For several years in a row, the European economy is underperforming and is experiencing growth rates that are seriously below potential growth. This continuing slump in the euro area testifies to the fact that the question is not only how to boost growth potential. Another question that should not be neglected is how to bring economic activity in line with existing (and/or) increasing potential. Lisbon will only be delivered if that question is also addressed.

However, the Commission’s communication on the mid term review of Lisbon does not raise this question. Instead, the Barroso document simply mentions the need for ‘sound’ economic policy making and then refers to the discussions in the Ecofin council on the revision of the stability pact. This implies that it is now up to Ecfin ministers to take the opportunity of designing economic policies that ensure that the economy lives up to its potential. Concretely, this implies strenghthening economic governance by providing an adequate reform of the stability pact.

I. A fact that cannot be denied : The existing Pact is failing to deliver stability

Although the Pact was constructed to ensure that countries would continue to respect and pursue stability policies even after adopting the euro, its track record is poor. On several measures of stability, the Pact simply did not deliver :

Public deficits. In line with the slump, deficits have increased. Since 2000,the euro area deficit has more than doubled from 1% to just below 3% in 2004. Six of the 12 members of the euro area now have a deficit equal or higher than 3%. Outside the euro area, another 8 countries are breaching the 3% figure in 2004.

Imbalance between investment/savings in the private sector. In an ideal scenario, falling public deficits will free up capital savings which are then used by the private sector to increase investments. At present however, and despite the rise in public deficits, the euro area’s private sector has aggregate savings in abundance. Private sector net savings now amount to almost 4% of GDP (up from near zero in 2000). In some countries the surplus of private savings over investments is even spectacularly high. In Germany for example, this private sector savings surplus has now reached 8% (!)of GDP. Such imbalances do not point to a ‘stable’ economic situation. They imply that important resources that could be used to invest and increase Europe’s growth potential are left idle. They also drive up the euro area’s current account surplus (0,7% of GDP) and this further accentuates the existing global financial imbalance (the US current account deficit). This situation is not sustainable and has already led to negative economic shocks (appreciation of the euro to the detriment of Europe).

Perverse incentives on the country level. The Stability Pact was supposed to prevent individual countries from abandoning the culture of stability and ensure continuing low inflation once entry in the euro area was assured. It is however striking to observe that those countries that are not respecting the 3% deficit limit are mostly countries with low inflation (France, Germany), whereas countries where deficits have disappeared are grippling with high inflation (Spain, Finland,Ireland,) [1]. In other words, the Stability Pact is targeting countries that deliver an important contribution in respecting the price stability target of the ECB. At the same time, countries that push euro area average inflation above the ECB’s 2% threshold actually receive good points from European policy makers and certainly no advice whatsoever to cool down their economy by consolidating public finance further. If this ‘logic’ of the SGP is left unchecked, this will lead to further instability : Countries already experiencing economic problems will be forced to push their economy further down the road of disinflation and deflation by applying pro-cyclical tightening policies. And countries already doing well may simply continue to ‘overheat’.

Inflation. In trying not to deviate too much from the Stability Pact, several countries have raised indirect taxes (France on tobacco for example) and administered prices (health reform in Germany). This has slowed down the fall in headline inflation since 2003, thereby keeping inflation in the euro area artificially above the ECB’s price stability target (see graph in annex I). In turn, this has provided the ECB a motive not to reduce interest rates even though economic prospects were grim and the recovery far from certain.

II. Why is the Pact not delivering ?

The basic flaw of the Stability Pact is that it fails to recognize that ‘stability’ can be obtained in two very different ways. Stability in the sense of low public deficits can be reached :

either by following an approach where pre- determined public finance targets are pursued at all cost thereby disregarding the economic context and situation (the ‘bookkeeper’s’ approach).
or by following an approach where the consolidation of public finance is done in close connection with policies that strengthen the ‘real’ side of the economy (growth, employment, social cohesion), thereby also allowing the economy to ‘grow out’ of deficits and debt.

The first approach assumes that the consolidation of public finance only involves limited and temporary costs and that growth will automatically follow once deficits and debt ratios have been brought down. This approach however neglects that debts and deficits cannot be brought down by consolidation progamms as such. Economies also need to grow out of debt.

More specifically :

Interaction between effective and potential growth is not neutral. A prolonged slump in growth (aggravated or not by pro cyclical fiscal consolidation) that keeps the economy operating below potential will drive down the potential growth rate through all sorts of mechanisms (labour market hysterisis, destruction of capital stock,..). However, a lower growth potential also impacts negatively on the sustainability of public finance through lower governnment receipts, higher deficits as well as higher debt ratios (through a nominator and denominator effect). In other words, a counter - cyclical fiscal policy may imply relatively higher deficits in the short run but may actually lead in the medium run to improved fiscal sustainability.

