The paper presented provides a discussion and evaluation of the functioning of the fiscal discipline instrument; it was designed in the early 1990’s for inclusion in the Maastricht Treaty, refined in 1997 with the creation of the Stability & Growth Pact (hereafter, ‘SGP’), and reformed in 2005. Assuming that we need it for reasons rehearsed in literature, the SGP will be evaluated and discussed in relation to its effectiveness to date. Although case law is not studied extensively, a brief overview of the SGP crisis in 2003 will be provided, followed by a legal/economic analytical framework perspective with the SGP examined under the lens of soft and hard law primarily. With the legal principles exposing the economics behind the SGP, the rules and discretion debate is followed supporting evidence that the current framework has proved to be inadequate. The methodology continues to analyse the SGP framework with a particular focus on the economic crisis of Greece. The lessons illuminated from this particular case study will further provide possible recommendations to help the SGP become a more effective regime, in face of ageing populations and a need for growth enhancing forms.
While monetary policy is delegated to the European Central Bank (ECB) who face a challenge of convincing speculators that they are serious about the maintaining of exchange rate stability and that they will not use the option of devaluing (Jacquet 1998), fiscal policy remains in the hands of national authorities. Member States (MS) should however, according to the Treaty on European Union (hereafter, Maastricht) comply with the principle of sound public finances. To ensure this, the Treaty presents a no bail-out clause which prohibits the ECB, and other nations of rescuing a MS in financial trouble. This was further protected by the introduction of the Stability & Growth Pact (SGP) which further specified rules and procedures.
A primary source of European Union law is provided for by the power-giving EU treaties which set broad policy goals and establish institutions that, amongst other things, can enact legislation in order to achieve these goals. The SGP is precisely this further legislation that is required to give force and credibility to the Treaty. The legislative acts of the EU may come in two forms; directives and regulations. In the case of the SGP, it consists of two council regulations 1466/97 and 1467/97 which are directly applicable and binding in all MSs without the need for any further domestic legislation.
The fundamental objective for the SGP is to identify excessive deficits and end them as soon as possible. However, the SGP, in its original, reformed and current form is not effective. Whilst initiating debt and deficit cuts, it fails to stimulate and enhance growth. It has no end to criticisms in applying fiscal discipline. This has led to not only the SGP crisis facing the European Court of Justice in 2003 where the Economic and Financial Affairs Council (ECOFIN) failed to impose sanctions on delinquent MSs but more significantly the recent crisis of Greece, where the failure of the SGP to discipline their budgetary discipline has led to spiralling debts forcing the EU to possibly ‘eat its own words’ in relation to the ‘no bail-out’ clause. This not only undermines the credibility of the SGP as a framework, but calls into question the functioning of the European Monetary Union as a whole. With the pact being described as an operational recipe and repeatedly being considered as too weak, will this finally spur policy-makers into producing a much harder pact?
2. Designing, Building and Naming the Ship – From Maastricht to SGP
The aim of the following chapter is to provide a brief focused review of how the SGP framework was formed.
The debate leading up to the creation of the SGP began long before the Maastricht treaty was signed in 1992. After the experience of the 1970’s and 1980’s it became clear that a new focus was required on medium term stability and fiscal discipline, and it became certain that there was a need for institutional mechanisms. In particular, the absence of a fiscal rule meant that the free rider problem was feared as MS’ may be tempted to run excessive deficits in the expectation that the Monetary Union will bail them out (Begg & Schelkle, 2005). Later, this became the one of the most compelling rationales for the SGP; to prevent the European Central Bank (ECB) from being pressurised for an inflationary bail out (Eichengreen & Wyplosz, 1998).
In 1989, The Delors Committee composed of central bankers reported that economic and fiscal decisions “would have to be placed within an agreed macroeconomic framework and be subject to binding procedures and rules” (Delors Report, 1989). This would also help to avoid differences in public sector borrowing requirements between MSs and present obligatory constraints on the size of budget debt and deficits (Delors Report, 1989), therefore limiting the use of fiscal policy itself. This not only combined but reflected both the Keynesian coordination and fiscal discipline arguments.
