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Stability and Growth Pact: Boosting its Enforceability

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
August 2006
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The seven-year-old fiscal framework of the European Union (EU)—the Stability and Growth Pact (SGP)—was intended to guide member countries toward fiscal prudence. But it has been difficult to enforce. Many countries, for example, have not been able to keep their fiscal deficits below the SGP’s 3 percent of GDP benchmark, and problems also abound on the procedural side. A new IMF Working Paper asks why some countries have coped better than others and how the SGP can be made more enforceable.

The SGP, introduced in 1998 and revised in 2005, fleshes out the 1992 Maastricht Treaty, which provided the EU with a two-pronged fiscal framework. The framework’s preventive arm focuses on multilateral surveillance and the avoidance of excessive deficits. The SGP complements the framework by requiring countries to strive for a medium-term objective that provides a sufficient cyclical safety margin to allow full operation of automatic stabilizers during downturns without breaching the 3 percent of GDP reference value. The framework’s dissuasive arm is charged with ensuring that countries respect the Maastricht Treaty’s limits on deficits (3 percent of GDP) and public sector debt (60 percent of GDP). If a country’s deficit is deemed to be excessive, it is obliged to undertake corrective policies within a defined time frame.

Causes of the deficit bias

EU countries’ fiscal records diverged widely before the signing of the Maastricht Treaty. While some countries, like France and Germany, held their public debt accumulation in check, others, particularly Belgium, Greece, Ireland, and Italy, ran persistent and unsustainable deficits. A range of factors—including divisions within governments, electorally motivated fiscal policy, and weak budgetary institutions—fueled this deficit bias, especially during the 1970s and 1980s.

A country’s political architecture, explains the Working Paper, can distort fiscal policy decisions and have an inbuilt bias toward excessive deficits and debt. First, by the logic of the common pool model, politicians who represent different groups and vested interests have no incentive to constrain their spending demands, given that the costs are shared by the population as a whole. Second, politicians tend to be more myopic than the general public, favoring short-run electoral gain and ultimately failing to take account of longer-term policy implications.

Deficit biases may be even greater in a monetary union, where exchange rate risk and the associated interest rate risk premium are no longer operable. The ability to pass on at least some of the costs of profligate fiscal policy to other members can also exacerbate the common pool problem within a monetary union.

Constraining discretion

To constrain policymakers’ discretion, numerous governments have adopted formal fiscal rules. A number of countries have also reformed their budgetary processes by introducing delegation—granting a leading role in the budget process to the finance minister—or commitment techniques, whereby different parties negotiate a fiscal contract involving strict budget targets.

Throughout the 1980s and 1990s, more and more European countries undertook reforms along these lines—some prompted by the need to meet the Maastricht fiscal criteria. Large countries, like France, Germany, and the United Kingdom, with stable delegation arrangements over long periods, have been joined more recently by Austria, Greece, Italy, and Spain. Other, typically smaller, countries—such as Belgium, Finland, Ireland, and the Netherlands—developed an affinity for commitment. In some cases, the desire to meet the Maastricht criteria was a catalyst for these budgetary reforms, as countries strengthened institutions to bolster the effectiveness of fiscal rules.

Some countries have also constrained discretion by placing greater reliance on independent fiscal entities. Countries like Austria, Belgium, and the Netherlands have used independent bodies to provide independent projections, whereas others have allowed the analysis provided by these bodies to influence fiscal policy and keep political distortions in check.

Mixed results

How has the EU’s fiscal framework fared? Ratification of the Maastricht Treaty spurred the EU countries into action as they scrambled to meet the deficit criterion. Most underwent substantial fiscal adjustment in the 1990s. By the onset of European Economic and Monetary Union (EMU) in 1999, almost all of the existing euro area members had succeeded in bringing their deficits below 3 percent of GDP.

Experience under the SGP has been more mixed, however. Data from the Organization for Economic Cooperation and Development indicate that the average cyclically adjusted primary balance did not budge between the Maastricht (1992–98) and SGP (1999–2004) periods. In only three countries did the adjustment in the SGP period go beyond that undertaken under Maastricht. This may be explained partly by adjustment fatigue and partly by the fact that the imminent threat of exclusion from EMU had passed.

