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Ineffective & Unworkable Stability & Growth Pact

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Abstract

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.

1. Introduction

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[1]. 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[2]

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.[3] 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[4] 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.[5] 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[6], 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).[7] 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[8] 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[9], 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.

Original Pact

Reformed Pact

Preventive Rule:

Medium-term Objective

(MTO)

All MS have an MTO of

“close to balance or in

surplus”

Country-specific

differentiation of MTO

depending on debt level and

potential growth, allows for

1% deficit if debt is low

In case of Deviation

from MTO

No adjustment path or action

Specified

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

for deviation

Corrective Rule:

Monitoring if Deficit

Exceeds 3%

No obligation for

Commission to prepare

report;

no mitigating other relevant

factors (ORF) specified

Commission will always

prepare report, taking into

account whether

- deficit exceeds investment

expenditure.

- ORF can justify

temporary “excess”

Debt Position

No specific provisions

“Sufficiently diminishing”

debt can be taken into

account qualitatively;

Systemic pension reforms

can be taken into account

for five years if reform

improves long-term debt

position

Excessive Deficit

Procedure

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

steps foreseen

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

circumstances occur

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.

Original Pact

Revised Pact

Obligation

high to medium:

Quasi-automatic sanctions under

EDP but political decisions by

Council required (with qualified

majority, the government under

scrutiny has to abstain)

medium to low:

Correction of excessive deficit can

be postponed, or high investment

and ORF classify the excess as

temporary, but conditions apply;

achieving MTO depends on

country-specific circumstances

Delegation

low (operational and

adjudicative):

supervisory and monitoring role of

Commission is optional or

contested; less detailed reporting

requirements specified in Code of

Conduct

high (operational) to medium

(adjudicative):

strong and detailed supervision by

Commission and Eurostat, detailed

reporting requirements specified in

Code of Conduct; reporting to Council by Commission now mandatory in the corrective

arm; option of early policy advice in

the preventive arm

Precision

Medium (goals) to low (means):

Excessive nominal, later structural

deficit of 3% to be avoided but

measurement issue unresolved

until June 2005 (not directly linked

to revisions);

no specification of means to

achieve correction or adjustment

MTO

Low (goals) to high (means):

Excessive structural deficit of 3% to be avoided, measurement issue

resolved for the time being, but

long-term sustainability (growth

potential, debt position) and

structural or systemic reforms are competing goals, specification of minimum fiscal effort to prevent unsustainable deficit or correct excessive deficit; country-specific exemptions (ORF, MTO etc) defined in detail

Schelkle (2007)

The architectural core of the revised SGP indicates that although obligation has weakened, delegation and precision have been strengthened (Schelkle 2007).

In the sense of obligation, it is widely agreed that the original pact was not as strong as the architects of the SGP framework intended. From a legal point of view, many argued that the revised version no longer imposed any obligation on MSs (Gros 2004) as it became even less likely that sanctions will ever be imposed (because of further flexibility and/or exemptions). To say that there are no obligations at all under the SGP is however misleading; why do rules exist at all then? Why does the Commission attempt to enforce them? From this it can be interpreted that obligations do not occur solely in the form of financial sanctions but also through peer pressure, as finance ministers may feel bound by Eurogroup, an informal body composed of finance ministers of the Euro-zone, with a strong identity. There is therefore an incentive to comply with the SGP in order to be a respectable member (Puetter 2006).

Changes in delegation mark more frequent communication with the Commission as its surveillance role was strengthened with the reformed SGP as mentioned before. In terms of the Commission's relationship with MSs, it is interesting to note that usually national legislatures delegate some of their own scrutinising power to the Commission so that they can pass and amend proposed budgets but in fact the Commission has adopted standpoint of being an agent of the legislature by insisting that its reports are laid before national parliaments. This addresses the criticism that the Commission's role is limited to surveillance.

Precision of fiscal rules have been sharpened; for example the measurement of MTO is subject to regular methodological discussions in ECOFIN and the definition and measurement of a country's fiscal balance is more tightly specified by Eurostat, a directorate-general of the European Commission. Eurostat promote harmonisation on how to report statistics across the EU and maybe be described as an' independent auditor'. But, a crucial point to make is that MSs are still not told how to achieve results and outcomes although it can be argued that it is unfair to expect the Commission to take even more responsibility, by identifying what is to be done as different approaches will be suited to MSs and their respective needs. An interesting question is why fiscal targets are not met. Is it because of a lack of effort or is it because MSs do not know what to give preference to when facing trade-offs? Most importantly, who should take responsibility when budgetary discipline is not complied with? This question, posed by Schelkle (2007), remains unanswered as it is difficult when complete transparency does not characterise the fiscal framework and responsibilities are blurred; this can viewed as a deficiency.