The vital question was how? The European Union (EU) was faced with key players representing different rationales. Whilst France wanted an ‘economic government’ the Germans central focus was on price stability, and they were adamant that excessive deficits must be avoided. Thus the result was the Treaty on European Union 1992. Whilst Article 99 states that MSs shall regard their economic policies as a matter of common concern and shall coordinate them with the Council, Article 104 states that “Member States shall avoid excessive government deficits”. The Treaty requires MSs to satisfy two fiscal convergence criteria to qualify fully as EMU members: to keep general budget deficit/GDP below 3% and nominal gross debt/GDP below 60% (Article 104c & Protocol) (hereafter the ‘rules’ of the SGP).
Furthermore, the excessive deficit procedure (EDP) is defined and shaped by the interaction between the Council and the Commission. For Euro MSs, this can lead to financial sanctions because of possible negative spillover occurring throughout the Monetary Union as a result of established excessive deficits. However the procedure, as laid down by the Treaty, is in no sense mechanistic. Ultimately it leaves the discretion of whether to take action to the Economic and Financial Affairs Council (ECOFIN). The EDP protects MSs from action in the form of ‘forgiveness clauses’ which accommodate deviations from the rules, for example resulting from an idiosyncratic shock, given that MSs meet specified conditions. This means MSs are still able to participate in EMU (Article 104(c) 2a & Article 104(c) 2b). For the debt ratio rule, the escape clause is ambiguous in its wording as the ‘satisfactory pace’ for approaching the reference value has not been defined and this has been interpreted very freely and at the discretion of each MS. It has proved difficult to devise a formal rule covering all possible events. It was interesting to note, that the SGP provided a further detailed specification regarding the interpretation of the deficit ratio emphasising the importance placed on it, yet it remained silent on the debt criterion. This can be interpreted as the SGP effectively overlooking the debt/GDP ratio as being unimportant in the application of fiscal discipline.
As Maastricht aimed at bringing into line the states whose fiscal history in previous periods had given rise to problems, Maastricht offered a great incentive of joining EMU successfully. However, pessimists worried that ‘Maastricht fatigue’ would set in once countries were admitted to EMU. It was thought that countries had been forced to suck their stomachs in to squeeze into Maastricht’s tightly tailored trousers, but upon EMU entry, they would expel their breath violently (Eichengreen 1997). Beyond doubt, a further mechanism was required to ensure that MSs sustained compliance. The EU faced two options; they could either continue to rely on voluntary agreements where MSs agreed to meet convergence criteria after EMU was fully operational or the EU could impose explicit rules that would elaborate on and give further instructions from Maastricht. Although the introduction of the SGP implied that the EU chose the latter, it soon came to light that in fact the EU had implicitly chosen the former.
The Original Stability and Growth Pact
Prior to the introduction of the Euro, the German government became extremely anxious about giving up the reputable Deutschmark in favour of the new single currency that would include fragile economies who lacked stability culture. Germany already maintained a low inflation policy, and through the SGP the German government hoped to limit the pressure other MSs could exert on the European economy. They hoped to remove the margin for discretion left by Article 104 of Maastricht by ensuring that the EDP would be implemented according to a predetermined timetable and the eventual sanctions would be levied according to a predetermined formula (Costello, 2001). However such an automatic sanctioning mechanism was considered inappropriate by some MSs.
In 1996, the SGP was finally concluded as being “far less mechanical than the initial proposal” (Fischer et al 2006). Based on two council regulations, it took the force of law, with decisions to be taken within the original standard legislative framework of the Treaty. Fiscal policy remained decentralised but the SGP hoped to combine restraint with flexibility, whilst representing a backbone of fiscal discipline in EMU to primarily address negative spill-over’s from MSs (Fischer et al 2006). Although the Commission reserved its ‘right of initiative’, the Council ultimately retained discretion in making decisions within an overall rule based framework.
Whilst some argued that the SGP was “no more than a clear affirmation of Article 4” (Jacquet 1998), others suggested that the SGP builds on the Maastricht provisions (Fischer et al 2006), by presenting a monitoring process, based on Article 99, which combines surveillance through stability programmes and a quasi automatic warning system for countries suffering from excessive deficits based on Article 104, often referred to as the ‘preventive’ and ‘corrective’ arm.
