maximum federal deficit/GDP = 0.35% by 2016; zero debt for Länder starting in 2020). Sarkozy is ready to follow. Moreover, National Statistical Offices should be more independent in providing reliable data on MS public finance. My partial disagreement with diagnoses given on enforceability will be explained in par. IV. 21 5. Limits on public debt are ignored, whereas debt, more than deficit, seems negatively correlated with growth at least beyond a threshold (Reinhart-Rogoff, 2010). However, it is necessary to re-examine the reversed causality problem (Barrios-Schaechter, 2008). The Greek case in Spring 2010 shows the negative spillovers on other partners, created by MS with unsustainable debt, coupled with general economic weaknesses, insufficient degree of competitiveness, unreliable statistical data. 22 6.Connections between MS’ fiscal policies on the one hand and the convergence of the underlying real economies, on the other, are virtually ignored. Yet macro imbalances (such as those created by diverging degrees of competitiveness) induce tensions on public finance and negative spillovers on other MS: Van Rompuy (June 2010) suggests that “macroeconomic surveillance should function next to the budget surveillance of the Pact”. 23 7.Connections between MS’ fiscal policies on the one hand and the other EU or MS’ economic policies (such as monetary, financial, labour policies), on the other, are loose, while they all contribute to a sustainable growth. The Commission Communication (June 2010) stresses this point, indicating that the “European Semester will integrate the different strands of economic policy coordination”. 24 The European Council of June 17, 2010 takes the decision at the political level to give more role to debt and overall sustainability in budgetary surveillance; reinforce the preventive and corrective arms of SGP with more sanctions; adopt a European Semester in Spring; ensure that each MS has budgetary rules and MTOs in line with SGP; ensure that statistical offices are fully independent from political pressures and provide reliable data on MS’ fiscal policy. 25 IV. MY REFORM PROPOSAL OF SGP While I share most of the above critiques and policy proposals/decisions, I think that these changes will prove ineffective unless the SGP enforceability is much strengthened. This requires a modification in the EU governance of SGP and an improvement in the intrinsic rules of SGP. 26 The SGP enforceability is weak because the governance of the European Council, which has the duty to decide EDP, is ill-conceived, as surpervised Finance Ministers coincide with supervisors: the probability and the moral cost of sanctions decrease when the number of fiscal delinquents (today almost the unanimity) increases; the intrinsic rules of SGP are misspecified: no distinction is made between asymmetric and common shocks hitting MS, and between demand and supply shocks. 27 It can be shown that the 3% ceiling on deficit may be too large facing a negative supply shock, when essentially no deficit should be allowed; it may be correct facing a mild asymmetric negative demand shock, when automatic stabilisers are sufficient to restore output; it is suboptimal when there is a systemic and/or a very strong negative demand shock, hence a discretionary expansionary fiscal policy beyond automatic stabilisers is called for and is beneficial for all MS. 28 It is possible to amend the present formulation of SGP, taking into account the relevant distinction on shocks that I propose, without changing primary norms, but reinterpreting in secondary norms the “exceptional” conditions for derogations from EDP. 29 Reliable and rapid information on the type of shock facing different MS is needed. A crude set of indicators is immediately available, and is understandable and trusted by national policy-makers, given that every quarter each MS and the European Commission produce harmonised series on output, inflation and constraints limiting manufacturing firms. 30 The distinction between a demand and a supply shock can then be obtained every quarter on the basis of a positive correlation between the real output growth and the inflation rate in the former case, of a negative correlation in the latter. When all MS face a common negative demand shock, they all show a contemporaneous decrease in both the growth rate of real output and inflation. 