The Stability and Growth Pact: Should it be reformed? - 03.04.2004

 Comments on the decision of the ECOFIN Council of November 2003
      

In his recently published book, "In an Uncertain World", former US Secretary of the Treasury, Robert Rubin writes within the context of the framing of the first budget of the Clinton administration in 1993:

"Proposing to balance the budget may have been the only feasible way to defeat the pernicious idea of adding a balanced-budget amendment to the Constitution. Such an amendment would violate all known wisdom about economic policy. It could compel the federal government to cut spending or raise taxes in a recession, substituting "procyclical" policies (which would cause the economy to contract even more) for the "countercyclical" ones that a recession ordinarily calls for."

The American example has shown that in the second half on the 90's, budgetary rigour during a period of economic growth led to a process in which each of these factors mutually reinforced each other allowing a record lengthening of the expansion  together with impressive budgetary surpluses. When the financial bubble finally burst, which lead to an unavoidable economic slowdown, it was possible for the new Bush administration to kick start the American economic machine through a combination of tax cuts and the acceptance of a budget deficit as spectacular as the surpluses engineered by the Clinton administration.  Let us note however that throughout the whole cycle, the American government scrupulously abstained from intervening with the monetary policy carried out by the Federal Reserve Board which demonstrates that it is possible to have a flexible economic and budgetary policy within the framework of a monetary policy that is independent from the executive branch.

We observe today that vigorous growth is once again developing in the United States while it is still lagging in Europe and in particular within the Eurozone. This lag can, at least in part, be ascribed to the lack of flexibility in budgetary policies resulting from the provisions of the Stability Pact.

Therefore, should the Pact be reformed?

Simply increasing the flexibility of existing rules to allow for ad hoc waivers in response to economic conditions would seem insufficient to the extent that it might encourage a lax attitude by Governments in both periods of strong and weak economic activity. One should indeed recall that the initial political choice made by the countries that adopted the single currency was to share monetary policy (managed independently by the ECB) but on the other hand to retain full national sovereignty in matters of economic and budgetary policy. This choice made a Pact indispensable so as to maintain a minimum of discipline and also to underpin the credibility of the single currency during its launching phase.

Today, the Euro has clearly established itself successfully and its existence has preserved the Union from the worst consequences of the monetary and financial crises that have shaken financial markets since its introduction. Even the significant fluctuations versus the US dollar take on today a lesser importance compared with the pre-EMU situation. This allows the Eurozone to reap some of the benefits - previously the sole privilege of the United States- of a policy of "benign neglect"  with regard to its exchange rate in favour of economic priorities of the internal market(NOTE : PROMEURO disagrees with this. It thinks that if the USA AND Europe take this attitude, it will lead to a more volatile International Monetary System that will harm primarily the less developed nations).

As to the question of maintaining budgetary discipline within the member states of the Eurogroup, the Pact remains an inescapable necessity as long as the principle of full subsidiarity remains in force in this particular area. To be credible, any relaxation of the Pact can only be countenanced within the framework of a simultaneous reinforcement of the coordination of economic policies at Eurozone level.
Scrapping the Pact completely should be an objective to be reached when there will be a single economic and budgetary policy within the Eurozone similar to the situation in the United States. This would not however mean that different political agendas at Member State level could not be implemented, leading to differentiated levels of taxation and social benefits, so that an element of subsidiarity would be maintained.

The debate surrounding the Stability and Growth Pact should therefore call for coherence of the attitudes of each Member State: Either they favour full subsidiarity in economic and budgetary matters or then they agree to comply with the stringent demands of the Pact with only limited scope for relaxing the rules, or they choose a greater flexibility of rules in exchange for abandoning a measure of national sovereignty to a more collegiate decision process within the Eurogroup.

Embarking on an evolutionary process would bring advantages because, as long as the need for a stringent Pact prevails, the effectiveness of  economic management tools will be constrained and will risk creating the perverse effects mentioned by Rubin and that the United States have avoided. In particular, the Eurozone will be forced to suffer passively rather than be able to influence the external value of its currency because in any system with three variables, two of which have been "parametised" ( budgetary deficit and inflation), the third (exchange rate) becomes automatically a "resultant" if the two others have reached their imposed limit. In the current environment, for example, the appreciation of the euro due to American fiscal stimulation combined with the tolerance of both its internal and external deficits, puts a break on renewed growth this side of the Atlantic without it being possible - Stability pact and inflation target rules applying - to take any measures that would limit the Euro's appreciation.

To be realistic, however, the introduction of "economic governance" within the Eurozone should be thought of as a progressive process in which each step aims at increasing the degree of flexibility of the rules until the Pact's final elimination. This process should, cumulatively, reinforce the effectiveness of the tools of economic management within the single market and consequently also reinforce the flexibility of the ECB in its management of monetary policy including its capacity to influence, when appropriate, the external value of the currency.

One shouldn't underestimate the political difficulties linked to the introduction of such "economic governance", the mere mention of which is considered a taboo in some circles. The debate concerning the structure and functioning of the necessary decision making body as well as how its decisions should be implemented and overseen will be long and complex. It does however constitute a perfectly logical development of the achievements accomplished to date in the implementation of the single market and single currency. In order for the citizen to benefit fully of the advantages of EMU, for the Union to implement the Lisbon declaration and also to play its full role on the world economic scene, the necessity to initiate such a process seems as obvious as the one presiding over the creation of a joint policy in foreign affairs and defence.

If the foregoing analysis has any value, then it should be possible to leave aside the sterile debate concerning giving more flexibility to the Pact in its present form in order to focus on the creation of the political and institutional conditions necessary for its evolution.

In conclusion, the reform of the Stability and Growth Pact appears indispensable, but can and should only be considered within the larger framework of economic governance within the Union.
            Paul N. Goldschmidt, RetiredDirector of the European Commission