Design and implementation of the Stability and Growth Pact: The perspective of new member states

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Current developments in the design and management of fiscal rules in the European Union may have negative implications for new member states, says Fabrizio Coricelli in a paper published by the Center for Social and Economic Research (CASE). Loosening of the Stability and Growth Pact (SGP) and a growing degree of arbitrariness in its implementation reduce incentives for fiscal adjustment in New Member States, adjustment that would be crucial during the transition to the Eurozone. High budget deficits may prove a serious obstacle in the process of catching up of New Member States to the income levels of EU-15 countries.

1. Introduction 

Following entry in the European Union in May 2004, the larger New Member States (Czech Republic, Poland, Hungary and Slovakia) have been subjected to the Excessive Deficit procedure, according to the rules of the Stability and Growth Pact (see Box 1). Hungary has even been declared in a state of excessive deficit. This pattern contrasts with past experience in the European Union. Entry in the European Monetary Union has been in the past a powerful mechanism to induce fiscal adjustment in EU members, such as Italy for instance. In the last few years, however, the Stability and Growth Pact has ceased to be an effective constraint on fiscal policy in EU countries. The decision of the ECOFIN (European Council of Economic Ministers) to stop the excessive deficit procedure for France and Germany weakened the credibility of fiscal rules in the EU. The reform of the Pact approved in March 2005 introduced a few innovations with respect to the old Pact, by allowing countries to breach under several circumstances the 3% ceiling, which is the maximum budget deficit as a ratio of GDP admissible for EU members. First, countries will be excused not only when there are exceptional circumstances, such as a decline in output higher than 2%, but also when there is a persistent slowdown of the economy, or when countries undertake reforms, for instance pension reform, that have an adverse impact on the budget. Furthermore, the horizon for adjustment has been lengthened. It is hardly disputable that the inability to effectively pressure large EU countries to adjust their budgets and the reform of the SGP have sharply increased the degree of arbitrariness in the evaluation of fiscal policy and in the implementation of the SGP. 

In such a context, rather than clear reference points and clear constraints, access to the Eurozone and the SGP become for NMs moving or elusive targets and “flexible” constraints. 

In this paper we argue that an effective implementation of the SGP is crucial for NMs, perhaps even more than for “old” EU members. Indeed, NMs are still emerging markets, characterized by dependence on foreign finance, large current account deficit, weak financial markets, higher potential output growth, but also higher volatility of main macroeconomic variables. 

Interestingly, one of the official justifications for the reform of the SGP has been enlargement of the EU: “The Stability and Growth Pact needs to be strengthened and its implementation to be clarified, with the aim of improving the coordination and monitoring of economic policies. In doing so, due account should be taken of changing circumstances, in particular the increased economic heterogeneity in the Community of 25 Members and the prospects of demographic changes” (European Commission, Proposal for a Council Regulation, Brussels 20.4.2005). Although some new features of the SGP, such as consideration of different growth of potential output, different initial conditions in debt levels and the fiscal impact of growth-enhancing reforms, represent improvements, one cannot neglect the risks that a less clear set of rules may produce an increased arbitrariness in the implementation of the SGP. This is the most worrying aspect of recent developments. We also emphasize that giving more relevance to debt sustainability rather than budget deficits, while generally correct, risks to give the wrong incentives to NMs, most of them characterized by low levels of debt. The peculiar features of NMs, such as the low development of financial sectors and high volatility output and fiscal revenues, call for a careful definition of safe debt-to-GDP ratios. We argue that there is little room for increasing debt ratios in NMs and we suggest to complement the SGP framework with national expenditure rules. These rules should also serve as a more effective reference for evaluating policies, avoiding confusion between policies and noisy outcomes. 

The paper is structured as follows. In section 2 we argue that during the transition to the Euro, especially during the ERMII period NMs have to rely on tight fiscal policies in order to avoid sizable output costs and the risk of failing the transition to the Euro. In section 3 we discuss the main trends of fiscal policy in NMs, highlighting the presence of two distinct patterns, one of low deficits in small countries and the other of high deficits in larger countries. In section 4 we discuss some features of the SGP, and its revisions, from the perspective of NMs. Section 5 contains some concluding remarks.

To read the full text of the paper, visit the CASE website.

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