The preventive arm requires Euro members to submit stability programmes while non-Euro members present convergence programmes. Both are required to include the medium term objective (MTO), and if applicable, an adjustment path towards it. The MTO is required to be ‘close to balance or in surplus’ and the rationale is to ensure sustainable fiscal positions in the long run whilst also creating sufficient room for fiscal policy to smooth out fluctuations in the short run without violating the 3% deficit ceiling as specified in the SGP regulations. Furthermore, it is interesting to note that although the programmes must be submitted to the Commission, it may be examined by the ECOFIN Council which may choose to make its opinion public, and this can be understood as ‘naming and shaming’. In addition, if the Council forecasts a deviance from the budgetary position it may choose to address a recommendation to the respective MS. However this is not obligatory, highlighting the Council’s power as it can take it upon itself to apply peer pressure.
The corrective arm however, in contrast to Maastricht, provides for a much stricter and formal procedure, designed with a rigorous course of action set with time limits, to enforce fiscal discipline in the SGP (Dutzler & Hable 2005). Whilst an excessive deficit is established upon a breach of the 3% deficit or 60% debt rule under the Treaty provisions, the SGP nonetheless focuses on the 3% deficit ceiling.
This is arguably, a mistake on the part of the SGP creators. The inability of monitoring deficits due to difficulty in time lags means that data is imprecise. It can take more than four years to detect disobedience reliably, which means that disciplining MSs is even more unlikely. Therefore, focusing on the debt/GDP ratio would be more sensible. After all, it is the total debt stock that needs to be financed. Focusing on the short term requirement does not do much in preventing MSs from getting themselves into situations where they may need to be rescued as the Greek experience illustrates. Because debt is a persistent stock and not a flow, it can help policymakers in nation states to choose more suitable and reasonable plans, which will help lower the probability of nations facing a crisis such as the one faced by Greece. The persistence of a debt will help give governments an incentive to keep debt at lower levels in order to be able to adjust to unforeseen circumstances more easily. There is a question of how to set that debt limit; but that can easily be done using the empirical work of Reinhart and Rogoff (2009), and others, on the links between debt and growth rates.
Nevertheless, the EDP clarified the following. Firstly, the ‘exceptional circumstances’ are defined as ‘an annual fall of real GDP of at least 2%’ meaning that countries will be automatically exempt from further action. Furthermore, a fall of between 0.75% and 2% may be deemed exceptional if MS provide evidence. The deadline for correction of excessive deficits should be completed in the year following its identification unless there are ‘special circumstances’; these were not defined. As the rules in the SGP are insufficiently flexible, they allow for breaches that ultimately may undermine the operation of the SGP. However, because the procedural steps clarify that the timing between reporting a deficit above 3% GDP and imposition of sanctions should be no more than 10months, it means that, if no corrective action is taken in adequate time to correct the deficit by the year following its identification, sanctions will be imposed. Financial sanctions will be in the form of non-remunerated deposits which will take the value of 0.2% of GDP and rise by one-tenth of the excess deficit up to a maximum of 0.5% of GDP. Additional deposits will be required each year until the excessive deficit is removed. If the excess is not corrected within two years the deposit will be converted into a fine; otherwise it will be returned. Ultimately, this means a MS can run excessive deficits for at least three years before their deposit is converted into a fine.
Although the inability of monitoring deficits is unfortunate, the effect of legal and institutional weight given to the corrective arm means that the short term requirement of keeping government deficit below 3% is treated with much more seriousness than the preventive arm. This is ironic since in practice, the excessive deficit procedure is not properly enforced as no MS has yet been fined. The preventive arm on the other hand is enforced, yet its lack of formal and legal basis and no procedure to punish a failure to comply with the objective of a medium term balance further emphasises the lack of importance placed on the preventive arm. (Rostowski 2004).
3. Soft Law to Softer Law
This chapter will provide a review of the SGP as a form of proper regulation up until the SGP crisis in 2003 which led to the consequent reforms. The hard versus soft law debate will be discussed.
