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EMU and the Growth and Stability Pact (GSP): what’s the link?

Postgraduate Students:

Pazara Maria - Chatzipoulidis Nikolaos

Thessaloniki, December 2012

DEPARTMENT OF BALKAN, SLAVIC AND ORIENTAL STUDIES

MASTER’S DEGREE IN

POLITICS AND ECONOMICS OF CONTEMPORARY EASTERN AND SOUTH EASTERN EUROPE

Instructor : Paraskevopoulos Christos

CONTENTS

1. Introduction

2. Economic and Monetary Union (EMU)

3. Monetary Union and Stability and Growth Pact

4. The Stability and Growth Pact

5. The problem with The Stability and Growth Pact

6. Reforms of the Stability and Growth Pact

7. The need for policy coordination: redistribution and budget transfers

8. Conclusions

9. References

Introduction

Economic and Monetary Union is an advanced stage of multinational integration involving a common monetary policy and closely coordinated economic policies of the member states. EMU is based on a common market in goods and services but is itself necessary for the proper functioning of the common market, as exchange rate variations between Member States currencies hinder trade and investments. In other words one Market one Money .The states are abandoned their sovereignty over the economy in order to have gains from EMU . The purpose of the pact was to ensure that fiscal discipline would be maintained and enforced in the EMU. “EMU fiscal rules reflect the interaction between the multinational nature of EMU and the lack of political authority of federal bank”.Marco Buti

Economic and Monetary Union (EMU)

The Economic and Monetary Union (EMU) that began on 1 January 1999 is the framework not only for monetary policy but also for fiscal policies of the member states that are part off EMU (Hagen, 2002). The Maastricht Treaty played a significant role in the formation of EMU first the treaty set out the timetable for the implementation of Delors Report, the substance of this report was the necessary transfer of powers to the level of the union and put more emphasis on the institutional changes that required that was applied under the 3 stages and the key features of these stages embodied in the treaty. In the first stage should be achieved : complete freedom for capital transactions increased co-operation between central banks, free use of the European Currency Unit and improvement of economic convergence, at the second stage regard the Establishment of the European Monetary , ban on the granting of central bank credit the increase co-ordination of monetary institute policies the process leading to the independence of the national central banks and strengthen of the economic convergence at last at the third stage we have the introduction of Euro, the single monetary policy by the European System of Central Banks, entry into force ERM II and entry into force of the Stability and Growth Pact (European Central Bank, 2012).

Secondly the treaty set out the Convergence criteria for qualifying the EMU, third the treaty set out the European central Bank (ECB) and Fourth it was set out the way that the EMU would operate. (Hix, 1999; Tsoukalis, 1997) Nevertheless the idea of EMU has its roots as back as in the negotiations in the treaty of Rome in 1956. Although the EMU is the outcome of a bargaining, a deal between France and Germany ,the design of EMU is German, and we can realize that through the convergence criteria , the independence of European Central Bank from political control is conducive to maintaining price stability (technocrats over politicians)  for example in Greece the replacement of Papandreou by the unelected former ECB member Papademus an act followed Papandreou’s public commitment to a national referendum on the EU’s bailout proposal, a project vehemently opposed by the European ‘Troika’ (the EU, IMF, and the European Central Bank (Hopkin, 2012). On the other hand the Maastricht formula represents a compromise between the monetarists and the economists (Germans) on the issue of European integration. It pleased the monetarists (French) by establishing a strict calendar for the transitional stages to the EMU and by using monetary policy and the desire for a common currency to compel the European economies acceptance of convergence (mongabay.com, 2012) At last the main ingredient of EMU is the central goal of price stability according to this belief in order to have a stable currency we must have stability of public finances. This belief is interlinked with the German fear that high and rising public debts would undermine the centrals bank ability to maintain price stability and will lead to hyperinflation similar to what happened in 1920s in Germany and in Austria that led to the disaster of World War II (Hagen,2003; Hix, 1999). The Germans hoped that the EMU would be an Optimal Currency Area(OCA) by few members and the euro would be as strong and stable as the Deutschmark. According to Mundell an Optimal currency Area (OCA) exists if the economic benefits of joining or forming a monetary union are bigger than the costs. One of main costs of the monetary Union is the loss of a policy tool which are the independent exchange rates. This macroeconomic tool is used to protect the economies from diversified economic conditions for example one state has economic growth and the other is facing a

