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“Consider the advantages and disadvantages of the Stability and Growth Pact in its present form within the euro area and critically discuss the extent to which the pact remains intact.”

Abstract

The main purpose of this essay is to examine and critically assess the above quoted question in relation to the advantages and disadvantages of the Stability and Growth Pact in its present form within the euro area. However, from the year 2002 onwards, the Euro has become the common currency of the twelve member’s countries of the European Union (EU).

In order to ensure the functioning of this European Monetary Union (EMU), the member countries have agreed on the Stability and Growth Pact (SGP), which guarantee’s members of the economy before the introduction of the currency and internal Stability of the Euro – Zone afterwards.

During the 1990’s the economic meaning has been discussed, especially because the countries violated the use of Stability and Growth Pact (SGP) political power within the EU System.

In order to critically discuss the underlying issues on the advantages and disadvantages of the Stability and Growth Pact in its present form within the euro area, I will be looking at various references such as journals, various articles and other sources in order to support my research.

In 1958 the establishment of the currency system within the European Communities (EC), the Head of States and the Governments decided to make the economic and the monetary union the official goal of the European Integrations.

Although, in the 1970 Werner plan was to propose the economy policy to the six member countries to create a system of fixed common currency. Unfortunately, this attempt failed due to the global system of a fixed exchange rate, which came into force from 1945 until 1973 (Bretton-Woods-System) Barysch (2003).

The Stability and Growth Pact (SGP) Framework

During the mid 1990s, the public fears raised in Germany this was that the Excessive Deficit Procedure (EDP) would not be sufficient to discipline the economic policies effectively after the start of the European Monetary Union (EMU). In 1995 Germany’s former finance minister - Theo Waigel, responded to these fears by proposing a Stability Pact for the European Monetary Union (EMU). This was than later adapted in Amsterdam as the ‘Stability and Growth Pact’ by the European Council Brunila, 2001.

Furthermore, Arits and Buti (2000) identifies the SGP modifies the EDP in several ways.

Firstly, it commits the member states to the new and medium term objective of achieving budgets ‘close to balance or in surplus’. This is a more specific goal than avoiding excessive shortfall and a more ambitious one than the reference value for shortfall under the EDP.

Secondly, it also created an early warning system for strengthening the surveillance of the public finances of the member states. Under the SGP, EMU economies submit annual programmes are known as ‘Stability Programmes’. Euro group participants explaining there intended economic policies and particularly, what they plan to do to reach and maintain the medium–term objective. Stability Programmes include annual economic targets as well as an explanation of the main economic assumptions underlying them.

Thirdly, the SGP gives more importance to the concept of exceptional and temporary breaches of the 3% insufficiency limit. However it also completely defines an excessive insufficiency based on the 3% insufficiency limit. The SGP clarifies the rules for the financial penalties and speeds up this process by setting specific deadlines for the individual steps.

Fourthly, the SGP provides a political guidance to the parties involved in the EDP, calling them to implement the rules of the EDP effectively and in good time. It commits the Commission and in particular allowed them to use its right of initiative under the EDP in a manner which facilitates the timely and effective functioning of the SGP’. This however, puts severe limits on the Commission’s right to exercise judgement on each individual case and situation, shifting the right to the Council.

It was clearly argued in Solbes (2002) that in October 1998, the rules of the SGP have been steadily improved. However, ECOFIN endorsed a Monetary Committee Opinion, the ‘code of conduct’ that specifies criteria to be observed in the assessment of a country’s medium term budgetary position, data standards and requirements for the programmes.

The European Council of Amsterdam and two additional Council Regulations formally made the SGP decisions in 1997. Stability and Growth Pact, (1997) identifies the strengths of the surveillance of budgetary positions, co–ordination of economic policies and on speeding up and clarifying the implementation of the excessive insufficient procedure.

The collective surveillance mechanism of the SGP is based on three elements: the medium term early warning system, the short-term observation of national budget programmes, and the excessive budget procedure.

Solbes (2002) stated that the early warning system basically consists of annual stability programmes submitted by EMU member countries and union programmes by the other EU countries. The official programmes are addressed to the Council of EU finance ministers (ECOFIN), the EU Economic and Financial Committee (EFC), with two representatives from each member state, the European Commission and the ECB.

Artis and Buti, 2000 identifies the main contents of the stability programmes are:

• Medium–term budget plans, which must aim for a balanced budget or even for budget surpluses.
• Include the basic assumptions of budgetary planning as well as the relevant measures of economy and the economic policy.
• Moreover the sensitivity of the plan changes in the assumptions has to be explained.