Difficulties facing the SGP after its Inception
Whilst several Euro countries bettered their fiscal outcome by moving their budgetary positions into surplus, others such as Germany, France, Italy and Portugal remained trapped in high deficits (Fischer et al 2006). The implied emphasis on correcting deficits rather than preventing them (because on its sanctioning nature) induced a failure to achieve ‘medium term balance’ meaning that they had little scope to allow automatic stabilisers to operate once economic conditions deteriorated (Rostowski 2004). They were criticised as not being tuned into the pact and this failure of key MSs to respect the requirements of the SGP just a few years after its inception, triggered a heated debate regarding a potential reform on the architecture of the SGP (Fischer et al 2006). Though some may argue that countries would have faired worse had there not been a SGP, the operation of the pact brought to light issues which where nevertheless important. A continued period of low growth levels triggered by the dot-com crisis in 2000, eroded budget balances to the point where fiscal policies had to become strongly pro-cyclical to respect the 3% limit (Wyplosz, 2008), highlighting the fact that the SGP encourages pro-cyclical behaviour. In addition, the SGP discouraged growth and economic reform, most importantly in the labour market. REFERENCE?
Although these are major criticisms of the functioning nature of the SGP itself, what’s more is that the SGP is perceived as being contradictory; although created as hard law it takes the effect of soft law. With a legally binding nature, there should be little room for discretion, however as mentioned the sanctioning is not automatically applied (Schelkle 2005) to countries who are in breach of the EDP but rather, the members of the Council are required to vote, and only by qualified majority can countries be declared to have excessive deficits (Rostowski 2004). The council composing of finance ministers from MSs, implies that not only is ECOFIN dependant but it is also partial (Schuknecht 2004). As concluded by Eichengreen and Wyplosz (1998), the SGP will in this respect have some, but not maximum, effect. As long as imposition of sanction remains a political decision in the hands of national governments, it is highly unlikely that large and influential states will be punished (Rostowski 2004). This was proven in the European Court of Justice (ECJ) crisis of 2003. Due to the fact that EU officials will be reluctant to levy fines and lose goodwill, EU decision makers will compromise, allowing the 3% deficit ceiling to be violated. MSs will be reluctant to incur fines and suffer embarrassment, and therefore governments will also compromise by modifying their fiscal policies just enough to obey the rules, and avoid forcing the EU to impose sanctions. Thus although the lack of hard law perhaps implies that the sanctions were to act as a deterrent for MSs from violating the rules, the presence of the sanctions which will ‘never be imposed’ provides no incentive whatsoever for countries to comply with fiscal discipline. This is not only in the best interests of the respective MS but for the best interests of EMU as a whole. Furthermore fines may adversely affect a MS, causing conditions to worsen, leading “to recrimination and dealing a blow to EU solidarity” (Eichengreen & Wyplosz 1998). It makes no sense to place emphasis on penalising MSs after the rules have been breached; rather the EU needs to do more to prevent these breaches from occurring.
Not surprisingly, to date no country has yet incurred fines. Evidence suggests that the SGP has created divergence between different sized MSs (von Hagen 2005). With the three largest countries seemingly unwilling to push for underlying balance, the Pact seems to have worked well for a group of smaller countries (as well as Spain) (Annett, 2006). This demonstrates that enforceability is not uniformly weak; generally small countries have respected the SGP provisions, the only exception being Portugal (Rostowski 2004). This suggests that either enforceability needs to be applied equally, or the pact must regain the support of the larger MSs, especially Germany and France who fought for the creation of the pact. Perhaps a more vital question is why the pact lost support of the key players in the EU. If governments do not believe fines will be imposed in bad times, what incentive do they have to run fiscal surpluses in good times? The following SGP crisis was therefore inevitable.
The Original SGP Crisis
In 2003, Germany and France established excessive deficits. However, the European Council (described as the ‘dozing watchdog’ in Heipertz & Verdun 2004) voted to hold the EDP in abeyance as it is permitted to do so by the articles in the Maastricht Treaty, causing great uproar for the ‘existence’ of the pact. As described by Begg & Schelkle (2004), “The ECOFIN council decision was widely interpreted as the death-knell for the Stability & Growth Pact.” The Commission challenged this decision by presenting the case to the ECJ whose judgement left many unanswered questions. This in turn led to legal uncertainty and the loss of credibility for the EU fiscal framework (Dutzler & Hable 2005).