Overall, although obligation has been weakened, there have been complimentary changes in delegation and precision. As noted, more could be done in the nature of the precision of the rules. This could be a reason for why MSs are not complying with fiscal discipline.

Since it should be recognised that soft law may often revolve into hard law, in that legislation is enacted to make it more legally enforcing, it is extraordinary in this case to see the opposite taking place. Where hard law is usually needed to make soft law ‘work', in this case, Schelkle (2007) has argued that soft law has encouraged compliance with the SGP relative to before. The conclusion points to the fact that the key to policymaking design is therefore to combine soft and hard law. However can the same be said for rules and discretion?

4. THE SGP: A RULE BASED FRAMEWORK

This chapter will address the question of why the SGP is ultimately a rule based framework, and discusses the implications it presents.

It can be thought that the economic versions of soft and hard law are rules and discretion. Kydland &Prescott (1977) initially triggered the rules and discretion debate highlighting the role of expectations and the value of pre-commitment as an answer to the problem of time inconsistency in discretionary policy making. They showed that if policy makers are left unconstrained and are able to reconsider their policy plans at each point in time, this can lead to suboptimal outcomes (Artis & Nixon 2007). Time consistency can arise in fiscal policy also; for example a capital levy provides a non-distortionary form of ex post taxation, while the anticipation of such a levy would destroy the incentives to invest and accumulate capital ex ante. They claimed that by relying on policy rules, economic performance could be improved. In the international context, the SGP as an overall rule based framework (Begg & Schelkle 2005) can be thought of as a product of this debate which in essence is being tested with the current economic crisis of Greece.

A Discretionary Presence

Elements of discretion can be seen within the SGP framework; at the time of creation, it seemed optimal to create a fine for the sanctioning of MSs so it could act as a deterrent. However, enforcement problems came to light very quickly; during the third stage of EMU, the 60% debt rule was relaxed in order to let Italy, Belgium and Greece join although they had debt/GDP levels of over 100% (Fatas & Mihov 2003, Rostowski 2004). If one is going to relax the rules upon entry, and then MSs do not respect the requirements during membership, it would come of no surprise that many would hold it unfeasible to hold the MSs responsible for this. Rather this is a deficiency on part of the EU authorities. Furthermore, in 2002, the Commission proposed that the Council should issue an ‘early warning' to Germany and Portugal that their deficits were almost in breach. The Council however, decided not to follow the Commission's recommendation (Fischer et al 2006). Not only does this highlight the weak enforcement as a lack of incentive for MSs but it further highlights the EU's unwillingness to respect the requirements of the SGP as well. As a result one must question the nature of these inadequate rules.

Although Schuknecht (2004) argues that simple rules are best, in this case the simplicity of a rule has proven to be detrimental to its credibility as it means that it can easily be manipulated to suit dissimilar needs at different times. This has undermined the credibility of the rules and meant that the SGP was considered as becoming more and more subject to discretionary interpretations (Fatas & Mihov 2003), highlighting the soft law elements. On the contrary, the clarity of rules are important when formal enforcement is difficult; the current rules are not litigable nor can any army or police force national governments to comply (Schuknecht, 2004).

Rules: Are they ‘Hard' Law?

However, it has become institutional wisdom that ‘rules' are better than discretion, hence the creation of the SGP as an overall rule based framework.[10] Although the rules in the SGP can be identified as soft law, soft law can be good in that it reduces political transaction costs by improving transparency. There is an argument that if rules are well designed, they can be self enforcing (Schuknecht, 2004). This not only provides a framework for discussion amongst key players but it allows national governments to use supranational institutions as political weapons (Fatas & Mihov, 2003). For example, the Maastricht criterion was able to play a big part in reducing deficits during the early 1990's. Arguably, without these criteria, the excessive deficits of many countries would have fared worse. Adopting common rules is time consuming and difficult as it requires an impressive amount of political co-operation. However, it is more politically feasible and importantly more credible than maintaining an effective discretionary cooperation policy(Jacquet 1998). However, rules in order to be effective must be legitimate; they must be seen as necessary and they must be enforced in an impartial and equal manner on all the states in the Euro-zone (Rosowski 2004). Unfortunately as discussed above, the SGP rules lack in their uninformed enforcement and as we shall see below, they are not seen as being necessary for all those involved in enforcing and complying.