recession these varying economic conditions are called as asymmetric shocks. (Hix, 1999; Mundell, 1961) In order to understand what is the role of the Stability Pact and the linkage between SP and EMU its obligatory to examine the asymmetric shocks and how these can be addressed .Asymmetric shocks can be addressed by many mechanisms as 1)Labour mobility 2) Wage Flexibility & Capital mobility 3) Fiscal transfers and 4)Budget deficits (Hix, 1999). Asymmetric shocks also can be addressed through devaluation or revaluation of the currency through low or high interest rates. But in a monetary union this is impossible as the exchange rates are fixed. Fiscal transfers are solutions to asymmetric shocks. Asymmetric shocks can be appeared both at national and regional level can be attributed to a variety of structural differences.

The stability and Growth Pact is one of the pillars of Economic and Monetary Union (EMU) a disciplinary device with a goal to ensure sound budgetary balances and low public debts. (Buti, 1998) The fiscal discipline is ensured by the SGP by requiring each Member State, to implement a fiscal policy aiming for the country to stay within the limits on government deficit (3% of GDP) and debt (60% of GDP), and in case of having a debt level above 60% it should each year decline with a satisfactory pace towards a level below (Wikipedia, 2012).

MONETARY UNION AND STABILITY AND GROWTH PACT

Given the permanent nature of monetary union, there was a need for a set of rules to govern public finances of member states once they entered the Eurozone. To ensure that Eurozone members continued maintain sound public finances necessary for the stability of the euro, the Stability and Growth Pact (SGP) was later established to provide continuity after the economic criteria in the Maastricht Treaty were fulfilled.

While the euro is a supranational currency, the EU has few rules beyond the Maastricht convergence criteria regarding policies in taxation and government expenditure in member states once they joined the euro. The Maastricht Treaty partly addressed this issue with the Excessive Deficit Procedure, but the latter was criticized as vague and unsatisfactory. Article 104c requires governments of member states to avoid excessive deficits and the European Commission, the executive body of the EU, was to monitor deficit levels of each country and report to the Council of the European Union, a body of national ministers from all member states, if there are gross deviations from the reference values. The Council has the power to issue warnings to member states and impose fines as recourse.1

The idea of a more detailed set of procedures to handle excessive debts, or a “Stability Pact” was proposed by German finance minister Theo Waigel in the mid-1990s. Germany had long maintained policy that emphasized low inflation, which had been an important part of the German economy's strong performance since the 1950s and subsequently. The German government hoped to ensure the continuation of that policy, which would limit the ability of governments to exert inflationary pressures on the European economy. Justification for such a pact was twofold: first, excessive debt cannot be financed in public markets and can lead to monetary financings by central banks. Second, a free-rider externality problem exists where debt-ridden countries could overspend to a point where they could demand support from other countries. Given that countries needed to forego control of monetary and exchange rate policies, countries were presumed to gravitate towards the use of fiscal policy and excessive fiscal deficits to manage macroeconomic shocks.2

THE STABILITY AND GROWTH PACT1 Nagai, Victor, Stability and Growth Pact and Fiscal Discipline in the Eurozone, Honor Thesis submitted for the Huntsman Program in International Studies and Business at the University of Pennsylvania, 12 May 2012, pp.13-14 2 ibid,p.14

Two Council Resolutions in July 1997 specified how the excessive deficits procedure under the Stability and Growth Pact would operate. First of all, on the basis of a report from the Commission and the Economic and Finance Committee of the Council, the EcoFin Council judges that a member state has an excessive deficit if its annual government deficit exceeds 3 per cent of GDP, unless there has been a severe economic downturn or an unusual event has occurred outside the control of a member state. The Ecofin Council then makes recommendations to the member state concerned and establishes a deadline of four months for effective corrective action to be taken, which normally means that the deficit is corrected in the year after its identification. If after a progressive notice procedure the member state fails to comply, the Council can decide by a qualified majority to impose sanctions, at the latest ten months after the reporting of an excessive deficit. Sanctions take the form of a non-interest-bearing deposit with the Commission. The deposit comprises a fixed component equal to 0.2 per cent of GDP and a variable component linked to the size of the deficit. Each subsequent year the Council may decide to intensify the sanction by requiring an additional deposit, although the annual amount must not exceed the upper limit of 0.5 per cent of GDP. A deposit may be converted into a fine if the excessive deficit has not been corrected after two years. Also, the Ecofin Council may decide to abrogate some or all of a sanction, depending on the progress made by the member state concerned in correcting the excessive deficit, but any fines already imposed are not reimbursable. 3