Similar conclusions can be drawn concerning policies that invest in a higher future growth potential. In this case also, temporarily higher deficits will eventually result in higher growth bringing the deficit back down and allowing the economy to grow out of debt.

Structural reform policies do not immediately deliver practical results in terms of growth and new jobs. Many of these structural reforms improve the ‘supply’ side of the economy without much instant reaction (or even a negative) reaction on the ‘demand’ side. Fiscal policy making is then necessary in managing the process of structural reform by bringing aggregate demand in line with (higher) aggregate supply.

The Stability Pact, as constructed at present is too much based on the first approach, the ‘bookkeeper’s’ approach. The ‘growth’ dimension of the Pact is mentioned in the official title but the mechanisms and the focus in practice of the Pact are almost exclusively on respecting deficit/debt targets as such. Less or even no attention is paid to the possible interactions between fiscal policy and growth. The practical experiences of the last couple of years illustrate the problems that result from this :

Member States did not respond to the growth slowdown in a discretionary and pro- active way. Instead of providing a convincing policy answer and preventing the slowdown to unfold itself further, fiscal policy makers have just undergone it. In doing so governments have only given half of the signal that was needed to give the general public. The signal that was needed was that fiscal policy would lift the economy into a strong recovery. However, the signal that was effectively given was that governments would not make matters worse by pursuing contractionary fiscal policy. Between these two signals, there’s a whole world of difference concerning the impact on consumer’s and investor’s confidence. As a result, confidence has remained low, growth has continued to be weak and deficits have gone up anyway.

If, on the contrary, member states would have addressed the unfolding slowdown, not by only preventing the worst outcome, but by addressing it in a convincing way, then the miserable growth outcome of the past years (only 0,6% growth in 2003 !) could have been avoided. In this case, due to discretionary spending, deficits would also have gone up, but this time with real prospects on a convincing recovery. Recall that the cyclical increase in deficits over the past years is estimated to amount to 2% of GDP (OECD), pointing to substantial margins for discretionary policy making at that time.

There is general concensus that Europe needs to invest in innovation and knowledge in order to revamp its economy in the game of global competition. However, the Stability Pact is a major stumbling stone in providing financial room for Europe to invest in the Lisbon prioirities. Europe simply cannot wait to invest in R and D, innovation and skills until deficits are brought down to zero. If there is one reason why member states have not implemented the Lisbon agenda, it is the fiscal straightjacket the SGP is forcing them in.

Monetary union implies per definition a single monetary policy for all member countries. A single monetary policy however may create serious problems when some members countries are hit by an a-symmetric shock and/or when changes in the single interest rates have a different impact on the different countries. The irony is that the euro area is exactly grappling with these kind of a -symmetrical problems because of the introduction of the single currency itself : Germany lost its competitive advantage of finance costs that were lower than in the rest of Europe, while other economies got a serious boost from falling risk premiums in long term interest rates. On top comes the fact that interest rate cuts seem to have a greater impact in economies with flexible housing credits (Spain for ex) compared to Germany for example. This could be one of the reasons why the ECB has not been inclined to reduce rates (further) : For an economy like Germany the impact would be relatively small whereas countries that already have high inflation would be further driven into overheating. All of this leads to the conclusion that such country divergences need to be addressed by country specific instruments such as fiscal policy.
Monetary union has another implication. With EMU, Europe is experiencing historically low inflation. This becomes highly relevant in the context of structural reform of the supply side of the economy. Maybe it is true that in the long run ‘supply will create its own demand’. However, this process functions through wage moderation bringing prices down to levels where aggregate demand and supply are back in equilibrium. The problem in EMU however is that inflation is already very low so that further disinflation coming from wage moderation and structural reform may very well tip the economy into a typical ‘keynesian’ deflation trap. Unless of course fiscal policy makers, not being constrained by ‘rigid’ rules, step in and act.

III. Are Commission and Ecofin proposals giving growth a chance ?

In August 2004, the Commission presented proposals to address the conflict with member states over the application of the Stability Pact. At first sight, these proposals seem to go in the right direction. They stress that countries are not the same and that the application of the SGP should take country specific circumstances and economic developments into account (no ‘one size fits all’).Also, it is being recognized that the definition of ‘excessive deficit’ (-2% growth in one year) is too strict. In this way, some flexibility in the SGP may be introduced.

However, the Commission’s communication is also introducing elements that could make the Pact even more strict. By making the debt criterion ‘operational (for example by defining the desirable rate of reduction of debt) and by evaluating debt ratios in the context of ageing and future pension liabilities, the ‘bookkeeper’s’ logic may well be strengthened.