But this is only part of the story. By the end of 2004, 5 of the euro area’s 12 member countries—Belgium, Finland, Ireland, Netherlands, and Spain—had fiscal positions that could be deemed as “close to balance or in surplus,” the SGP standard. Others—including France, Germany, Greece, Italy, and Portugal—posted deficits in excess of 3 percent of GDP and became entangled with the excessive deficit procedure.

One clear pattern was the opening up of a gulf between large and small countries. Although the three largest countries were apparently reluctant to push for underlying balance, the SGP seems to have worked well for a core group of smaller countries, as well as Spain. Ironically, the traditional bastions of fiscal stability in Europe—France and Germany—slipped to the bottom of the pack (see chart).

An analysis of the data, as described in the Working Paper, indicates that some of the fiscal policy distortions that were mitigated by the Maastricht Treaty have staged a return under the SGP, because the threat of exclusion from EMU has passed. First, procyclical fiscal policy, largely eliminated with the advent of the Maastricht Treaty, came back during the SGP period, and electorally motivated fiscal profligacy rose in prominence under the SGP.

Finally, the study finds that commitment countries tend to take annual stability programs—the backbone of the SGP’s preventive arm—more seriously, as evidenced by lower forecast errors in their budgetary projections. Also, countries using independent forecasts tended to have lower forecast errors under the SGP.

Diverging deficits

The Stability and Growth Pact seems to have helped a core group of smaller countries bring down their fiscal deficits.

Citation: 35, 16; 10.5089/9781451968606.023.A011

(percent of potential GDP)

Data: Organization for Economic Cooperation and Development.

Explaining the differences

What explains countries’ diverging performances under the SGP? An analysis of the determinants of fiscal policy before and after the SGP’s introduction reveals three core results:

• Budgetary institutions underpinned by commitment (typically in the smaller states) contributed more to fiscal discipline in the post-SGP period. Delegation was effective in disciplining fiscal policy before the SGP but not after: with its emphasis on multiyear targets and a regular review procedure, the SGP fits snugly with the fiscal contract approach associated with the commitment states, but it is less compatible with delegation countries that rely on domestic governance institutions.

• Countries experiencing higher growth volatility tended to adopt a more disciplined fiscal policy under the SGP. In this regard, the SGP could act as an external anchor for countries prone to macroeconomic volatility, especially in the absence of exchange rate discipline.

• There is also some evidence that larger countries performed worse than smaller countries in meeting fiscal targets under the SGP. This could reflect either political considerations, whereby smaller countries are more accustomed to external influences over policy and suffer a greater loss in reputation from deviating from the rules, or economic ones, since the costs of fiscal consolidation tend to be higher in large countries. But this result holds only when the fiscal governance variables are excluded from the analysis.

Fortifying enforceability

Overall, the evidence shows that a rules-based fiscal framework can be an effective disciplining device but that the SGP works best in countries that are smaller, subject to greater volatility, and more inclined to adopt the commitment form of fiscal governance to strengthen budgetary institutions. Since most of the new members share these characteristics, the advantage of having a robust SGP should only increase over time.

At the same time, ways must be found to make the SGP more compatible with countries that are large and rely on domestic governance mechanisms, such as delegation to a strong finance minister. Here, a promising avenue might be reforms that bolster domestic institutions, such as independent entities that audit fiscal policy in a forward-looking manner and exert domestic reputational costs on the government. These have been shown to contribute to fiscal discipline, especially when they provide independent forecasts.

Anthony Annett

IMF European Department

This article is based on IMF Working Paper No. 06/116, “Enforcement and the Stability and Growth Pact: How Fiscal Policy Did and Did Not Change Under Europe’s Fiscal Framework.” Copies are available for $15.00 each from IMF Publication Services. See page 256 for ordering details. The full text is also available on the IMF’s website (www.imf.org).

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