Many countries have high deficits after years of high spending, with each MS having different political characteristics, such as divided governments, coalitions and division of power in budget making processes. Macroeconomic evidence undertaken by Romer suggests that deficits result from deliberate decisions of policy makers to leave large debts to their successors. Since future generations are not represented within the democratic process, governments are able to restrain their successors spending, leading to intergenerational unfairness. Evidence suggests it is likely that division of power leads to high deficits, as can be seen in Italy and Belgium who have succession of coalition and minority governments (Romer). High deficits lead to higher real interest rates crowding out investment with a negative impact on capital formulation and growth (Artis and Nixon 2007). It is these high deficits, no matter what their source, that makes public finances more fragile as they reduce the effectiveness of monetary policy (Giavazzi et al 1997), illustrating that fiscal policy is far from sustainable, and this is what makes deficits undesirable.

It is considered that deficit bias exists in fiscal policy since present forces tend to cause fiscal policy to produce deficits that are on average inefficiently high, and so there is a need for restriction (Fatas & Mihov 2003). Deficit bias exists for many reasons[11], for example inefficient policies which occur when MS governments may not know what optimal policies are. To illustrate, consider widespread protectionist policies that exist because many people do not understand the sufficiently subtle idea of comparative advantage. Therefore, it must be recognised that voters and policymakers knowledge is incomplete (Buchanan and Wagner 1977) and this is an important cause of deficit bias[12] (Romer). A further example is of imprudent fiscal behaviour that exists when countries have high spending coupled with low taxes and therefore resort to borrowing.

Therefore a rationale for the rules of the pact is therefore to limit the size of excessive deficits and provide a solution to combat the deficit bias by aiming to move Europe's budgets towards balance or surplus sufficiently to stabilize the debt income ratio or to allow it to decline (Annett 2006)[13]. However, in a fundamental light, the application of budgetary discipline to get rid of excessive deficits simply means that by imposing numerical caps on the size of deficits, it encourages MSs to continue to incur excessive deficits rather than getting rid of the deficit/reducing total debt stock, itself. As noted by Eichengreen & Wyslopz (1998) this can be likened to suppressing the symptoms rather than fully eradicating the disease. This obvious objection to the rationale of the pact means that the free-rider problem of the pact is aggravated. Nonetheless, suppressing the symptoms is standard practice when disease is untreatable. When doctors cannot fully eradicate cancer, they administer powerful painkillers to the patients. If the only way excessive deficits can be prevented is by EU authorities imposing constraints then there is no reason why this should not happen (Eichengreen and Wyplosz, 1998).

This then leads to the next question; is it even possible for MSs to achieve budgetary positions on average in balance or close to surplus? During the early years of the SGP it was reported that MSs were not growing fast enough; at the growth rates of the time they were never expected to reach the required levels. Discretionary initiatives such as tax increases or expenditure cuts were the only hope; if they continued at the same rates they may have had a chance. However further spending cuts cannot take place if past spending cuts were comprehensive. Others argue that improvements in the fiscal position due purely to faster cyclical growth will be of little help since what is required is an improvement in the cyclically corrected fiscal position. Permanent and sustainable increase in the level of output is needed and is harder to achieve. What in fact happened during the early years was that fiscal fatigue set in (Eichengreen & Wylopsz 1998). Furthermore the deep nature of the current recession is imposing a considerable burden on public finances in MSs such as Germany (Carare et al 2009), because more and more individuals are eligible for state payouts, a consequence of the functioning of the automatic stabilisers. This further exasperates the deficit. However it is not clear how this problem can be solved unless the government reforms social welfare. It is therefore not surprising that the European Commission has been appealing for social reform for quite some time in the face of significant political difficulty. The situation is feared to get worse as the EU is facing an ever-worsening demographic crisis where a growing population is relying on the working of the automatic stabilisers.

