EMU SGP Rules | Economics Dissertations

To what extent is the EMU hampered by inflexible SGP rules

1.0 Introduction: The Stability and Growth Pact (SGP)

The Stability and Growth Pact is designed to ensure sound public finances and acts as a pre-requisite in achieving long term economic growth. This economic growth can only be achieved through sound monetary and fiscal policies. The policies may come in the form of controlled government expenditures, price stability, optimal interest rates, exchange rates determination, manageable inflation rates and sustainable unemployment figures in the overall economy.

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The UK’s HM Treasury (2004), in its working paper, defines SGP as an important step in ensuring sustainable public finances to prevent high-debt countries from continuing to run high deficits and debt that could adversely affect all the members in the monetary union.

Deficits come when an institution, like the government, exceeds its expenditure targets beyond its budgetary limits or when revenue generated is lower than the expenses incurred. Such macroeconomic disturbances can only be controlled by appropriate reforms and by taking corrective measures.

However, when we are faced with a situation whereby monetary situation in one country greatly influences the macroeconomic situation in another country or a group of countries, as in the Economic and Monetary Union (EMU), it becomes a matter of concern. In the euro area, for example, the treaty explicitly states that European Central Banks (ECB) “should take corrective measures to bail out member states.

This intervention can only come by creating credibility in the monetary union and by introducing additional safeguards to bolster sustainability and minimise the risk of spill overs”. To prevent such cross-country spill over of such disturbances, The SGP represents a significant step forward to recognise the importance of long term budgetary discipline.

1.1 SGP – In Detail

Adopted in 1997, the Stability and Growth Model aims at providing concrete answers to concerns relating to budgetary discipline in the Economic and Monetary Union (EMU). The SGP provides treaty provision son fiscal discipline in EMU foreseen by articles 99 and 104. It came into complete force when the Euro as a common currency was launched. At the time of its formation the primary concern of SGP was to safeguard government finances as a means to strengthen the conditions for price stability and sustainable growth prospects to create employment opportunities.

In the Economic and Monetary Union, policy co-ordination and economic governance more generally is founded on the principle of an inter-governmental approach. For example, The Treaty and SGP provides for Excessive Deficit Procedure (EDP) which may be initiated if the government deficit exceeds the stipulated 3 present of the GDP or the government gross deficit exceeds 60 percent of the GDP. However, it also states that government deficit is not excessive if the excess over the 3 percent is exceptional and temporary and the deficit remains close to the reference value.

In addition to the EDP, Articles 6 (2) and 10 (2) of the council regulations 1466/77 states that “in the event that the council identifies significant divergence of the budgetary positions from the medium-term budgetary objectives, or the adjustment path towards it, it shall, with a view to giving early warning in order to prevent the occurrence of an excessive deficit, address, in accordance with Article103 (4) a recommendation to the member states concerned to take the necessary adjustment measures”.

Since the EMU comprises a number of nations, policy co-ordination is intrinsically more complex because of the need for co-ordination and information sharing among various fiscal authorities as well as the effective co-ordination between the fiscal and monetary authorities. The SGP, for these purposes, provides for an effective mechanism and surveillance process that enables the various fiscal authorities access to information with regard to fiscal plans in the euro area countries. This surveillance is necessary as it provides an early warning should the risk of a member state having unwarranted deficits.

Some notable and important Articles and Regulations under the EMU treaty and SGP:
Article 98 (ex Article 102a)

Member States shall conduct their economic policies with a view to contributing to the achievement of the objectives of the Community. The Member States and the Community shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set.

Article 99 (ex Article 103)

• Member States shall regard their economic policies as a matter of common concern and shall coordinate them within the Council, in accordance with the provisions of Article98.

• The Council shall, acting by a qualified majority on a recommendation from the Commission, formulate a draft for the broad guide-lines of the economic policies of the Member States and of the Community, and shall report its findings to the European Council.

