Sound public finances – a key factor for achieving stable money

Sound public finances on a sustainable basis are essential for a stable currency. For this reason, budgetary rules were introduced as a key fundament of a stability-oriented European monetary union. After the first ten years of EMU, the results in terms of budgetary discipline are mixed. Overall fiscal policy developments during the past few years have not come into conflict with monetary policy objectives.

However, the EU modified the Stability and Growth Pact in 2005, allowing the rules to be applied more loosely and flexibly. The pact thus lost some of its transparency, clarity and “bite”. Some euro-area countries do not comply sufficiently with the rules. In the present situation, it is particularly striking that, contrary to the rules of the pact, only partial use was made of the cyclical upturn to put public finances in order; consequently, a number of countries now have considerably less fiscal policy leeway in the current downturn. Now of all times, confidence in sustainable public finances must not be lost. For this reason, joint efforts to maintain the credibility of the fiscal policy rules and an appropriately strict implementation are needed.

If government debt is high, there is a danger that politicians will pressurise the central bank to loosen its monetary policy, ie allow or bring about excessive inflation so that, among other things, the real value of the debt and, by extension, the cost of government debt servicing are reduced.  Moreover, one member state in a monetary union having excessive government debt can have negative consequences for the others: it may lead to a rise in the interest rate for government bonds throughout the currency area, thus increasing the cost of debt servicing for the other countries. In a monetary union, it is therefore particularly important to establish rules for preventing excessive deficits, with penalties for non-compliance (sanction mechanisms).

In the Maastricht Treaty, the EU member states agreed upon provisions for limiting government borrowing: ceilings of 3% of GDP for general government deficits and of 60% of GDP for general government debt. The Stability and Growth Pact – adopted in 1997 and reformed in 2005 – specifies these provisions. A monitoring procedure helps to identify undesirable developments in individual countries' fiscal policy at an early stage. All the countries have to keep their budgets close to balance or with a marginal surplus in structural terms – ie especially after the exclusion of cyclical factors. Furthermore, the amendment in 2005 stipulated the procedure for dealing with countries that do not apply the rules or apply them selectively and thus do not sufficiently reduce excessive deficits (“budget transgressors”). The list of sanctions ranges up to fines of billions of euros. One flaw in the pact was – and is – that these sanctions do not come into force automatically but depend on the ECOFIN Council’s evaluation, meaning that (potential) transgressors pass judgement on fellow transgressors.

How has the Stability and Growth Pact performed after the first ten years of the euro? One positive factor is that debt in relation to GDP (the debt ratio) has fallen in many euro-area countries since 1999 (see chart 1). However, in 2007, the debt ratios of seven of the 15 member states were still above the reference value of 60%, in some cases significantly. In 2007, all of the euro-area countries apart from Greece had a deficit ratio of below 3%. By contrast, eight member states were still failing – in some cases, by a wide margin – to meet the medium-term objective of a structurally close to balance budget. Some member states failed to make adequate use of the boost provided by the favourable economic conditions and revenue developments during the past few years to bring about a structural improvement in their budgetary positions. In the current downturn, all of the countries face the threat of a substantial deterioration in their budgetary positions.

Some countries did not even take advantage of the “New Economy boom” at the beginning of monetary union to consolidate their budgets. In the wake of the subsequent slowdown, they soon exceeded the deficit limit. At times, the three largest euro-area economies (Germany, France and Italy) all had excessive deficits simultaneously (see chart 2). In this situation, the finance ministers were unable to reach an agreement on how to implement the Stability and Growth Pact appropriately and instead approved its reform. This allowed the rules to be applied more flexibly and increased the scope for political discretion, which impaired transparency and weakened commitment to the rules.

The current downturn and the associated countercyclical stabilisation measures will be the acid test for the revised pact. In these circumstances, member states that have achieved the aim of a structurally balanced budget have sufficient leeway to allow the automatic stabilisers to take effect. They can tolerate the deficits caused by the cyclical decline in tax revenue and increase in expenditure without exceeding the reference value of 3%. By contrast, member states with budgetary deficits of close to 3% of GDP generally have less leeway for automatic – let alone discretionary – stabilisation measures.

In the present situation, it would be wrong to “water down” – or even “temporarily” suspend the rules of the pact. The pact offers sufficient flexibility to accommodate the demands of crisis situations and, at the same time, safeguard solid public finances. Under certain conditions, for instance, it is possible to decide against opening an excessive deficit procedure. This is the case, for example, where the deficit exceeds the 3% ceiling but the breach is small, temporary and due to exceptional circumstances. By contrast, opening a procedure purely for appearances' sake whilst supporting or even calling for an expansionary fiscal policy from a member state with an excessive deficit would further undermine the pact’s credibility and damage it in the long term.

Overall, the rules – even in their modified form – are essentially an adequate means of contributing to solid public finances. Without budgetary rules and the constant reprimands from the European institutions, higher government deficits and debts would undoubtedly have been incurred in the euro area and calls for a loosening of monetary policy would have become more insistent. Despite the modification of the pact and the lack of budgetary discipline in some cases, there is a fundamental consensus on the need for budgetary rules in the euro area. Developments in many small euro-area countries, and, in recent times, Germany have clearly demonstrated this. Moreover, the European institutions (especially the European Commission and the Eurosystem) have repeatedly issued public warnings against straying from the path of sound public finances and have called upon countries to comply with the rules.