Meanwhile, first reports from the discussions in the Ecfin council seem to confirm that the debt criterium in connection with the ageing/pension challenge are being considered as overriding priorities in the reform of the SGP :

While continuing to refer to a zero deficit or even a surplus, the medium term objective for the public deficit would now also depend on the rhythm with which debt should be reduced. This ‘desirable’ rhythm of debt reduction in turn depends on the initial debt level of the country and on the national specifics of the ageing challenge.
In the short run, deviations from the medium term objective would be possible for countries engaging in structural reform (read : switching from public pension schemes to privatised capitalisation schemes ?) or economies in need of public investment, provided these countries have a low level of debt or high economic growth. (Does this also imply that countries would first have to realise the medium term objective before being allowed a deviation from it ?)
In determining the period of time for countries to correct their excessive deficit, the cyclical situation and the debt ratio should be taken into account.
The definition of ‘exceptional circumstances’, allowing a deficit higher than 3% not to be qualified as an ‘excessive’ deficit, would now concern a recession, that’s to say any period of negative growth instead of a negative growth rate of at least - 2%.

Striking in all these proposals (except the last one)is the fact that all of the measures that could ‘flexibilise’ the existing SGP somewhat and introduce a certain balance between considerations of growth on the one hand and short term fiscal concerns on the other hand are systematically linked with the problematic of debt and the challenge of ageing. In this way, the ‘flexibilisation’ of the SGP will not provide many, if any, possibilities to introduce a more balanced approach. If the intention is to take the existing economic divergence into account in the implementation of the Stability Pact, and if this is being done primarily through the criteria of debt ratios, future pension liabilities and ageing, then the new Pact may well in practice introduce a fiscal straightjacket that is even more biting (and less realistic !) than the existing one.

Fiscal sustainability is indeed a worthy goal. But again all depends on the way how this goal would be achieved. If it’s simply by stressing ‘debt ratios/pension liabilities’, thereby ignoring the role fiscal policy making can play in ‘growing out of debt’ then several other key points will be missed :

Debt ratios only represent one coin of reality. If behind an increase in public debt is an increase in a country’s capital stock ( investments in infrastructure, in communications networks and in the education/skills level of te labour force), then this implies that future generations not only inherit increased public debts, they also inherit improved public assets that are crucial for future development and productivity.
It would indeed be wrong to pretend as if the ageing challenge did not exist. But the current approach, decided by European ministers, is to tackle this ageing problem not only by reducing debt ratios but also by increasing employment rates and reforming pensions. Current proposals focus on the first (and probably also the latter) approach, while neglecting the contribution fiscal policy can and should make in investing in a more efficient labour market that allowing higher employment.
Finally, focussing the SGP and fiscal policy making throughout Europe on debt objectives in connection with pension liabilities and ageing is not the signal that the economy at this moment needs. At this moment, the economy (the private sector) is already saving to such an extent that it is blocking the recovery. Making debt/pensions and ageing the focus of the new SGP may very well lead to further insecurity and increase fear amongst workers. In turn, private precautionary savings may rise further or remain at high levels, thereby continuing to weigh on growth. This would be the absolute paradox : a new SGP that is more ambitious than the previous one and that, exactly because it is so ambitious, leads in practice to increased public deficits , lower growth and higher public deficits.

Another remarkable consequence of the current proposal to revise the Stability Pact is that countries experiencing high growth would be allowed to run short run deviations from the medium term deficit objective. This runs completely counter to the logic of bringing fiscal policy in line with the business cycle.

Finally, the proposal to consider any negative growth rate as an exceptional circumstance is to be welcomed. But again, the question is whether this step in the right direction is sufficient. An economy growing several years below its potential rate (as has been the case in the euro area over the past years) can be seen as being in a more serious situation compared for example to an economy that experiences one year of (slight) negative growth after having grown for several years over its potential growth rate.

Bring Maastricht back in line with Lisbon. The discussion on the Stability Pact can not continue to ignore any longer that ‘Maastricht’ as it exists today is not compatible with ‘Lisbon’. Europe simply can not afford to wait to do the necessary investments until deficits have been reduced to zero. The innovation and knowledge gap Europe has needs to be addressed and it needs to be addressed now. Pressure from the Commission or the Council on member states to ‘implement Lisbon’ is simply not credible when at the same time the fiscal framework Europe provides is prohibiting member states from making the necessary investments. The European Council should acknowledge this crucial issue and declare that the present European deficit in innovation is a ‘special circumstance’ allowing a temporary deviation of for example 0,5% of GDP from the traditional fiscal rules so that member states can invest in those areas that are crucial to the Lisbon agenda (research,innovation, ensuring broad access to education and lifelong learning, investing in infrastructure and eco- innovation....). However, in implementing this care should be taken not to boost economies that are already overheating.
Implement a real Growth Initiative. This ‘temporary deviation’ should not be a ‘free lunch’ for member states but should be followed up closely by the Commission ,the Council and the Parliament. This can be done by reviving the growth initiative. This growth initiative, as presently constructed, does not work. Its impact is too limited (0,05 to 0,1% of European GDP) and from the 30 quick start European projects that were identified end 2003, only two projects have really started. Instead, member states should be invited to present national plans for economic recovery’ that increase investments in Lisbon priority areas such as education, research, renewable energy projects, infrastructure and training by 1% of GDP. The European level should then provide coordination to make sure that all member states effectively follow up their national plan for recovery.
A Stability Pact that really ‘bites’ in the economic upswing. Investing in Lisbon through these measures will rekindle growth. And once the self sustaining cycle of growth/investments is back, then fiscal policy should indeed take the route of stabilisation. Experience from the late nineties (when the Commission never gave a single budge when some member states, despite good growth, openly declared to postpone the zero deficit target from 2002 to 2006 in order to finance competitive tax cutting) testifies that Europe needs clear rules and procedures that force rapid deficit reduction in good economic times. There are several possibilities to do so :