Article 100 (ex Article 103a)

• Without prejudice to any other procedures provided for in this Treaty, the Council may, acting unanimously on a proposal from the Commission, decide upon the measures appropriate to the economic situation, in particular if severe difficulties arise in the supply of certain products.
• Where a Member State is in difficulties or is seriously threatened with severe difficulties caused by exceptional occurrences beyond its control, the Council may, acting unanimously on a proposal from the Commission, grant, under certain conditions, Community financial assistance to the Member State concerned.

Article 102 (ex Article 104a)
• Any measure, not based on prudential considerations, establishing privileged access by Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States to financial institutions, shall be prohibited.

Article 103 (ex Article 104b)
• The Community shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.

Article 104 (ex Article 104c)
• Member States shall avoid excessive government deficits.
• The Commission shall monitor the development of the budgetary situation and of the stock of government debt in the Member States with a view to identifying gross errors. In particular it shall examine compliance with budgetary discipline on the basis of the following two criteria:(a) whether the ratio of the planned or actual government deficit to gross domestic product exceeds a reference value and (b) whether the ratio of government debt to gross domestic product exceeds a reference value, unless the ratio is sufficiently diminishing and approaching the reference value at a satisfactory pace. The reference values are specified in the Protocol on the excessive deficit procedure annexed to this Treaty.

These articles provides for an effective mechanism to correct and influence fiscal policy measures in the region. The EU in the last 5years has seen major changes in its structure. SGP has come with some drawbacks over its applicability since its birth. For instance, the EDP which is instrumental important component of the SGP was breached by Germany and France in late 2003 when these countries found themselves in a protracted phase of low growth.

Based on these Articles, the following chapters shall assess the applicability of SGP in an expanded Europe. In the next chapter I have looked at some current trends in European economies since the expansion in May 2004.

2.0 Current Estimates and Trends.

The current trends in the euro-area show those government deficits have significantly reduced. The European Commission – The Public Finance in EMU – 2005 suggests that after almost 3 consecutive years of deteriorating government finances, the euro-area general government deficit improved marginally in 2004 to 2.7 per cent of GDP from 2.8 per cent of GDP in 2003. The nominal deficit of the EU fell from 2.9 per cent of GDP in 2003 to 2.6 per cent of the GDP in 2004. It is also forecasted that the overall outlook on EU – wide government spending will remain stable and sustainable this year.

It must also he highlighted that in the year 2004, only 3 Euro-area countries and six EU countries had managed to achieve budget positions in balance or in surplus, both in nominal and cyclically-adjusted terms. In contrast to this, Euro-area countries such as Germany, France, Greece, Italy and seven non-euro-area countries – UK, Cyprus, Hungary, Malta, Poland, Czech Republic and Slovakia deficits reached or breached the 3 per cent of GDP reference value in 2004.

Predictions also suggest that in the euro-area, the debt – to – GDP to increase this year. After having stood at 70.8 per cent in 2003 and 71.3 per cent in 2004, the debt-GDP ratio is predicted to hover around 71.9 per cent this year. Whereas, in the EU, the debt-GDP ratio will remain as high as 64.2 per cent this year with Belgium, Italy and Greece accounting for most of the budgetary imbalance.

The paper also shows that there was widespread difference among member states outside of the euro area. For instance, In Malta, the nominal budget balance in the year 2004 was at 5.2 per cent of the GDPas compared to 2.8 per cent of the GDP in Denmark. The Commission’s Spring Report 2005 also shows that the budgetary situation remained week in Italy and Portugal in the year 2004 as the budgetary deficits reached 3.0 per cent and 2.9 per cent of the GDP respectively.

