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Stability and Growth Pact of the European Union, the

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Abstract

While fiscal policy making in the EU is in the hands of national governments, it is to be carried out in accordance with commonly agreed rules: the Stability and Growth Pact (SGP). The SGP originates in the understanding that uncoordinated fiscal policy produces cross-border effects that can harm the functioning of the Economic and Monetary Union. For member states with an excessive deficit, that is, a general government deficit of more than 3% of GDP, the SGP rules are more invasive. Since its inception in 1997, the SGP has undergone a series of amendments aimed at improving fiscal governance in the EU.
stability and growth pact of the European
Union, the
Martin Larch and Lars Jonung
From The New Palgrave Dictionary of Economics, Online Edition, 2014
Edited by Steven N. Durlauf and Lawrence E. Blume
Abstract
While fiscal policy making in the EU is in the hands of national governments, it is to
be carried out in accordance with commonly agreed rules: the Stability and Growth
Pact (SGP). The SGP originates in the understanding that uncoordinated fiscal policy
produces cross-border effects that can harm the functioning of the Economic and
Monetary Union. For member states with an excessive deficit, that is, a general
government deficit of more than 3% of GDP, the SGP rules are more invasive. Since
its inception in 1997, the SGP has undergone a series of amendments aimed at
improving fiscal governance in the EU.
Keywords
automatic stabilisers; discretionary fiscal policy; excessive deficit procedure;
fiscal policy making
JEL classifications
E6; H3; H6
Article
The Stability and Growth Pact (SGP) is a set of rules, laid down in primary and
secondary legislation of the European Union (EU), for the coordination of national
fiscal policy making of the EU member states. It first entered into force in 1997, the
year that also marked the beginning of the third phase towards establishing the
European Monetary Union. The fiscal constraints on national fiscal policy making
imposed by the SGP are motivated by the well-known interactions between monetary
and fiscal policy making and, more specifically, by the understanding that in a
monetary union independent national fiscal authorities do not fully internalise the
effects of fiscal indiscipline on the monetary commitment of the centralised monetary
authority (see, for instance, Uhlig (2003) for a useful overview of the debate).
Hence, the common rules of the SGP are meant to ensure the effectiveness of
centralised monetary policy of the ECB, the central monetary authority of the euro
area, by keeping the public finances in the EU, and in particular of the euro-area
member states, on a sustainable path and by promptly correcting any possible
deviations. Some parts of the SGP rules, in particular enhanced budgetary
monitoring, fines and sanctions, do not apply to EU member states whose currency
is not the euro. The rule-based character of the SGP also embodies a well-documented
insight in the fiscal policy literature according to which there is an empirical
1
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tendency towards running deficits and accumulating debt (see, for instance, Alesina
and Perotti (1995) for a comprehensive review of the political economy underlying
the deficit bias).
Since its inception in 1997, the SGP has been amended three times, in 2005,
2011 and, more recently, in 2013. The amendments responded to lessons learnt from
the implementation of the SGP. As a result of the successive amendments there has
been an increase in both the flexibility and also the complexity of the SGP. The
increase in flexibility, especially after the 2005 reform, was a reaction to a widely
held view that the original set of rules was too rigid most importantly that the rules
did not account for economic circumstances. The most prominent envoyof this
view was Romano Prodi, who in 2002, while President of the European
Commission, characterised the SGP as stupid because it was too rigid, while at
the same time defending the basic rationale for the SGP. The increase in complexity
is partly due to the political constraints in the SGP, where the need for impartiality
and equality of treatment between member states has led to a consensus that
this is best achieved through detailed rules rather than the exercise of judgement.
The SGP consists of two parts: the preventive and the corrective part. The
preventive part consists of a set of rules and procedures aimed at ensuring healthy
underlying budgetary positions and avoiding unsustainable debt positions. At its core
is the requirement for EU member states to achieve and/or maintain a medium-term
budgetary objective (MTO). The MTO is country-specific and pursues a triple aim.
It should:
(i) ensure a sufficient safety margin against the risk of breaching the 3% of
GDP deficit threshold of the Treaty;
(ii) ensure rapid progress towards long-term sustainability of public finances
taking into account the budgetary impact of aging population; and
(iii) taking (i) and (ii) into account, allowing room for budgetary manoeuvre
over the cycle.
For euro area countries and countries participating in the Exchange Rate
Mechanism II (ERM II) the nominal exchange rate of ERM II members is fixed
against the euro and is only allowed to fluctuate 15% above or below the central
rate the MTO should not exceed a structural deficit of more than 1% of GDP,
while signatories to the inter-governmental Treaty on Stability, Convergence and
Governance (commonly called fiscal compact) have committed themselves to an
MTO that does not exceed a structural deficit of less than 0.5% of GDP, unless their
debt level is significantly lower than 60% of GDP and they face no sustainability
risks. Euro area and ERM II member states that have not yet achieved their MTO are
expected to implement an annual budgetary adjustment towards it of 0.5% of GDP in
structural terms per year as a benchmark, while countries with a debt over 60% of
GDP or facing high sustainability risks should implement an annual budgetary
adjustment greater than 0.5% of GDP. In all cases, a higher adjustment is expected
when economic conditions are favourable, with a lower adjustment being possible
when conditions are more difficult.
Compliance with the MTO requirement is judged by looking at changes in
the structural budget balance, in conjunction with an expenditure benchmark.