31 When this negative demand shock is very strong, firms are constrained in their demand rather than in their productive capacity at an increasing rate and above the average trend (the corresponding curve in Graphs 1 is rising and above the threshold of 10) 32 Demand and Supply Shocks in the European Union (Annual Data) 16,0 14,0 (D-C)/Average (D-C 19972010) Detrended demandconstrained (D) relative to capacity-constrained (C) business regime (x 10) 12,0 10,0 8,0 Real GDP annual rate of change(%) 6,0 4,0 2,0 Inflation rate (%) 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 -2,0 1998 1997 0,0 -4,0 -6,0 Years Demand and Supply Shocks in the Euro Area (Annual Data) (D-C)/Average (D-C 19972010) Detrended demandconstrained (D) relative to capacity-constrained (C) business regime (x 10) 16,0 14,0 12,0 10,0 Real GDP annual rate of change(%) 8,0 6,0 4,0 2,0 Inflation rate (%) -6,0 Years 10 20 09 20 08 20 07 20 06 20 05 20 04 20 03 20 02 20 01 20 00 20 99 19 -4,0 19 19 97 -2,0 98 0,0 33 Demand and Supply Shocks in Germany (Annual Data) 20,0 (D-C)/Average (D-C 19972010) Detrended demandconstrained (D) relative to capacity-constrained (C) business regime (x 10) 15,0 10,0 Real GDP annual rate of change(%) 5,0 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 0,0 Inflation rate (%) -5,0 -10,0 Years Demand and Supply Shocks in France (Annual Data) 18,0 (D-C)/Average (D-C 19972010) Detrended demandconstrained (D) relative to capacity-constrained (C) business regime (x 10) 16,0 14,0 12,0 10,0 Real GDP annual rate of change(%) 8,0 6,0 4,0 Inflation rate (%) 2,0 -4,0 Years 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 -2,0 1997 0,0 34 Demand and Supply Shocks in Italy (Annual Data) 15,0 (D-C)/Average (D-C 19972010) Detrended demandconstrained (D) relative to capacity-constrained (C) business regime (x 10) 10,0 Real GDP annual rate of change(%) 5,0 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 0,0 Inflation rate (%) -5,0 -10,0 Years Demand and Supply Shocks in Italy (Quarterly Data) 16,0 14,0 (D-C)/Average (D-C 19972010) Detrended demandconstrained (D) relative to capacity-constrained (C) business regime (x 10) 12,0 10,0 8,0 Real GDP rate of change relative to previous quarter (%) 6,0 4,0 Inflation rate (%) 2,0 19 97 19 99 20 01 20 03 20 20 05 07 20 Q1 07 20 Q3 08 20 Q1 08 20 Q3 09 20 Q1 09 20 Q3 10 -Q 1 0,0 -2,0 -4,0 Years 35 The Graphs show that all EU MS were hit in 2009 by a systemic, strongly negative demand shock. Limiting deficit spending that year was irrational. And it was impossible. Never before in the years under consideration something similar had happened. 36 For example, in the period 2001-2003, Germany was hit by a moderately negative demand shock, France was not. A reformed SGP would have perhaps avoided in 2003 the dramatic conflict between the Commission and the Council (with consequent loss of SGP credibility), suggesting to allow Germany to overcome the 3% limit (as decided by the Council) , but to start the EDP towards France (as demanded by the Commission). 37 The year 2010 looks very different from 2009 and not identical for all MS: a positive rebound in demand is observed everywhere, real output growth rates are recovering, inflation is rising. Looking at quarterly data (Graphs 2), Germany does not appear any longer to be constrained at all on its output demand, as world trade is now expected to sharply increase (by 11% this year, while it was decreasing by 9% in 2009), while the country has been gaining in competitiveness in the last decade relative to other EU MS (in Graphs 3 gains in competitiveness are indicated under the threshold of 100). 38 Demand and Supply Shocks in the European Union (Quarterly Data) 16,0 (D-C)/Average (D-C 19972010) Detrended demandconstrained (D) relative to capacity-constrained (C) business regime (x 10) 14,0 12,0 10,0 Real GDP rate of change relative to previous quarter (%) 8,0 6,0 4,0 Inflation rate (%) 2,0 1 Q 3 Q 20 10 - 1 Q 20 09 - 3 20 09 - 1 Q 20 08 - 3 Q 08 - 20 Q 1 Q 20 07 - 05 01 07 - 20 20 99 03 20 -4,0 20 19 -2,0 19 97 0,0 Years Demand and Supply Shocks in the Euro Area (Quarterly Data) 16,0 (D-C)/Average (D-C 19972010) Detrended demandconstrained (D) relative to capacity-constrained (C) business regime (x 10) 14,0 12,0 10,0 8,0 Real GDP rate of change relative to previous quarter (%) 6,0 4,0 2,0 Inflation rate (%) 19 97 19 99 20 01 20 03 20 20 05 07 -Q 20 1 07 -Q 20 3 08 -Q 20 1 08 -Q 20 3 09 -Q 20 1 09 -Q 20 3 10 -Q 1 0,0 -2,0 -4,0 Years 39 Demand and Supply Shocks in Germany (Quarterly Data) 20,0 10,0 (D-C)/Average (D-C 19972010) Detrended demandconstrained (D) relative to capacity-constrained (C) business regime (x 10) 5,0 Real GDP rate of change relative to previous quarter (%) 0,0 Inflation rate (%) 1 Q 3 Q 20 10 - 1 20 09 - 3 Q 09 - 20 Q 1 Q 20 08 - 3 08 - 20 Q 1 Q 20 07 - 05 20 07 - 03 -5,0 20 01 20 99 20 19 19 97 15,0 -10,0 Years Demand and Supply Shocks in France (Quarterly Data) 20,0 (D-C)/Average (D-C 19972010) Detrended demandconstrained (D) relative to capacity-constrained (C) business regime (x 10) 15,0 Real GDP rate of change relative to previous quarter (%) 10,0 5,0 Inflation rate (%) 1 Q 3 20 10 - 1 Q 20 09 - 3 Q 09 - Years 20 Q 1 20 08 - 3 Q 08 - 20 Q 1 07 - 20 Q 05 07 - 01 99 03 20 20 20 20 -5,0 19 19 97 0,0 40 Harmonised competitiveness indicators and real effective exchange rates based on consumer price indices (period averages: 1999-Q1=100) 110,0 105,0 100,0 Euro Area Italy 95,0 France Germany 90,0 85,0 80,0 1996- 20012000 2005 2006 2007 2008 2009 2010 2010 March April 2010 May 2010 June Years 41 Germany is probably ready to start an exit strategy to reduce fiscal imbalances according to the old SGP rules. France and Italy are recovering at a different pace and probably need more time, the former having gained less in competitiveness and the latter having lost it continuously for 10 years and a half. 42