The Commission’s Spring Report 2005 suggested that the economic performance in the euro area would show robust growth in the year 2005 and 2006. Estimates showed economic growth in the euro-area to hover around 1.6 per cent in the year 2005 and 2.1 per cent (increase) in 2006.It would be interesting to look at the predictions and situation since year 2001 in the budgetary positions in euro-areas and the budget balance in select 15 EU member states since 2003. The tables below looks at the government budgetary positions in certain European countries:

2.1 Budget Balance in 15 select EU member states

If we observe the budget balance of each of these selected EU countries, both original and new members, most countries are likely to have budget deficit this year. It is predicted that countries such as Italy, Greece and France will breach the 3 per cent reference mark for the current year. The UK, quite interesting, is likely to hover around the 2.7 per cent mark lower than last year and within the permissible 3 per cent level. Although most EU nations are expected to cut budget deficit, countries such as

Table I: Budget Balance in 15 EU Members States, 2003 – 2006 (% of GDP).
Budget Balance Cyclically Adjusted Budget Balance
2003 2004 2005 2006 2003 2004 2005 2006
Germany -3.8 -3.7 -3.3 -2.8 -3.2 -3.3 -2.8 -2.3
Greece -5.2 -6.1 -4.5 -4.4 -5.7 -7.1 -5.5 -5.3
Spain 0.3 -0.3 0.0 0.1 0.2 -0.3 0.0 0.2
France -4.2 -3.7 -3.0 -3.4 -4.0 -3.6 -2.8 -3.1
Italy -2.9 -3.0 -3.6 -4.6 -2.6 -2.4 -2.9 -4.0
Hungary -6.2 -4.5 -3.9 -4.1
Denmark 1.2 2.8 2.1 2.2 2.0 3.4 2.5 2.4
Poland -4.5 -4.8 -4.4 -3.8
Finland 2.5 2.1 1.7 1.6 3.2 2.4 1.9 1.8
Sweden 0.2 1.4 0.8 0.8 1.3 1.7 0.8 0.7
UK -3.4 -3.2 -3.0 -2.7 -3.0 -3.0 -2.9 -2.6
Austria -1.1 -1.3 -2.0 -1.7 -0.8 -1.1 -1.9 1.8
Latvia -1.5 -0.8 -1.6 -1.5

Of the countries listed, Italy, Hungary and France will actually see an increase in their budget deficit. If we look at all 25 nations EU, we will get better picture of the budget balance in the region. The chart below shows the budget balance of all 25 EU nations.

The graphical representation of the EU, as a whole, shows that most nations except Denmark, Estonia, Finland, Spain and Sweden are likely to have a negative budget balance for this year. Of the 25, only 8 nations are expected to breach the 3 per cent permissible level.

2.2 Euro Area – Government Budgetary Levels

Table II shows us the Government Budgetary level in the euro-area. The actual balance which is the difference between the total revenue earned and total expenditure incurred is negative for the euro-area and the cyclically adjusted balance since 2001 appears to be below the 3 per cent reference mark.

We can understand from the figures provided that governments the euro-area has managed to control budgetary deficits within the stipulated and permissible level. Therefore, it would be imperative to conclude that euro nations have been able to sustain deficits despite countries such as Italy and France breaching the reference mark since 2003.

Table II: Government Budgetary Positions Euro-Area, 2001-2006 (% of GDP).
2001 2002 2003 2004 2005 2006
Total Revenue (1) 46.5 46.1 46.3 45.7 45.6 45.4
Total Expenditure (2) 48.3 48.6 49.1 48.5 48.2 48.0
Actual Balance (3) = (1) – (2) -1.7 -2.4 -2.8 -2.7 -2.6 -2.7
Interest (4) 4.0 3.7 3.5 3.3 3.3 3.3
Primary Balance (5) = (3) + (4) 2.2 1.2 0.6 0.6 0.6 0.6
Cyclically Adjusted Balance (6) -2.4 -2.6 -2.4 -2.4 -2.1 -2.2
Cyclically – Adjusted Primary Balance = (6) + (4) 1.6 1.0 1.0 0.9 1.1 1.0
Change in Actual Balance -1.9 -0.7 -0.4 0.1 0.1 -0.1
Due to – Cycle -0.1 -0.5 -0.6 0.1 -0.1 0.0
– Interest 0.1 0.3 0.2 0.2 0.0 0.0
– Cyclically Adjusted Primary Balance -0.7 -0.5 0.0 -0.1 0.2 -0.1

2.3 Government Debt Ratio in the EU member states.

The objective of this section is to look at the Debt Ratio of the EU member states. I shall also look at the debt ratios of the new 10 EU states since their inclusion in the union. This is being done to assess whether or not these nations have benefited by the inclusion and if they have, to what extent they have benefited.