The Council then decides within two months whether the medium–term budget aims contain an adequate margin of security to prevent an excessive shortfall of 3% of GDP, whether the plan’s assumptions are realistic and whether the planned measures provide for a stable budgetary development. If not then the country has to revise its planning and report once more.

Short–term surveillance is provided in the form of semi–annual reports of current national budget data on 1 March and on 1 September each year. The EU–Commission and the EFC examine separately from one another whether there is an excessive budget deficit.

As a result this is normally the case if at least one of two criteria from the SGP is not met the budget shortfall is higher than 3% of GDP, or the debt threshold is higher than 60% of GDP or is not approaching this point of reference with adequate speed.

If an excessive shortage has been identified or is expected, the procedure for an excessive shortage according to article 104 TEC and the SGP is initiated. As procedure the Commission and the EFC first present their considerations to ECOFIN which then decides with a qualified majority of votes whether there is in fact an excessive shortage or not.

Furthermore, it was a argued in Artis and Buti, 2000 that this decision is whether or not there are any exceptional circumstances justifying a higher shortfall, but however, if certain exceptions are natural disasters, a solely temporary character of the shortfall, or a recession.

A recession is operationalised by a reduction of GDP within a year. A reduction of less then 0.75% is defined as not exceptional, a reduction of 2% is generally accepted. But however, the Council decides on indeed percentages within these two reference values. The position of the causing problems for the country as well as the unexpectedness and the cumulative effect of the shocks are taken into consideration. Buti and Franco (2001).

Article 104(7–11) TEC come into force if the Council concludes that there is in fact an excessive shortfall. Firstly, the Council gives some confidential advice to the country, in order to reduce shortfall this may be made public.

Therefore, Arits and Buti (2000) identifies that if the country still does not comply with these directions, the Council may impose allows enforcing the implementation of the combined measures. These include the requirement needs to give additional information when releasing government bonds, revisions in the lending policies of the European Investment Bank, the obligation to give a no interest–bearing deposit bearing no interest to the Union, and the burden of fines.

The period between the submission of the budgetary data and the decision to impose potential sanctions is only ten months. In October 1998, the Code of Conduct, as agreed by EFC and endorsed by ECOFIN, subsequently it was revised in June 2001 which then was clarified the content and format of the Stability and Convergence Programmes as part of the surveillance process.

However, it was also noted in Creel (2002) that the main targets was strengthening and clarifying the implementation of the SGP includes:

• The medium term should be interpreted over the length of the economic cycle.
• The medium term objectives of close–to–balance or balance surplus should, while respecting the government shortfall reference values, ensure a rapid decline in high debt ratios
• SGP should take into account the costs associated with ageing populations
• Measures aimed at improving the quality of public finances should be considered
• The objectives of SGP should be consistent with the budgetary recommendations of the Broad Economic Policy Guidelines (BEPGs).

It was clearly mentioned in Beetsma (2001) that although, the huge European Fiscal Framework and the whole process together with EU–Commission, ECOFIN and national stability programmes of all EU member states, the national economic authority of each member state have the independence over economic policy. They set specific objectives of policy and make policy decisions about the overall view of economic tax- and spending policies.

Compared with the original EDP, the SGP has achieved two advances: Firstly, it has shifted the nature of the fiscal framework significantly towards a rule– based concept restraining annual deficits and away from a framework based on informed judgement. Secondly, it has weakened the position of the European Commission in the process, to the benefit of ECOFIN Calmfors, 2005.

Maastricht Treaty gave the Commission considerable discretion in initiating the EDP and advancing it. The SGP made the process more automatic and reduced the Commission’s role and raised the importance of ECOFIN judgements.

Calmfors, 2005 also identified in his research that the connection between the EDP and SGP has completely changed the role of the numerical reference values for the annual debts from an assessment process in the pre Maastricht period into a ‘binding constraint’.

Therefore any breaching of the SGP requires swift corrective actions by the Member State concerned and a timely commencement of the Excessive Deficit Procedure. Two factors have advanced this development. The first is the lack of credibility in the process. This was already a problem in the EDP. It has now however become more courteous due to the increase in the ministers power against the EU–Commission and for this reason it will tend to do more economically negligent.

Arits and Buti (2000) also argued that the European public and the media have paid increasing attention to it and criticised on the interpretation of the EMU economic framework. Particularly the ’Stability and Growth Pact’. However, EU–Commission’s assures that the economic framework is applied equally to all member countries, and it also confirms that the Commission’s general role as the institution watching over the proper implementation of EU law.

As a result the nature of the fiscal framework has been transformed from a procedural ruled by oversight and informed judgement, as foreseen by the Maastricht Treaty, into a severe numerical rule for the annual budget shortfall.