More specifically the Council stated that France & Germany had established excessive deficits. In the case of France, Council recommendations on basis of art 104(7) set a deadline for taking appropriate measures to reduce their deficit. Once the deadline was reached, the Commission observed France had not taken effective action upon the recommendations (Dutzler & Hable 2005). The case of Germany differed slightly; although another deadline was established, in face of the economic slowdown facing Germany, the content of the recommendations was moderate. Upon reaching the deadline, Germany had, from the Commissions point of view, taken inadequate measures to implement Council recommendations. Thereafter the Commission issued further recommendations to the Council in order to advance with proceedings with regard to both MSs, and in particular, to take action in face of art 104(8) and art 104(9) EC respectively (Dutzler & Hable 2005). Although, from the Commission’s point of view, this should have resulted in the Council immediately resuming the EDP (Dutzler & Hable 2005), the Council upon voting, chose to suspend the EDP for both Germany and France. This decision was not unanimous; most of the smaller countries (who incidentally hold better fiscal positions) voted in favour of the Commission’s recommendation, but the larger countries formed a blocking minority (Fischer et al 2006). As commented by Dutzler & Hable (2005), in essence, the ECJ had to deal with two claims by the Commission. On one hand it was asked to annul the decision of the Council of not adopting the formal instruments contained in the Commission’s recommendations pursuant to art 104(8) and 104 (9). On the other hand it was asked to annul the Council’s conclusions, because it involved the decision to hold EDP in abeyance.
The Court, in its judgement, demonstrated an appreciation of both parties. It ruled that the Council can and must hold the EDP in abeyance if the majority in Council does not vote to sanction the MS in question. However, it ruled in favour of the Commission in stating that the Council cannot adopt political conclusions (Dutzler & Hable 2005).The judgement proved fatal to the existence of the pact as it failed to address important questions and clarify the institutional balance of powers between the Council and the Commission. It not only called into question the political willingness of countries to adhere to the prior agreed fiscal rules but it remains unsettled if the issue is to arise again in the future. Although Dutzler & Hable (2005) comment that it remains unclear whether the EDP can be continued without the Council’s approval, it is likely that the sanctions will never be applied without the backing of MSs as this would never be politically accepted. Therefore the question of whether the SGP effectively enforces MSs to obey fiscal rules is brought to light. The extent to which the system of fiscal surveillance and economic policy coordination binds the MSs and institutions remains unclear. The 2003 crisis called for a refocusing of the SGP and a need for political agreement opening the path to reform the SGP architecture (Begg & Schelkle 2004), as supported by many of its critics.
Question of Reform?
To restore the credibility of the so called ‘hard-law’ fiscal coordination, in 2004 the Commission “suggested that an enriched common fiscal framework with a strong economic rationale would allow differences in economic situations across the enlarged EU to be better catered for and would contribute to greater credibility and ownership of the SGP in the MSs building on the culture of sound fiscal policy established in the EU over the last decade” (Commission 2006).
In 2005 the reforms took place (legal provisions in EU Council (2005a,b)). The revised version arguably offers some answers to what was known as the inadequate SGP. There are changes in the preventive/corrective arms and the EDP, for example a variety of standards such as the position in the cycle, the nature of expenditure and the level of public debt must be taken into account to calculate whether a MS is in breach of the 3% deficit rule (Couere & Pisani-Ferry, 2005), emphasising further flexibility. Contrastingly, there are no changes in governance. The voting methods and basic procedures remain the same, as changes to these would require modifications to the Maastricht treaty. Though the changes are welcomed (Fatas & Mihov 2003), the SGP may still be identified as the ‘dog that would never bite’ (Heipertz & Verdun 2004). For many critics, it was unruly that a softer pact was coming into existence, as a harder pact was desirable. However the Commission role has been strengthened considerably in that it can now give early policy advice and is under obligation to file a report if a budget deficit has been violated.
The changes are summarized in Table 1.