It can be observed that since joining the EU, most of the 10 new nations have had significant reductions in their respective budgetary constraints. I have dissected the data for the 10 EU new nations separately in the sub-topic. In countries such as Malta, the debt-FD Pratio has remained as high as 77.1 per cent which is significantly high. The Gross Debt has in fact increased in Poland.

Keeping in mind these figures, the next table extracted from EU website looks at the debt-GDP ratio since 2003. However in most new EU new members will see a decline in its gross debt. I shall also show the share of the 10 new EU states contribution in the overall EU debts.

Careful consideration of the table shows that 12 EU states have been successful in curbing its debt with Cyprus accounting for the largest drop (5.3 per cent) in gross debt followed by Spain with 4.7 per cent. Portugal, on the other hand, has seen an increase of 6.6 per cent in gross debt in the period shown in the table. The overall EU debt as a percentage of GDP stands at 63.8 per cent in 2004, 64.1 per cent in 2005 and a predicted 64.2 per cent this year.

Table III. EU Debt-GDP Ratio, 2003 – 2006
Gross Debt Changes in Gross Debt 2004-2006
2003 2004 2005 2006
Belgium 100 95.6 94.9 91.7 -3.9
Germany 64.2 66.0 68.0 68.9 2.9
Greece 109.3 110.5 110.5 108.9 -1.6
Spain 51.4 48.9 46.5 44.2 -4.7
France 63.9 65.6 66.2 67.1 1.5
Ireland 32.0 29.9 29.8 29.6 -0.3
Italy 106.3 105.8 105.6 106.3 0.5
Luxembourg 7.1 7.5 7.8 7.9 0.4
Netherlands 54.3 55.7 57.6 57.9 2.2
Austria 65.4 65.2 64.4 64.1 -1.0
Portugal 60.1 61.9 66.2 68.5 6.6
Finland 45.3 45.1 44.3 43.7 -1.4
Czech Rep 38.3 37.4 36.4 37.0 -0.4
Denmark 44.7 42.7 40.5 38.2 -4.4
Estonia 5.3 4.9 4.3 4.0 -1.0
Cyprus 69.8 71.9 69.1 66.6 -5.3
Latvia 14.4 14.4 14.0 14.3 -0.1
Lithuania 21.4 19.7 21.2 20.9 1.2
Hungary 56.9 57.6 57.8 57.9 0.3
Malta 71.8 75.0 76.4 77.1 2.2
Poland 45.4 43.6 46.8 47.6 3.9
Slovenia 29.4 29.4 30.2 30.4 1.0
Slovakia 42.6 43.6 44.2 44.9 1.3
Sweden 52.0 51.2 50.3 49.2 -2.0
UK 39.7 41.6 41.9 42.5 0.9

The graphical representation next page of gross debt in the 10 new EU states, both before and after joining the EU, shows similar trends. All countries except Estonia and Cyprus show a drop in debts since joining EU. If we analyse the reference mark for each of these countries, we can observe that Malta, for instance, has not breached the 3 per cent mark despite having an increase in the debt-GDP ratio and the same can be said about Slovenia. Poland and Hungary is expected breach the 3 per cent reference mark and also to witness an increase in the gross debt. Czech Republic gives as a contrasting picture in that it is likely to breach the 3 per cent mark but will see a drop its debts.

Chart me: Gross Debts of 10 new EU states before joining the European Union.

