ABSTRACT
The Stability and Growth Pact (SGP) is one of the main pillars of the Economic and Monetary Union (EMU). It was agreed with the aim of setting a proper balance between fiscal discipline and the macroeconomic stabilization role of fiscal policy. It was conceived as a discipline device which should ensure budgetary balances close to balance or in surplus, while keeping gross debt at low levels in terms of GDP. Since the very moment of its conception the Pact has been the subject of numerous cri-
ticisms, which would suggest more or less drastic reforms of the institutional framework of the EU Member States (see, among many others, Brunila and Martinez-Mongay 2002; Buti et al. 2003, 2005). The debate on the drawbacks, challenges and possible reforms of the Pact significantly gathered momentum in 2002, when budgetary developments in some Member States, especially in Germany and France, put the Pact under serious stress. The final trigger for reform took place in November 2003 when the ECOFIN Council refused to adopt the recommendations by the European Commission to step up the excessive deficit procedure for France and Germany (see, for instance, Buti 2007). In a communication adopted in September 2004 the European Commission put forward
a series of proposals to introduce changes in the Pact (European Commission 2004). These mainly aimed at avoiding pro-cyclical policies, better defining the medium-term objective (MTO) of fiscal policy, giving greater prominence to the debt criterion, considering economic circumstances in the implementation of the excessive deficit procedure (EDP) and improving governance and enforcement. Taking the Commission communication as a starting point, the ECOFIN Council of March 2005 reached an agreement to introduce changes in the Pact. Where necessary, legislative changes were proposed in both its preventive (surveillance and coordination of economic policies basically through the assessment of convergence and stability programmes) and corrective (excessive deficit procedure) arms (Council of the European Union 2005). The legislative process ended in July 2005. One of the most recurrent critical issues on the Pact was based on an apparently exces-
sive focus on short-term objectives for the budget deficit, which might not only create incentives for creative accounting and the recourse to one-off deficit-reducing measures, but also lead to almost fully disregarding debt developments, and so to an inadequate handling of long-term sustainability issues. Disregard of the issue of public debt was considered as a clear limitation of the original
SGP (Buti et al. 2005). Consequently, taking public debt and long-term sustainability more into consideration when assessing budgetary positions was broadly shared by policy makers as one of the lines along which the Pact should be reformed. The agreement reached at the
ECOFIN Council in March 2005 gave a more prominent role to debt in the preventive arm by differentiating medium-term budgetary objectives across Member States on the basis of their potential growth and debt levels. Also, structural reforms with positive effects on long-term fiscal sustainability have to be taken into consideration when assessing the adjustment path towards the medium-term objective, when considering deviations from the target, and when evaluating the deficits exceeding the 3 per cent of GDP limit. The Council also called for giving a stronger weight to public debt in the implementation
of the Pact, but was not able to agree on, for instance, a minimum debt reduction for countries with very high debt ratios (Buti et al. 2005). In terms of the role of debt and sustainability, the reform of the Pact also appears limited when compared with some proposals made during the long debate on the Pact, such as the permanent balance rule by Buiter and Grafe (2003) and the debt sustainability pact by Coeuré and Pisani-Ferry (2003). The permanent budget balance is given by the difference between the constant long-run average future values of tax revenue and government spending. The rule proposed by Buiter and Grafe (2003) was to keep the permanent budget adjusted for inflation and real growth in balance or surplus. For countries with debt levels below 50 per cent of GDP, Coeuré and Pisani-Ferry (2003) proposed giving them the choice of opting out of the corrective arm (the excessive deficit procedure) and adopting a so-called debt sustainability pact, according to which countries should submit a five-year budgetary programme with a debt ratio target for the period. However, if the concern is government solvency such debt criteria impose unnecessary
constraints on fiscal policy on the basis of debt ceilings (as the Pact also does) or relationships between the components of the budget and ad hoc discount factors. Where government solvency is concerned, this chapter emphasizes that sufficient conditions for solvency are rather weak, while, as general rule, it does not appear that sustainability has been in danger during the last 30 years in Europe. Specifically, this chapter analyses sustainability within the framework of the recent lit-
erature on fiscal reaction functions, which provides a convenient framework to assess fiscal sustainability. This literature investigates the type of fiscal flow reaction (namely the primary surplus) to public debt accumulation that would guarantee fiscal sustainability. Bohn (1998) and Canzoneri et al. (2001) have developed and applied this approach for the US case. Ballabriga and Martinez-Mongay (2003, 2005) have estimated the reaction of the primary surplus to debt levels for the EU Member States. In the line of Canzoneri et al. (2001), Ballabriga and Martinez-Mongay (2003) focused on the fiscal dominance versus monetary dominance debate. They estimated fiscal and monetary policy reaction functions and found supportive evidence of a monetary dominance regime in the EU Member States. Our paper of 2005 put the emphasis on fiscal sustainability and, in this sense, is closer to Bohn (1998). By fine-tuning the estimation of the fiscal reaction functions reported in 2003, the paper provided evidence of the existence of a structural policy shift in the run-up to the euro (after 1995), which enhanced sustainability. On theory grounds, Ballabriga and Martinez-Mongay (2005) have been criticized for
seemingly discarding the distinction between ad hoc sustainability and model-based sustainability as discussed in Bohn (2005a). On empirical grounds, the availability of additional sample evidence allows one to compare the existence of the sustainability-enhancing impulse associated to the run-up to the euro with a potential post-EMU fatigue, which would have shown up after 1999. Furthermore, the ad hoc dummy-modelling approach for the ‘euro impulse’ can be complemented with an endogenous mechanism for structural shift detection.