By constraining the growth rate of an expenditure aggregate the benchmark provides
operational guidance to countries. Increases in expenditure beyond the constraint are
permitted as long as they are accompanied by equivalent revenue measures.
2
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The rules of the preventive part of the SGP epitomise the conclusion matured
over past decades that discretionary, counter-cyclical fiscal policy should be avoided
completely or deployed only in the wake of particularly large demand shocks. There
is widespread understanding in the literature that, under normal conditions, discretion
as opposed to rules in fiscal policy making generally leads to suboptimal results in
view of the many political considerations or considerations of interest groups that
come into play with decision making in the political arena (see, for instance, Taylor
(2000) and Blinder (2004)).
The corrective part of the SGP, known as the Excessive Deficit Procedure
(EDP), applies to member states that breach Treaty requirements to keep the general
government deficit below 3% of GDP and the general government gross debt at
below 60% of GDP or diminishing sufficiently towards that level at a satisfactory
pace which is defined as an average annual 5% reduction in the excess of the debt
over the 60% threshold level over three years.
The corrective part of the EDP encompasses a detailed list of procedural steps
aimed at correcting the excessive government deficit or debt. An EDP can be opened
on the basis of outturn data or of member statesplans, that is, a breach or planned
breach of the deficit threshold or of a debt level that has not or is not on course to
comply with a satisfactory pace of reduction. The opening of an EDP brings with
it recommendations for corrective action with which the member state must comply
or face an escalation in the procedure. For euro area member states each new step of
the EDP contains the possibility of the imposition of sanctions, and ranges from the
lodging of a non-interest bearing deposit at the opening of the EDP to an annual fine
in the case of persistent non-compliance.
Somewhat confusingly, as a result of the wording in the Treaty on the
Functioning of the European Union (TFEU), the word deficitin the EDP and its
procedures, is at times used to refer to both the government deficit as a flow and the
government debt as a stock, while at other times it applies only to the flow measure.
Prior to the 2011 amendment which operationalized the debt requirement this
was less apparent. Compliance with the debt requirement was subsumed in the
evaluation of the deficit on the basis that compliance with the 3% of GDP deficit
limit would be sufficient to place the debt on a downward trend, based on the
expectations for average nominal growth that seemed reasonable in the late 1990s.
The main legal references of the SGP are:
(i) Article 126 of the Treaty on the Functioning of the European Union (TFEU);
(ii) Council Regulation (EC) No 1466/97 on the strengthening of the
surveillance of budgetary positions and the surveillance and coordination of
economic policies; and
(iii) Council Regulation (EC) No 1467/97 on speeding up and clarifying the
implementation of the excessive deficit procedure.
As indicated above, the two regulations have been amended and complemented
over the years. The first reform took place in 2005, followed by a more important
overhaul in 2011 with the so-called six-pack; some additional elements were
introduced in 2013 with the so-called two-pack.
The 2011 amendment to the SGP introduced widespread changes to both
parts of the Pact, motivated by the lessons of the financial crisis (see, for instance,
Larch et al., 2010). The recognition that it is the policy decisions made at times of
strong growth and/or positive output gaps that are crucial in enabling stabilisation and
3
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support during times of recession led to a substantial strengthening of the preventive
arm of the Pact. In parallel, the transformation of the crisis into a sovereign debt crisis
put the debt on an equal footing with the deficit in the corrective arm. The sanctions
applicable to euro area member states under the corrective arm were intensified and a
degree of automaticity was added to the voting procedure, while sanctions were also
introduced to the preventive arm for the first time. The degree of automaticity consists
in applying reversed qualified majority voting: sanctions are considered approved
unless there is qualified majority in the Council against them.
The additional rules that entered into force in 2013 apply to euro area countries
only. The most prominent innovation is the obligation by member states whose
currency is the euro to submit annually their draft budgetary plans to the European
Commission and the Eurogroup by 15 October. Based on an overall assessment, the
European Commission adopts and publishes an opinion on the draft budget. If the
draft budget is in serious conflict with EU fiscal rules the member state would be
asked to submit a revised draft.
In all parts of the SGP, the final legally binding decisions and recommendations
are taken by the Council of the European Union in its ECOFIN configuration,
where the member countries are usually represented by their Ministers of
Economics and Finance, on a recommendation from the European Commission.
In all voting, the country under discussion does not participate in the vote. For the
EDP, non-euro area member countries do not participate in the voting on euro area
countries. This is also the case in the preventive arm, for the votes leading to the
imposition of sanctions.
See Also
budget deficits;
European Monetary Union;
political budget cycles
Bibliography
Alesina, A and Perotti. R. 1995. The political economy of budget deficits. Staff
Papers International Monetary Fund, 42: 131.
Blinder, A. S. 2004. The case against the case against discretionary fiscal policy.
CEPS Working Paper No. 100.
Larch, M., Van den Noord, P. and Jonung, L. 2010. The stability and growth pact:
lessons from the Great Recession. European Economy, Economic Paper No. 429.
Taylor, J. B. 2000. Reassessing discretionary fiscal policy. Journal of Economic
Perspectives, 14, 2136.
Uhlig, H. 2003. One money, but many fiscal policies in Europe: what are the
consequences? In: Monetary and Fiscal Policies in EMU, Interactions and
Coordination (ed. M. Buti ), pp. 2964. Cambridge University Press, Cambridge.
4
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