Yet only by achieving budgetary discipline, will MSs thereby leave scope for customary levels of automatic fiscal stabilization (Fatas & Mihov 2003) in order to ease the severity of economic downturns. In this aspect, the SGP is failing to allow countries to respond to individual country specific shocks (Pisani-Ferry et al 2008) since the SGP does not leave enough room to manoeuvre in recessions. Ultimately, the SGP fails to incentivise MSs to stimulate surplus during booms and this in turn results in the ‘tough' times being very bad in the sense that the governments run even bigger and unsustainable deficits as lower tax revenues means the persistence of a deficit may lead to difficulty in financing and servicing the total debt.

Olivier Blanchard wondered how ‘strict' a government needed to be in the long run in order to keep room for manoeuvre against an occasional but significant recession. How much below the 3% level would the budget deficit have to be to provide this cushion? (Eichengreen & Wyplosz 1998).This will ultimately depend on how far below the 3% deficit ceiling MSs were when the SGP fully came into force in early 1999. Furthermore, the phenomenon in the last decade seems to be that governments lack the appetite to cut spending, and to reduce government deficits, and therefore fast growth is required. The SGP in this case will grow more binding, and automatic stabilisers will fail to work as they should, further depressing growth and making the pact even more binding than before. Through this vicious circle, ‘Europe could be condemned to a low level equilibrium trap' (Eichengreen & Wyslopz 1998). This relates to where economic growth is rising per capita income, meaning that the economy is not growing (Nelson, 1956). Not only will the SGP have significant costs of diverting effort from fundamental problems, but the SGP will indeed make these fundamental problems worse than before.

This has meant that critics have labelled this very same rule based framework as ‘inadequate'. As commented by Charles Wyplosz, fiscal rules used are either too lax, or they are too tight leading them to be ignored. For example, they are flexible in the UK's Code for Fiscal Stability but very stringent in the case of the SGP. A further disadvantage is that once a rule is in place, it misleadingly seems straightforward to measure the government's performance against it. Unfortunately in practice this is not as clear cut; firstly for rules to be effective they must be enforced and secondly, it must be noted that fiscal outcomes are the product of both policy and endogenous economic developments. Hence, what seems to be a compliance with the rule may just be the result of lucky economic circumstances. It is therefore necessary to separate the two to see whether or not a rule has changed government policy (von Hagen 2006).

The distinction between good and poor quality fiscal strategies is therefore crucial (Pisani-Ferry et al, 2008)[14]. The rule needs to be built as checks and balances in budgetary process (Fatas & Mihov 2003). This is hoped to prevent policy makers from incurring large and frequent politically motivated discretionary changes in fiscal policy without preventing proper functioning of automatic stabilisers. However, more so than the type of rule, enforceability is the biggest issue. Without enforceability a rule has no substance.

Yet although the framework is inadequate, having rules in the EMU context allows some form of discipline - and this is a second rationale of the pact. Discipline is needed in the fiscal realm to prevent the fuelling of inflation throughout the Monetary Union of sovereign countries when free riding MSs run excessive deficits. This is defined as the ‘externality problem' by Heipertz & Verdun (2004). Inflation throughout EMU would require the ECB to increase interest rates in order to curtail this inflation, but this step may further depress investment and consumption within EU and cause the Euro to appreciate, possibly leading to the area trade balance sheet to deteriorate (Leblond 2006). However, from the ECB's inaction of taking anti-inflationary measures whenever countries breach the rules of the SGP, it seems that they are unwilling to believe that excessive deficits will cause huge problems for EMU. Anthony Thomas, economist at Dresdner Kleinwort Wasserstein, summarises: ‘What is remarkable is that deficits are something that the European Commission worries about - but nobody else' (Atkins, 2005). The SGP can therefore be considered as not only soft law, but also bad policy.

This is supported by Eichengreen and Wyplosz (1998) who believe that inflation spillovers are not huge. Misbehaviour documented in Table 7 of Eichengreen and Wylospz (1998) has provided evidence that excessive deficits do not result in dramatic inflationary consequences. Average annual inflation for a sample of MSs was a relatively moderate 6% over period. This 6% may be more inflation that some Europeans would like but it is hardly the inflationary disaster feared by Euro sceptics. After pooling data for all countries partial correlation between inflation and budget deficit is negative, contradicting assumption that deficits are associated with inflation. Not only is the SGP soft law in the sense that the rules can be breached by member states without it bearing the supposed consequences but it is also bad policy since such spill-over's do not exist therefore questioning the need for fiscal discipline in first place. It is not the excessive deficits that should be of concern but rather the total debt stock as the crisis of Greece is showing at the moment.

