[A-List] EU stability & growth pact

["Michael Keaney" <michael.keaney@xxxxxx>]

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Europe's problem is not stability pact
By Daniel Gros
Financial Times: October 24 2002

Tough economic times expose weakness in economic policy-making. This is
illustrated by the collapse of support for the stability pact, the European
Union's rules on public deficits. Everybody, including the president of the
Commission, the guardian of the treaty, is chafing at the limits it imposes
and seems to be clamouring for it to be made more flexible.

The pact was invented in 1996 to make fiscal policy sustainable. It was
clearly needed, given years of rising public debt as a proportion of gross
domestic product. There is little disagreement over the need to stabilise
debt/GDP ratios at reasonable levels. This is why the 3 per cent ceiling on
deficits makes sense and why it is not really disputed at the political
level - except when it hurts.

Why is Germany breaching the 3 per cent limit and why are the other large
countries close to doing so? Governments are claiming that it is not their
fault, that their economies are the victims of an unfavourable business
cycle. This might be an optimistic view. Our recent research has shown that
the potential growth rate of the eurozone is declining, due primarily to the
fact that productivity growth has slowed to a snail's pace in Europe (while
it has accelerated in the US). Productivity is a slow-moving variable and
the exact numbers are available only after several years. There can
nevertheless be little doubt that productivity growth is now significantly
lower than it was 10 years ago, when the Maastricht treaty was signed.
During the 15 years to 1990, labour productivity growth had been increasing
at 2.3 per cent a year. It is now running at 1.3 to 1.4 per cent. Moreover,
there is no reason to hope for a quick rebound (as happened in the US over
the 1990s).

Most policymakers would not admit that potential growth may have declined.
They maintain that all we need do is to wait for growth to return to its
full potential, which they estimate to be over more than 2.5 per cent. In
fact 1.2 to 1.8 per cent might be a more realistic target, especially for
the larger eurozone economies.

The decline in potential growth has two immediate implications for how
fiscal policy is judged. First, current estimates of structural balances are
too low. Since public spending accounts for about 50 per cent of GDP, each
percentage point of lower potential growth implies an overestimate of
structural balances by 0.5 per cent of GDP. If potential growth is in
reality only 1.5 per cent, the 2001 deficit would be almost totally
structural, not cyclical.

For example, Germany's deficit will probably be about 3.5 per cent for 2002.
Growth in Germany might turn out to be only 0.5 to 0.8 per cent this year.
If potential growth in Germany is only 1.5 to 1.8 per cent, as suggested by
the recent productivity data, this would imply that its structural deficit
for 2002 is close to 3 per cent of GDP.

Second, lower potential growth will affect debt sustainability. If potential
growth is as low as 1.5 per cent while inflation averages 1.5 per cent, the
maximum allowable deficit to keep public debt at 60 per cent of GDP is only
1.8 per cent of GDP, not the 3 per cent stipulated by EU rules. If Germany
continued with a structural deficit of close to 3 per cent, its debt/GDP
ratio would soon start to rise and would stop only at 100 per cent.

Policy-makers should face up to the problem of slower productivity growth
and stop blaming the global business cycle. Apart from Portugal, it is the
large countries - Germany, France and Italy - that have strained budgets.
The reason for this is quite clear. The eight virtuous members have cut
expenditure on average by about 1.5 per cent of GDP over the past three
years, whereas the three large members and Portugal were not able to manage
even one third of this. In the smaller countries, the body politic has been
quicker to appreciate the merits of the pact.

What is the most likely outcome at this point? France's long-standing
opposition to the pact's tight rules is well known. The Commission appears
to have abandoned its role as guardian of the treaty. What about Germany,
the country that invented the pact? After the elections, one might have
hoped that it would revert to being the custodian of financial stability.
But apparently Berlin now believes that German interests are better served
by political haggling than defending clear rules.

Germany and Europe will pay dearly for sacrificing sensible long-term
policies to myopic political convenience. The only hope is that the small
countries will bring their larger partners back to reality.

The writer is director of the Centre for European Policy Studies