Advantages of the Stability and Growth Pact in its Present form within the Euro Area.

Reduction of the Business Costs - The sum of £2 billion pounds is currently spent by the UK businesses a year in buying and selling foreign currencies in order to carry on further business in the EU. As a result this is a great increasingly beneficial business for the EU firms.

Cost Simplicity - EU businesses and households often find it very difficult to compare the accurate prices of goods, services and resources that are available across the EU. This is simple because of the misrepresent exchange rate differences which opposes trade.

According to K. Barysch (2003) who has stated that the economical theory, prices should act as a procedure to share out resources available in the best possible way as to improve economic efficiency. Furthermore by adopting this method would provide a far greater chance of this happening across an area where E.M.U exists.

Reduction of Exchange rate - Many firms through out are becoming cautious when investing in other countries. This is simply because due to the regular fluctuation of the currencies within the EU. This would raise Investments within the EMU area, as matter of fact the currency is universal within the area.

Single currency in single market– Trade should be operated more in an effectively and efficiently way with the Euro. As a result it was agreed by A. Fatas (2003) that the single currency in a single market is the easy way to move further.

Competition – Taking a look out in the world today we see strong currencies such as the Japanese Yen and The American $. America and Japan they both have a strong economy and have a very high population.

Solbes (2002) noted that the recently established monetary union and a new exchange in Europe could also be a rival. However, EMU can be self-supporting which they could survive without trading with anyone outside the EMU area. Furthermore, these circumstances for EMU is better, because it seems that it can survive on its own, with or without the help of Japan and U.S.A and other powerful countries.

Avoid War - The EMU is a political project. Which step towards European integration to prevent war in the union. It is also a well-known statement that countries, which trade effectively together, don't contribute any income towards war on each other. However, on the basis if EMU is satisfied which could mean a peace throughout Europe and beyond.

Increased Trade and Cost Reduction – It is argued that increased trade and cost reduction brings considerable economic trade through the wiping out of exchange rate fluctuations. Therefore, this helps to lower costs to industry because companies will not have to buy foreign exchange for use within the EU.

Price Raises –Many politicians at the start of the mid 1980’s thought that the UK and EMU should provide the way to achieve low inflation rates throughout the EU.

Countries such as France and Italy were also forced to adopt policies in the early 1980s, which therefore, helped reduce inflation rates. If this had not been implemented then the franc and the lira would have had to be devalued for some time, opposing to the fixed exchange rate advantages of the system. After which the German central bank (the Bundesbank) set inflation targets and monetary targets for the rest of the EU.

The Bundesbank was independent of the German Government hence the reason to Germany having a better inflation record than the rest of the EU countries. It had the overall decision and had the right to decide to overrule decisions can suggested by the German government. The Bundesbank was independent of a government and meant that by law it has a duty to maintain stable prices. This would be an advantage to them as they can make independent decisions according to inflation and deflation.

The governments controlled central banks in UK and France. This meant that the government would have the control over inflation. If the UK government for example decided to loosen monetary policy, e.g. by reducing interest rates, it had the power to order the Bank of England to carry out this policy on its behalf.

German inflation rates in the early 1990s rose to over 4% as Germany struggled with the consequences of integration. Inflation was nearly three times as high in Germany as in the UK and twice as high as that in France. Some countries, such as France, have made their central banks independent on the Germany model and therefore arguably don't need to the EMU link to Germany to maintain low inflation. Events of the early 1990s have shaken the naive faith that linkage to the independent ESBC, the central bank of Europe would solve all inflationary problems.

Disadvantages of the Stability and Growth Pact in its Present form within the Euro Area.

The instability of the system –In the 1980s, the UK refused to join the ERM (Exchange rate mechanism). The argument being that it would be impossible to preserve exchange rate stability within the ERM and the UK’s inflation rate was more often then not above that of Germany’s due to the currency of the sterling pound being stronger in the 1980’s.

UK joined the ERM in 1990, there had been three years of currency stability in Europe and it looked as though the system had become relatively strong. However the events of Sept. 1992 state otherwise when the UK and Italy were forced to leave the system.

Over estimation of Trade benefits - Some argue that the trade and cost advantages of EMU have been grossly over estimated and state that there is little to be gained from moving from the present stable system, to the inflexibilities, which EMU would bring.

Loss of Sovereignty – It is argued form a political side that an independent central bank is unfair. The reason given was because the people the government would be trusted to make decisions whereas the independent bank would be non-elected and would have sole control elected the Government.

This would mean that there would be a considerable loss of sovereignty. Power would be transferred from London to Brussels. This would not be in favour because national governments would lose the capability to control policy.