THE PROBLEM WITH THE STABILITY AND GROWTH PACT Subsequently, the Stability and Growth Pact places a severe

constraint on a member state running a large enough deficit to threaten the stability of the euro. However, a political decision is needed to impose sanctions. The main problem with the Stability and Growth Pact is that if an asymmetric shock occurs, because of the rules imposed by the Pact, the government instead of running a budget deficit has to find another way to gain money. It has to cut other expenditure programmes or to raise taxes. Raising taxes however will be a major problem for a state at the bottom of an economic cycle. Raising taxes will reduce the competitiveness of an economy because it will increase production and wage costs. Also, raising taxes takes money out of circulation at a time that it is mostly needed, when a state faces an economic crisis. Also the ECB pursues a restrictive monetary policy as defined by the price 3 p.335

stability goal in the treaty and national governments are forced to pursue restrictive fiscal policies because government funds must be close to balance or in surplus. Thus, the Stability and Growth Pact leads to a particular mix of monetary and fiscal policies. This mix is certainly anti-inflationary but if there are asymmetric economic cycles it is likely to be very unpopular in member states with the lowest levels of growth. With divergent cycles, the interest rates set by the ECB will be higher than those needed for a state at the bottom of an economic cycle. In this occasion the state will not be able to borrow money to overcome its economic crisis. Additionally, because of tight monetary policies at the EU level and constraints on national government budget deficits, states are unlikely to introduce structural reforms. EMU would work more efficiently if states reformed their labour markets and welfare states. But structural reforms would produce high unemployment in the short term. Consequently the public would be unlikely to support such structural reforms, unless they were balanced with monetary and fiscal policies to stimulate economic growth.

The contradictions of this policy mix within EMU came in surface in 2002 and 2003. The French and German governments wanted to borrow money in order to tackle the problem of rising unemployment and sluggish economy, knowing that raising taxes or introducing labour market reforms at the bottom of an economic cycle were politically unfeasible. By increasing their borrowing, these governments exceeded the 3 per cent annual deficit criterion in the Stability and Growth Pact. In November 2003 France and Germany were able to secure the support of enough other member states to suspend the excessive deficits procedure. The Commission was astonished with the decision of the member states to practically abandon the Stability and Growth Pact and it decided to take the case to the European Court of Justice. This incident comes in contrast with the description of the Stability and Growth Pact as “Stupidity Pact” by Romano Prodi, the then president of the Commission.4

REFORMS OF THE STABILITY AND GROWTH PACT

In 2005 the EU Council under the pressure of France and Germany relaxed the rules. The EC said it was to respond to criticisms of insufficient flexibility and to make the pact more enforceable. The Ecofin agreed on a reform of the Stability and Growth Pact. The ceilings of 3% for budget deficit and 60% for public dept were maintained, but the decision to declare a country in excessive deficit can now rely on certain parameters: the behaviour of the cyclically adjusted budget, the level of 4

dept, the duration of the slow growth period and the possibility that the deficit is related to productivity-enhancing procedures.

In March 2011, following the European sovereign dept crisis, the EU member states adopted a new reform under the open method of coordination, aiming at strengthening the rules, by adopting an automatic procedure for imposing of penalties in case of breaches of either the deficit or the dept rules. The new Euro Plus Pact is designed as a more stringent successor to the Stability and Growth Pact, which has not been implemented consistently. The measures are controversial not only because of the closed way in which it was developed but also for the goals that it postulates. The four broad strategic goals are: fostering competitiveness, fostering employment, contributing to the sustainability of public finances and reinforcing financial stability. An additional fifth goal is tax policy coordination. With respect to public finances member states commit themselves to enshrining fiscal rules into national legislation and imposing dept brakes on primary balance and expenditures at both national and sub-national levels.5 Additionally, the European Financial Stability Facility (EFSF) was created by the euro area member states following the decision taken on May 2010 within the framework of the Ecofin Council. The EFSF’ s mandate is to safeguard financial stability in Europe by providing financial assistance to euro area member states within the framework of a macroeconomic adjustment programme. EFSF was created as temporary rescue mechanism. In October 2010, it was decided to create a rescue mechanism, the European Stability Mechanism (ESM). The ESM entered into force on October 2012. 6

