The Stability Pact and Public Expenditure - 14.03.2002

An article written by Sir Brian Unwin - former President of the European Investment Bank
      

                   THE STABILITY PACT AND PUBLIC EXPENDITURE

Background

Member countries of the European Union who wished to qualify as founder members of monetary union (EMU) and the single currency (the Euro) in January 1999 were required under the Maastricht Treaty to meet certain minimum budgetary and other criteria. Prominent among these were that national budget deficits should not exceed 3% of GDP and outstanding public debt should amount to less than 60% of GDP or be clearly moving downwards towards that figure. The purpose of this and of other related criteria (eg on rates of inflation) was to ensure that their economies were sufficiently converged to allow the new monetary policy, with its single interest rate regime, to work effectively for the economic benefit of all members of the Euro zone and to prevent any single member from acting irresponsibly, for example by borrowing excessively in a way that could fuel inflation throughout the monetary union.

Although the Maastricht Treaty itself contained provisions committing member countries to avoid "excessive" budget deficits in the future, including sanctions against anyone who broke the rules, a number of member states, led by the then  German Finance Minister, proposed in 1995 that the Treaty should be complemented and strengthened by a more specific set of agreed procedures. These would have the dual objective of reinforcing the Treaty provisions on budgetary discipline and also establishing a more formal framework for coordinating economic policies in the future in order to maximise growth and employment and at the same time keep inflation under strict control.    

Following detailed discussions at the Ecofin Council among Finance Ministers, in which Britain supported the broad proposals, the resultant Stability and Growth Pact was finalised by Heads of Government at the Amsterdam European Council in June 1999. Its principal provisions required member countries to keep their budgetary positions "close to balance or in surplus" by the end of 2001 and in particular not to exceed the 3% GDP ceiling. In addition, the Pact contained clauses under which, if any country exceeded or looked like exceeding the 3% deficit limit, other member states could (on a non legally binding basis) recommend corrective action, with the ultimate sanction of financial penalties. At the same time, however, the terms of the Pact provided for a good deal of flexibility to allow for breaches of the ceiling that were temporary or caused by exceptional circumstances, such as a severe recession or an unforeseen economic shock.

Practical Implications of the Pact

In the event the high degree of economic convergence already achieved by members of the single currency zone before it was launched - which allowed, for example, the initial single interest rate to be set by the new European Central Bank at 3.5% - has been followed by further good progress in bringing budgetary balances under control. The latest official statistics issued by the European Commission show that in 2000 the budgetary balances both of the twelve governments of the euro-zone and of the EU as a whole moved into surplus and that the ratio of public debt continued to decline. This was entirely in accordance with the objectives of the Maastricht Treaty and the Pact and there has been no question of sanctions or penalties needing to be invoked. It is worth, however, examining a little more closely the rationale of the Pact and its implications for member countries and in particular for Britain, whether or not it decides to join EMU the euro-zone.

The first point to emphasise is that the Pact is not designed to be a constraint on the ability of the euro-zone as a whole, or of its individual members, to pursue flexible public spending or taxation policies designed to meet particular economic circumstances, whether of a European wide nature, or specific to an individual country. On the contrary, the combination of a budget deficit ceiling of 3% of GDP and a commitment to keep budgets close to balance or in surplus is expressly designed to provide substantial room for governments to adjust spending or taxation if the need should arise, including use of the so called automatic stabilisers. In the case of Britain, which last year achieved a budget surplus of over 4%, though not a member of the euro club, 3% of GDP amounts to some £28 billion and is far greater than any adjustment ever made by a British Chancellor of the Exchequer to public spending or taxation in any single year.

This built in room for manoeuvre is particularly relevant in present circumstances where an already developing world recession is being exacerbated by the situation following the 11 September attacks on the United States. Indeed, in recognition of this, European Finance ministers recently decided that budget deficits should this year be above pre-agreed limits in order to cushion member countries as the world economy worsens. This follows a declaration by Heads of Government at the Stockholm European Summit in March of this year that from now on the emphasis in the debate on spending and budgets should be shifted  towards how public finance could make a greater contribution to generating economic growth and jobs.  

It should also be remembered that the deficit to which the Maastricht and Stability Pact rules apply is the difference between each government's public spending and its income from taxation and other revenues at both central and local government level (in other words, the net amount it has to borrow). Britain and other member states are thus perfectly free to decide their own balance between public spending and taxation, to suit their own particular national priorities and circumstances. In practice, all the governments have agreed on the need to coordinate such policies in the interests of the common good and to aim at certain broad objectives such as reducing the overall burden of taxation, which is still particularly high by international standards in some member countries, and more specifically the taxes on employment. This in effect continues and reinforces the less formal economic policy coordination arrangements which existed before the launch of EMU, in which British governments readily participated. Formal tax harmonisation as such is not on the agenda; indeed, there is widespread recognition that, with a single interest rate and a common monetary policy operated by the European Central Bank, there is greater need for individual member countries to be allowed considerable flexibility in deciding their own taxation and public spending policies, provided they stay within the overall fiscal parameters set by the Treaty and the Stability and Growth Pact.

Britain thus has nothing to fear from the provisions of the Stability Pact. It is entirely in line with the British Government's own medium term public spending and taxation policies and there is nothing in the Pact to prevent the government,for example, giving policy priority to spending on essential public services such as education, health and public transport or to particular tax adjustments. The British government's success in achieving a substantial budget surplus and reducing public debt well below the 60% reference mark in fact currently gives it greater room for manoeuvre than almost any other member state.    

                    


            Sir Brian Unwin - Former President of the European Investment Bank