Switch from deficit targeting to expenditure rules. Deficits are very misleading as a tool for fiscal policy. In good economic times, deficits fall automatically so that governments can use part of the automatic fall, use this for additional measures the economy does not need at that moment and still present a somewhat falling deficit. Expenditures rule (if corrected for the impact of the business cycle on social expenditure) combined with a rule to keep government revenue stable avoid this trap.In this case, the upturn automatically translates itself in higher revenue, lower spending and lower deficits.

Install national stability reserve funds. Here, the principle is that in any upturn, governments should put aside the extra resulting revenue in a special fund, to be used for a future downturn. Guidelines and recommendations from the Commission are necessary to follow up on the good practice of member states.

A European Stability Fund. An even stricter version would be to construct an European level fund. Every member state enjoying growth above potential or above trend would be invited to deposit the extra revenue into this European Fund, managed by the Commission and in cooperation by the EIB. Again, if the economy turns, then these funds can be liberated for the member states.

Stronger economic governance for a strong economy. It is of most importance that the Ecofin/Europan council goes beyond making some corrections to existing fiscal rules and resists the temptation to focus on some technocratic rules that cause difficulties for the relationship between the Commission and some member states. Instead, the opportunity should be grasped to redefine the place and role of fiscal policy making in relationship to other policies (wage policy, monetary policy). In other words, the aim should be to strengthen economic governance, ensuring better interplay between individual countries’ fiscal policies and with monetary policy makers in particular. This can be done by :

Presenting a single and consolidated budget for the euro area as a whole. In this way, it is made clear that discussion between fiscal and monetary authorities (the ECB) should focus on fiscal policy of the euro area as a whole and not on individual member states. At the same time, this opens up the possibility to get national fiscal policies into line with national economic situations by using criteria to assess whether an economy is overheating or undercooling such as :
the contribution of national economies to euro area wide inflation
the presence of an important private sector savings/nvestment imbalance providing net savings to the rest of the euro area.
Countries that record extremely low inflation and/or extremely high private savings surpluses should be viewed as experiencing ‘exceptional circumstances’. Vice versa, countries with high inflation/low private savings should be stimulated to engage in aggressive consolidation.

The discussion between fiscal policy makers and the ECB can be substantially improved by correcting inflation figures for one - off measures resulting from the fiscal policy side. This should be done alongside the ‘euro area budget’ presentation and should correct headline inflation for the impact of hikes in indirect taxes or taxes which influence labour cost directly (increases employers’ social security contributions). In this way, it is made clear for all actors (governments, ECB,wage policy actors, financial markets) to which extent headline inflation rates reflect the economic situation (undercooling/overheating) and to which extent inflation is influenced directly by governmental decisions. Given the strictness of the price stability target in the euro area, where even an indirect tax hike in one major economy may tilt euro area inflation over the 2% threshold, it is of the upmost importance to clarify this.

Fiscal policy makers should also strengthen coordination amongst themselves by addressing the fiscal competition and dumping that continues to take place in Europe. Again, if Europe wants member states to invest in the Lisbon priorities, then such kind of ‘beggar-thy-neighbour’ games should be addressed.

Fiscal policy can also boost domestic demand without changing the ex ante deficit. This can be done by ‘smart’ Keynesian policies, by changing the mix in government expenditures and revenues, thereby resulting in net additional aggregate demand. Here also, coordination at the European level to ensure that member states implement such policies at the same time is useful.

Debt/ageing stability plans to be written by national governments. Finally, it could indeed be useful that the new version of the SGP also focuses on public debt in combination with the challenge of ageing. However, it is important to avoid an approach where the Commission, on the basis of technocratic models would force member states to respect tightened debt ratios. Instead, member states should choose for themselves which balance they want to ensure between the different approaches to address ageing (lowering public debt, increasing employment, pension reform).