We can see from the tables and charts that some economies depict contrasting predictions for the future in terms of debt ratios and deficits. Since all these nations are diversified in terms of demography, industry and macroeconomic situation, we must analyse the relationship between certain macroeconomic indicators such as Interest Rates and Inflation.

Looking at these current trends and the need to study the macroeconomic indicators, the next chapter seeks to explain the challenges faced by these 10 nations and what changes have been brought about in the treaty and the SGP.

3.0 Challenges to SGP reforms post-expansion of the EMU.

Studies conducted by the EMU shows that income levels in the 10 new states are comparatively lower than the original 15 members. The challenges they face largely comes from macroeconomic policies and structural policies to foster strong and sustainable convergence.

It requires fiscal policies that ensure that tax and expenditure policies are formulated in such a way that it encourages private sectors to invest. It should also provide for adequate infrastructure and education facilities. The EMU study highlights that strong fiscal policies can help preserve macroeconomic stability by offsetting fluctuations in the private sector and credible sustainability of public debts.

We know for a fact that one of the main objectives of fiscal policies is to enable increase in income level, to sustain inflation rate and to create employment opportunities. The basic objective of this section is to analyse the difference in the EMU before and after its expansion. To analyse it, I shall make use of Ordinary Least Squares (OLS) method or rather a simple two variable regression function.

But first, we shall look at the trends patterns in the lending rates of the ECB and Euro-zone unemployment rates. I have created separatecharts for pre and post-expansion of the European Unions. The reason for this separation is that despite new members not being part of the euro-area, there has been increased movement of labour from these countries to euro-area. Another reason for this separation is to see the impact of lending rates on employment on EU post expansion. The period under consideration starts from Jan-2000 till April 2004.

Macroeconomic principles tell that interest rates are often used as an effective tool in creating employment opportunities. As interest rates goes down, investors / borrowers will find it more profitable to lend /borrow money to fund investment opportunities.

This ideally should create more and more employment opportunities as production levels increase. It will also influence an increase in income which should in turn influence the increase in demand. The chart next page shows the trend pattern witnessed before the expansion of the European Union and in the euro-zone area. I shall also produce a simple econometric model to test the linear relationship between the two variables.

We can observe that during the beginning of year 2000/01, the Euro-zone witnessed an increase in unemployment rates while the lending rates of the ECB showed consistent decline during the same period. The logic stated previously in the last page can be applied here. The decline in lending rates may have been to revive production, employment and investment opportunities in the region. However the results I have obtained seems to question the logic behind the argument as to how successful this fiscal measure has been able to tackle the unemployment issues in the euro-zone areas.

Remarkably, there appears to be an inverse relationship between the interest rates and unemployment rates in the euro-zone area. I have plotted the positioning of the residuals from regression function line (slope), also known as the “Goodness of Fit”.
ECB Lending Rates (VAR00001): Independent Variable (Y)
Euro-Zone Unemployment Rates (VAR00002): Dependent Variable (X)
Simple Regression Model: Y = α + βX + μ

Y = 9.030 – 0.078X + μ
(0.218) (0.049)

R2 = 21.7 per cent.

From the equation model, we can conclude that during the period 01/00 –04/04, 1 per cent increase in the ECB lending rates brought 0.07 per cent decrease in unemployment rate within the euro-zone at 5 per cent significance level. This is remarkable considering the fact that in an ideal situation an increase in interest rates should bring macroeconomic disturbances such as increase in unemployment or a drop in production level.

Looking at the trend pattern shown in the graph, we can observe the different directions in which the curves move. The R2 i.e. Co efficient of Determination which shows the explanatory power of the independent variable is quite low at just 21.7 per cent. We can, therefore, assume that factors not including the interest rates had proven to be significant in influencing the unemployment rate in the zone during that particular period.

In the next model, I shall look at how unemployment rates have changed since the expansion of the EMU. Since its expansion, we have observed widespread movement of labour from many of the east and central European economies into western European economies. Variables, as in the other model, shall remain the same except the time period. I have20 observations starting -04/2004 – 12/2005 (EU expansion).
Ya = α + βXa + μ
Ya = 12.742 – 1.305Xa + μ
(2.095) (0.695)
R2 = 40.5 per cent.

