Tuesday, September 7, 2004

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Night of the living growth and stability pact

When we last left the European Union's growth and stability pact in the fall, it had been scuttled for both economic and ;political reasons. The economic reason was that the pact did not make a whole lot of economic sense in a world with a continent-wide monetary policy combined with business cycles; the political reason was that France and Germany were violating the Maastricht criteria of keeping their budget deficit within three percent of their GDP, and the EU finance ministers refused to sanction either country

Inexplicably, the European Commission then decided to sue France and Germany in the European Court of Justice. This was inexplicable because the Commission was guaranteed to lose either way. If the ECJ ruled against the Commission, then it undercut the power of the EU's principal policymaking body. If they won, they'd be in the awkward and intractable position of trying to force the two largest EU states into compliance -- a highly unlikely outcome.

The Economist catches up with what's happened since the fall:

The commission won that procedural battle—the European Court of Justice ruled in July that finance ministers could not suspend the pact at their own convenience—but it has now conceded the war. On Friday September 3rd Romano Prodi, outgoing president of the commission, and Joaquín Almunia, the EU’s commissioner for monetary affairs, announced their proposals for a reformed pact that will be economically literate and politically feasible, albeit legally feeble....

The single currency’s fiscal rules are meant to ensure that all members maintain sustainable public finances. But sustainability is a complex issue. The old pact tried, in effect, to reduce fiscal prudence to a single number (3%) for a single variable (the annual budget deficit). The new proposals, by contrast, look at the public finances in the round. They take account of where a country stands in its economic cycle and how much debt it carries, as well as how big a deficit it runs in any given year. The new version of the pact sacrifices the legal virtues of clarity and predictability—everyone knew what the old pact meant and where they stood in relation to it. But in doing so, it sheds the old pact’s economic clumsiness and perversity....

The commission also wants to shift its focus from the size of a country’s deficit to the sustainability of its debts. Italy, for example, is bearing a debt burden worth more than 106% of its annual output. In July, its sovereign credit rating was downgraded. Its finance minister had resigned a few days before, remarking that “it is difficult to manage the world’s third-biggest debt pile without being its third-biggest economy.” And yet Italy escaped censure under the old stability pact, because its annual budget deficit remained within 3% until this year. By resorting to ad hoc measures, such as privatisations and tax amnesties, it sidestepped the stability pact without ever addressing the underlying weakness of its finances.

How much debt is too much? The commission will work on the loose presumption that debts should be below 60% of GDP, or headed in that direction. But again, it will not be able to rely on a single number. Some countries can sustain a higher debt ratio than others because they have a higher underlying rate of growth, for example; and some countries’ finances are in worse shape than they seem because of the future cost of pensions that have yet to appear on their balance sheet. The commission’s judgment will always be open to question, critics of the proposals say; indebted governments will always find some factor the commission has overlooked. Maybe so. But at least the new fiscal framework forces the commission and the euro area’s finance ministers to exercise their judgment, rather than relying on an arbitrary rule.

The old pact was politically divisive. Some, such as Mr Prodi himself, thought it stupid. Some thought it sensible but not credible—it threatened countries with fines, but never followed through. Others complained that the threat of punishment was only credible for smaller countries, such as Portugal, not big powerful ones, such as France. The commission hopes its new, revised pact will work by consensus and “peer pressure”. It puts its faith in political persuasion, not quasi-judicial punishments.

So what does this mean for the debate over whether the EU is an international organization or a supanational one? I argued last year that this type of outcome would undercut the supranational line of argumentation. However, because of the underlying problems with the policy that was at issue, this outcome may be overdetermined.

posted by Dan on 09.07.04 at 01:18 AM


Keeping Debt under 60% of GDP sounds like a reasonable place to start, but I assume that PBOs are ignored.

posted by: Joel B. on 09.07.04 at 01:18 AM [permalink]

It shows that the bigger countries can treat it as an international organization while the smaller countries get bullied as if it were a supra-national organization. The stability pact was enforced until Germany and France started violating it.

posted by: Sebastian Holsclaw on 09.07.04 at 01:18 AM [permalink]


posted by: lex on 09.07.04 at 01:18 AM [permalink]

I have a nasty feeling that we're looking at a free rider problem here. Interest rates are set throughout the Eurozone by the European Central Bank. Germany is just one country. France is another. Might one or both of these two feel tempted to spectacularly break out of the fiscal straitjacket of the ECB and only suffer the modest consequences of a tightening of monetary policy that's averaged all over the Eurozone? Or would certain other countries simply walk -- or at least raise hell?

posted by: Daniel on 09.07.04 at 01:18 AM [permalink]

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