All MS have an MTO of
“close to balance or in
differentiation of MTO
depending on debt level and
potential growth, allows for
1% deficit if debt is low
In case of Deviation
No adjustment path or action
Commission can issue direct
“early policy advice;”
adjustment path specified as
a minimum fiscal effort of
0.5% of GDP and countercyclical;
structural reforms can be
taken into account to allow
Monitoring if Deficit
No obligation for
Commission to prepare
no mitigating other relevant
factors (ORF) specified
Commission will always
prepare report, taking into
– deficit exceeds investment
– ORF can justify
No specific provisions
debt can be taken into
Systemic pension reforms
can be taken into account
for five years if reform
improves long-term debt
Excessive deficit must be
fixed in year following
identification; if not, a noninterest
bearing deposit must
be made with the
Commission that is turned
into an “appropriate size”
fine if situation persists; No
‘minimal fiscal effort’
defined; No repetition of
Correction can be postponed
for one year if ORF applies;
Minimal fiscal effort of
0.5% of GDP to reduce
excessive deficit required;
Deadlines for correcting
deficit can be extended if
necessary steps are taken or
if unforeseen adverse
Table 1: Schelkle 2007
Analysis Under Soft and Hard Law
Hard law instruments can be distinguished from soft law in that they are fully binding. When MSs do not comply with these laws they are breaking the law and may be sanctioned accordingly. Contrastingly soft law instruments are negotiated in good faith and provide a new framework for cooperation between MSs. Whilst favouring openness and flexibility, policy processes follow a codified practice of benchmarking, target setting and peer review. This allows national policies to be directed towards certain common objectives. The essence of it is not to provide a single common framework but instead to share experiences and to encourage the spread of best practice. By avoiding regulatory requirements, it allows experimentation whilst fostering policy improvement and possibly policy convergence. These can be seen as managing techniques which provide means to promote policy coordination without further undermining sovereignty. An example in the general EU context is the OMC method used under the Lisbon strategy. Whilst soft law is easy to agree on but hard to enforce, hard law instruments on the contrary are difficult to agree on but easy to enforce. According to Wessels and Linsenmann (2001), EMU introduced both hard coordination in fiscal policy in the form of the SGP and soft coordination in economic policy in the form of Broad Economic Policy guidelines (BEPG). If a country deviates from the guidelines the Council can – as in the case of Ireland – adopt a non-binding recommendation against the respective MS (Jacquet &Pisani-Ferry 2005). Unlike the EDP, the guidelines are not supported by any sanction. However, there is a fixed format of reporting and a predetermined timetable is followed, rather than allowing for ad hoc decisions by policy makers that set the agenda for discussion and action. Therefore, upon this insight, it suggests the SGP takes the form of hard law in that it is legally binding, but soft law in that enforcement is not automatic. Of course there are many shades of softness in the SGP framework. The preventive arm with it’s close to balance or surplus provision, without sanctions is rather soft. By contrast the corrective arm with the ultimate threat of sanctions comes much closer to hard law (ESB working paper 2004.)This is not effective as it implies that only when things are wrong, is it time to sanction and this is an ultimate downfall of the SGP design.
It is therefore confusing that following the reforms, critics claimed that the ‘hard law’ institution for fiscal surveillance has become soft. Furthermore, critics claim that the SGP has become so soft that the functioning of the SGP is jeopardized (Schelkle 2007). Schelkle (2007) refutes this claim by arguing that the revised pact will be better suited in constraining MSs in their fiscal behaviour since the new rules will be perceived as binding constraints that shape domestic efforts. An apparent paradox exists; the weakening of obligation to the pact may in fact make it difficult to evade, although it implies a softening of the governance framework.
Abbott et al (2000) have proposed that there are three dimensions of governance – all of which characterise the degrees of legislation; obligation, delegation and precision. This allows one to compare and contrast the original SGP with the reformed version for effectiveness of instruments and for the relationship between these dimensions. Obligation has been defined as a commitment arising under rules. At the two ends of spectrum, hard law is defined as sanction-able obligations whereas soft law are norms which are too general to create specific duties. Delegation, whilst at the hard law end of spectrum would mean an international court or organization given powers to resolve a dispute, contrastingly with the soft law end, which implies diplomacy. Precision defines whether a rule indicates the type of action that needs to be taken and by whom it needs to be taken in order to comply with the rule. For example, the BEPG state the objectives, but not how these objectives could be met. As the following table summarises the changes from the original to the revised pact, it can be understood the changes were not a uniform move from hard to soft law.
high to medium:
Quasi-automatic sanctions under
EDP but political de