The values obtained in this figures largely appears to be similar(relationship) to those obtained in the previous model. There still appears to be an inverse relationship between the two variables suggesting that interest rates by the ECB did not play a significantrole in correcting unemployment problem within the expanded EU.

There has been considerable influx of people from the Baltic and Central European region into countries such as Italy, Spain, and France. At 5percent significance, an increase of 1 per cent in lending rates by theca brings a 1.305 per cent decline in unemployment rate. Such linear relationship between the two is questionable if we were to go by macroeconomic principles.

Similarly, if we look at the linear relationship between the Blending rates and unemployment in the Euro-zone for the same period(04/04 – 12/05) an increase of one per cent in ECB’s lending rates brings about 1.558 per cent decline in the unemployment rate in the euro-zone area.

Both the euro-area and the EU labour markets have been markedly less influenced by the recent economic downswings and upswings, compared to earlier cycles. In line with the usual lagged response of the labourmarket, around 1.4 million jobs were expected to be created in the euro area and 1.9 million in the EU. These figures should improve further this year 2006 as growth regains momentum. The euro-area unemployment rate is expected to diminish from 8.6% this year to 8.1% in 2007. Forth EU, the profile is similar, from a higher starting point of 8.7%this year to 8.1% in 2007.

Let us now look at the trend pattern displayed by the CPI index in the European Union since the beginning of the year 2000.

The CPI Index in the EU appears to show a steady pattern since early2000. The trend displayed by the curve does not show any significant surge or decline since the inclusion of the 10 new EU nations. However, we can witness a sudden drop in the index post January 2003.

In the third econometric model, I shall produce a linear relationship between the ECB’s interest rates and inflation rate in the euro-zone. As noted earlier, the primary objective of any fiscal policies is to control inflationary pressures. I shall consider Inflation rate to beindependent variable (By) and interest rates to be the dependent variable (Xbox). The period under consideration starts from May 2004since the expansion of the EU.

By = α + Xbox + µ
By = 3.052 – 0.018Xb + µ
(0.154) (0.068)

From the regression model obtained we can observe that during the period after the expansion of the EU, the ECB had used interest rates as a corrective measure to control inflationary pressures. Though the explanatory power of the independent variable is low (6.1 %), at 5percent significance, one per cent increase in inflation rate prompted the ECB to slash interest rates by 0.018 per cent. There is an inverse relationship between the two variables and is in accordance to macroeconomic principles.

Unemployment remains a major problem in the new member region and challenge to policy formation and implementation in many new member states. From the first two econometric models, the result suggests that interest rates are not effective mechanism to correct unemployment problem in the region.

Unemployment policies have not brought any significant improvement in the region and it can only be corrected ban increase in production levels, increase in general income level and consequent raise in the aggregate demand. However, we must not ignore that Interest rates have fallen substantially over the recent years and have had positive impact on the inflation rates. It stands at 3.25percent as of December 2005.

But what affect does such fiscal policies have on the individual economies within the union is the point of discussion in the essay. We’ve seen that ECB’s fiscal policies have limited role in checking macroeconomic disturbances in the region and in particular unemployment. We shall, therefore, now look at certain specific countries that seem to have benefited since the expansion.

It is suggested that policy makers must make judgements and priorities on a case by case basis taking into account the differing economic and financial circumstances, restructuring public finance policies and even plans to adapt euro system.. Fiscal policies can contribute immensely in safeguarding stability at times of credit boom which most economies in the Baltic and central European region are experiencing. The disparities seen in the region can further be explained if we look at some trends in the Baltic and central European nations.

One of the major challenges to the EMU would come from the credit booming private sector and is likely to rise sharply over the coming decade. We have seen that most booms are followed by a bust and in real terms pro-cyclical behaviour supporting the building up of large financial imbalances.