In summary, if rules worked, surely they would stop delinquents from offending? The fiscal framework should strike a delicate balance between different goals. It should avoid constraining national fiscal behaviour excessively while redressing possible incentives towards deficits. It should make joint action possible without forcing coordination (Couere & Pisani-Ferry 2005). Although, there is a widespread agreement that the current rules are not ideal in achieving their goal of eradicating deficits completely, the rules are seen to be the best way of disciplining MSs in their fiscal behaviour. This is surprising since not all MSs are thought to be in a position to achieve a budgetary position of close to balance or surplus in the first place. Furthermore, without budgetary discipline automatic stabilizers stop functioning effectively as the rules of the SGP do not allow countries to respond to asymmetric shocks. It seems restraining excessive deficits is not necessary for the reason of preventing spill-over's because in fact, neither the EU, nor the ECB believe that these spill-over's will be detrimental to the European Union. An interesting conclusion that can be made is that it is not the excessive deficits that cause problems when they cannot be financed; it is the failure of the pact to limit the total debt stock. It is this that can cause the EU being faced with a decision of a potential bail-out.

5. CASE STUDY: GREECE

As mentioned, Greece has tested the rule based framework as a means of applying fiscal discipline. Essentially the rules have proven to be inadequate in the course of the economic crisis facing Greece and ‘discretion' seems to be winning.

Faced with high deficits, and a downgraded credit rating, Greece is facing economic chaos. Although it has only been recently highlighted in the media, Greek's debt/deficit levels have been alarming since their accession into EMU (Couere & Pisani-Ferry 2005). Early 2009 the EDP was triggered, with the council adopting recommendations in April 2009. In November, under Article 104(8), the Commission put forward a recommendation to the Council that Greece has not taken adequate action to correct their deficit. The Council also adopted the decision that inadequate action had been taken. Following this, in early 2010 the Commission adopted a further “series of recommendations to ensure that the budget deficit of Greece is brought below 3% of GDP by 2012, that the government timely implements a reform programme to restore the competitiveness of its economy and generally runs policies that take account of its long-term interest and the general interest of the Euro area and of the European Union as a whole” (European Commission 2010). Disciplinary action would be the conventional response to Greece's problems; however, there is not much point in this. The Commission feels that continuing a dialogue with Greece is much preferable to taking sanctions, as that will only deepen the loss of confidence in Greece and making it virtually impossible for Greece to sell bonds in the capital market. The Commission recognises this and is working to get an agreed resolution with Greece involving stricter fiscal policy targets. This highlights the soft law element existent in the functioning of the SGP, meaning that in fact although the SGP is rule based, the discretion part of the debate is winning.

The situation coincides with the reporting of the previous chapter; the rules of the SGP do not eradicate the underlying disorder and therefore, the country's debt has spiralled out of control. This can lead to the EU being faced with the decision to bail out a MS although the no bail out clause in the Maastricht treaty prohibits them from doing so. Article 104b says that if a MS fails to service its debt, there will be no bail-out by the EC or the other MSs; the defaulting country and its creditors will bear the consequences of such a fiscal crisis. However, the clause lacks credibility; although the costs of maintaining EMU are high, the Greece government defaulting on its debt will produce disastrous consequences. This is an example of a time consistency problem, highlighting the absence of a commitment device that should be present on part of the EU authorities. Although an interesting observation identified by Joseph Stiglitz in his interview states that Greece is simply a victim of speculative attack, he suggests that the Eurozone MSs need to stand by Greece and restore confidence to the markets by guaranteeing that countries under speculative attack will not default on their debt. If this is convincing, the situation will return to normal and Greece will not need to be rescued. (Harel 2010). However as the EU are scared of creating a precedent for other troubled economies, it remains unclear whether the EU will indeed step in to bail Greece out. Should governments be made liable for each other's fiscal difficulty? If the answer is yes, the SGP's untested credibility is certainly going to be thrown up in the air with the ‘discretionary' actions of the EU taking precedent over the no-bail out clause.

Greek Economy

Along with other Euro MSs, Greece has long term economic weaknesses (Grant 2009). Whilst their over-regulated economies discourage innovation and efficiency, higher education is of poor quality and there is little investment on Research & Development. They are too dependent on low tech industries that cannot compete with Asia, yet powerful trade unions have pushed up wages (Grant, 2009). With a huge public sector, and low tax revenues consequent from a large black economy, the Greek government has built up large amounts of debt (BBC, 2010). Data shows that direct taxes in Greece as a percentage of gross domestic products are much lower, around 20 per cent, than in the other Eurozone countries (roughly 26 per cent), (European Commission).