The need for policy coordination: redistribution and budget transfers

The sovereign dept crisis in the euro area is a symptom of policy failures and deficiencies. The European Monetary Union wasn’t able to adjust to asymmetric economic cycles, especially after the crisis that began in 2008. Many scholars have argued that although there is a monetary union within the eurozone, the problem is the absence of economic policy coordination. Additionally, the absence of sufficient redistributive mechanism and budget transfers constitutes a major problem, which must be resolved in order for EMU to be successful. Varoufakis argues that the European Union’s pretence that a currency union can prosper without a surplus recycling mechanism together with

5 European Council conclusions,EUCO 10/1/2011, in http://www.cosilium.europa.eu/uedocs/cms_data/cocs/pressdata/en/ec/120296.pdf6 www.efsf.europa.eu

the economic inequalities which is growing within Europe constitutes a major problem. Germany insisted that the Treaty of Maastricht must not include a surplus recycling mechanism within its legal framework. If a surplus recycling mechanism existed, according to Varufakis, it would prohibit the economic collapse of countries with high deficits within the Eurozone, which leads to the economic crisis of the Eurozone. Additionally, the absence of such mechanism led the investors to withdraw their investments from countries in recession within the Eurozone and further worsened their economy.7

The operation of the EU has an agreed budget of €141 billion for the year 2011 and €862 billion for the period 2007-2013, this presents around 1% of the EU’s GDP. With such a small budget the redistributive capacity of the EU is small. As Hix indicates and as it happened after the crisis, if asymmetric economic cycles persist, and the EU maintains a restrictive set of constraints on national fiscal policies, there is likely to be a growing demand for interstate fiscal transfers linked to the macroeconomic consequences of the EMU. In the event of a demand shock in EMU, member states in recession might demand an increase in expenditure under the EU’s structural funds. However the decision on this would have to be taken by unanimity and the net contributor member states might not wish the EU budget to be enlarged.

References

7 Varoufakis Yanis, (2012),The Global Minotaur, Greek edition Athens: Livani pp.404-407

Buti, M., Euffinger, S. and Franco, D. (1998). Revisiting EMU’s Stability Pact: a pragmatic way forward. Oxford Review of Economic Policy, Vol. 19, No. 1. Available at: http://arno.uvt.nl/show.cgi?fid=61314

European Central Bank: Economic and Monetary Union (EMU) (cited 24 December 2012). Available at: http://www.ecb.int/ecb/history/emu/html/index.en.html

Hagen, J.von (2003). Fiscal Discipline and Growth in Euroland. Experiences with the Stability and Growth Pact. Center for European Integration Studies, Rheinische Friedrich-Wilhelms-Universität Bonn, Working paper B06. Available at: http://www.zei.uni-bonn.de/dateien/working-papaer/B03-06.pdf

Hix, S. (1999). “The Political System of the European Union”. The European Union Series, pp 278-306

Hopkin, J. (2012). Technocrats have taken over governments in Southern Europe. This is a challenge to democracy. The London School of Economics. European Politics and Policy, 24/4/2012. Available at: http://blogs.lse.ac.uk/europpblog/2012/04/24/technocrats-democracy-southern-europe/

MONGABAY.COM, Germany and the European Monetary Union (cited 24 December 2012). Available at: http://www.mongabay.com/history/germany/germany-germany_and_the_european_monetary_union.html )

Mundell, R. (1961). “A Theory of Optimal Currency Areas”. American Economic Review, vol. 51, pp 657-65

Tsoukalis , L. (1997). The New European Economy Revisited. Oxford University Press, pp 164-172.

Wikipedia: Stability and Growth Pact (cited 22 December 2012). Available at: http://en.wikipedia.org/wiki/Stability_and_Growth_Pact