Deflationary tendencies - The most important economic argument relates to the deflationary tendencies within the system. France succeeded in reducing their inflation rates to German levels in 1980’s & 90’s. This was however at the cost of higher unemployment.

Higher inflation in one ERM country means that it is likely to generate current account shortfall and put downward pressure on its currency. To reduce the shortfall and inflation, the country has to deflate its economy. In the UK, it could be argued that the battle to bring down inflation had been won by the time the UK joined the ERM in 1990.

However, the UK joined at too high an exchange rate. The UK at the time was still running a large current account deficit at an exchange rate of around 3 Dm to the pound. The UK government then spent the next two years defending the value of the pound in the ERM with too high interest rates not allowing the economy to recover. Many predicted that if the UK had not left the ERM in Sept 1992, inflation in the UK in 1993 would have been negative (i.e. prices would have fallen).

In the early 1990s, the Germans struggled with the economic consequences of German reunification. There was a large increase in spending in Germany with a consequent rise in inflation. This proved that the needs of one part of Europe could have a negative impact on the rest of Europe.

The Bundesbank responded by raising German interest rates. As a result, there was an upward pressure on the DM as money was attracted into Germany. Germany’s ERM partners were then forced to raise their interest rates to defend their currencies.

However, higher interest rates forced most of Europe into recession in 1992 - 1993. Countries such as France couldn't then get out of recession by cutting interest rates because this would have put damaging strains on the ERM. The overall result was that.

Critics of the ERM and EMU argue that this could be repeated frequently if EMU were ever to be achieved. Local economies would suffer economic shocks because of policies forced on them, and designed to meet the problems of other parts of Europe. One way around this would be to have large transfers of money from region to region when a local area experienced a recession, e.g. N. Ireland which suffered structural unemployment for most of the post war period, has had its economy propped up by large transfers of resources from richer areas of the UK with lower unemployment.

The Change of the Stability and Growth Pact within the Euro Area

Stability and Growth Pact in March 20, 2005 states the following the complaints of the two countries, Germany and France, within the Euro area, the Ministers of Finance of the European Union agreed upon the alteration of the:

Major change in the pact affects the explanation of the 3 % arrears limit. The “exceptional and temporary influences” which allow higher arrears now include negative growth rates – according to the “old” version a 2 % decline in GDP was necessary. For the violation of 3 % limit several called “miscellaneous factors” which has been added as exceptions.

These include: expenses for research, development and modernisation, development of growth potential, improvement of the retirement system, charges to achieve goals of the European policy and others.

The general union criteria have been upheld and it is obvious that the variety of the exceptions will have an impact. The rules and regulations have been softened, so countries might not consider the 3 % arrears limit as their target. For example, Germany seeks to account for the expenses of the German reunification in 1990 – Germany still has a net transfer of € 85 billion or 4 % of GDP from West to East Germany per year – towards the 3 % arrears limit.

The exceptions create opportunities for various interpretations of the “miscellaneous factors”. This may lead to more violations of the union criteria, less discipline, and consequently higher risk to maintain price stability. Each Euro area member has his or her own specific requirements therefore equal treatment would become problematic.

Advantage of the Stability and Growth Pact allows for more flexible government spending. This enables countries to tackle necessary structural reforms. This may lead to increased prosperity and success of the European economies under the requirements of economic discipline.

Conclusion

The Euro developed successfully after its depreciation at the beginning of its introduction. The J.P. Morgan Index impressively supports this development, and shows the strong performance cannot just be attributed to the Dollar’s weakness.

The influence of the Euro will increase after the successful addition of the new European Union members in Eastern Europe. The prospect of the adoption of Sweden, Denmark, and the U.K. in the remote future will result in greater use and importance of the Euro. However the joining of the Eastern European countries to the EMU also bears risks for the currency.

The EMU is not a union of equals, and the inclusion of the new Eastern countries further widens the gap between the “old” and the “new” members. Therefore, not iforming of wages, prices, and economies in the EMU is crucial.

Finally a further threat to the Euro is the possibility of decreased stability of the currency, aroused by several factors: the weakening of the Stability and Growth Pact, the government’s need to spend more money for pension and health care for its aging population, and the additional expenses for the inclusion of 10 less economically developed countries.

Conclusively, the “grand monetary experiment” has been a success so far. Looking into the future, the Euro has the chance of becoming the key currency in the world, especially in light of the current problems of the U.S.-Dollar and the increased influence and usage of the Euro. However, the challenges facing the EMU will be demanding and economic mechanisms will be crucial for the Euro to work.

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