Moreover, because Greece has tried to import and adapt models used in other nation states, Greece does not have a competitive socio-economic model that fits with the country's geographical location, climate, natural and other assets, and the skills and the mentality of the Greek people - this has in turn decreased the competitiveness of its economy (Tilford, 2009). Because of declining competitiveness, current account deficits have grown to 13.5% in Greece. The recession is preventing the government from cutting their deficits by exporting more; only a big fall in consumption can shrink the deficits.

Because of its high deficits, Greece is seen as great credit risk (Grant, 2009). Because a Euro MS loses the freedom to devalue its currency, it can be punishing for countries whose economies are slow to adjust to unforeseen circumstances. It is in this case that the argument of the SGP rules being too tight, and not allowing enough room for manoeuvre can be applied. Although some argue that Greece's problems relate back to years of high spending, the recession has further accelerated the bad circumstances in Greece; government borrowing is out of control with debt to GDP ratio expected to rise dramatically. Standard & Poor, the financial-market intelligence have said that Greece's debt burden may climb to 125% of GDP in 2010, the largest among the 27 European Union nations, and stay at that level or higher in the “medium term”. Fitch ratings noted “concerns over the medium term outlook for public finances given the weak credibility of fiscal institutions and the policy framework”. The International Monetary Fund (IMF) estimates the total debt will to rise to 134% by 2014. In reality however one may argue it looks much higher than this, and once it reaches this level the situation will be even worse because of the burden of interest payments (Tilford, 2009). This provides evidence of the SGP's failure of preventing unsustainable fiscal paths. Investors whilst fearing default, by the government will sell their bonds leading to bond prices plummeting. A collapse in bond prices can cause a loss of asset values for commercial banks holding this debt. Operating in an environment of asymmetric information, fears that banks are at risk triggers bank runs (King 1997). As bond yields rise indicating the risk of default, Greece faces difficult choices. The best course would be to follow Ireland, Hungary and Latvia with a credible fiscal plan heavy on spending cuts that the government can control such as wage freezes (although this could depress domestic demand) (Tilford, 2009). Productivity can be strengthened by applying structural reforms, as Germany has since unification, to regain competitiveness. This approach is working in Ireland with public spending being cut by 20%. However, is the Greek political system robust enough to swallow such bitter medicine? (Grant, 2009) Chaos would face Greece, with protests and perhaps even calls to quit the Euro. So far the unwillingness of the Greek government suggests that not only are they ignoring their disobedience to the SGP rules but they are throwing to light the question of whether the 3% deficit rule exists. Previously, the problem was that the letter of the SGP but not the spirit was being met; now both have been disregarded. The SGP reforms in this case have been disastrous as they have had as little as zero effect. Whilst the early problems of the SGP provided evidence that a harder pact should have come into force, the softer alternative has not done any justice.

Option of Default

Jörg Krämer, chief economist of Commerzbank, said policymakers in Berlin had to be aware of the dangers of a Greek default. “Should Greece become insolvent and the value of its bonds collapse, European banks would have to take massive write-offs,” he said, warning of effects rippling across the financial system and a destabilisation of the Euro (Barber, 2010).

Greece is currently faced with two problems of credibility, in one scenario the SGP will lose great credibility if a rescue operation takes place and in the second scenario of Greek default, robustness of the EU will fail. By defaulting on its debt, speculation will mean that it will be unlikely that Greece will be able to borrow in the future, which may inevitably force them out of the Euro-zone. It is unknown what exactly would happen to Greece as it is unprecedented, though one can be sure that confidence in the Greek economy would be severely dented and the repercussions would be felt for generations. The option of defaulting, leaving the Euro, and devaluating will indeed increase the competitiveness nature of exports. If Greece contemplated on leaving, the financial markets would speculate against other potential quitters; Italy or Ireland for example could find their markets and economies going deteriorating significantly. However, few Greeks would want to leave the Euro because it is “a symbol of economic and political modernity” (Grant, 2009). Secondly, Greece's partners would rather bail it out than see it leave the Euro (Grant, 2009). Former Germany's Finance Minister Peer Steinbrueck said in Febraury- “in reality other states would have to rescue those running into difficulty.” This reinforces the idea that MSs would rather lose creditability and authority in the short term so as to ensure that long term stability of the


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