The most concerning factors in the new member region are market imperfections, asymmetric flow of information, moral hazard which could influence the pro-cyclical behaviour of risks in the region. It often leads to misallocation of resources and credit, asset price bubbles, as witnessed during the East Asian crisis, and exposure of non-financial firms to un-hedged foreign currency borrowings. At macroeconomic level, these market imperfections can or could lead to deficits in the external current accounts.

Another challenge to the EMU’s policies comes from reversal in market sentiments which leads to reduction of capital inflows or even outflow – triggered by either a specific event in the country itself, or by a sudden larger than expected rise in global interest rates.

Diversity of the sectors within the national economy and that of Economy as a whole, another challenge comes from the fact interest rates fluctuations affect some sector more severely than some other. To tackle some of the issues with regard to debt ratio and deficits highlighted earlier, the EMU has introduced 2005 reforms to assist convergence of EU – 10 nations (new members). We shall look at them in detail in the next section.

3.1 2005 Reforms and its consequences for new members.

The agreement on the reform of the SGP adopted on the 22nd March2005 introduces more economic rationale and greater differentiation reflecting the increased economic heterogeneity in the enlarged European Union. Some essential and important reforms put forward are –

• Country – Specific Medium – Term budgetary objectives: The reforms foresees that Medium Term budgetary objectives will be differentiated across countries according to their debt ratio and potential growth. The reforms specifies that new members participating in the ERM-II will have a medium term budget objectives between one per cent of GDP for countries with low debt and high potential growth and if they have not achieved low debt, they should pursue, as a benchmark, an annual adjustment of 6.5 per cent of GDP, net of one-off and other temporary measures.

• Deeper and more differentiated assessment of budgetary developments in the excessive deficit procedures: The new agreement specifies a setoff “other relevant factors” that should be taken into account when deciding on the existence of an excessive deficit. It shall consider under special circumstances a deficit of 3 per cent or higher as exceptional and temporary.

• Taking into account systemic pension reforms: The agreement stipulates in particular that an excess close to the deficit reference value which reflects the implementation of a pension reform introduces multi-pillar system that includes mandatory, fully-funded pillar, should be considered carefully. Consideration to the net impact on teed deficit of multi-pillar reforms will be given for the initial 5years after a member state has introduced a mandatory fully-funded system, or 5 years after 2004 for member states that have introduced such a reform before 2005, in a regressive way over five years.

3.2 SGP: Country Focus – Portugal.

Portugal is one country in the EU that is likely to have a severe deficit in its budget balance this year. It is likely to breach the 3percent reference mark by a big margin. The 2005 general government deficit was projected to reach almost 6 per cent of GDP after a deficit of 3 per cent of GDP in 2004. In the same year, 2005, both revenue and expenditure have increased as a share of GDP.

However on the positive side, the tax revenues have been growing in excess of what the relevant tax base would indicate which suggest a further improvement in tax collection. Domestic demand in the economy is forecast to slow down over the current fiscal year and 2007. It is partly blamed for the cooling of private consumption. In 2005, both consumption and investment rates were dampened by a negative carry-over during the second half of 2005. However, due to no-policy change, it widely believed that macroeconomic situation in Portugal will improve in 2007.

3.3 SGP: Country Focus – Estonia

Estonia has been performing remarkably well since its inclusion in the EU. In fact, it is the only likely to have a positive budget balance and economic growth. It is unlikely to breach the reference mark of 3 per cent.
The Estonian economy is expected to remain strong and showcase broad-based growth with annual rates well above 7 per cent and little or no significant cyclical variation.

Investment atmosphere is likely toremain stronger fuelled by public infrastructure spending and smoothabsorption of EU transfer. The private corporate sector is expected toincrease its participation in investment largely due to expected tax exemptions for reinvested earnings by 2008.

In the labour markets, however, wage pressures are mounting in certain sectors but the overall wage growth continues to be largely in line with the substantial productivity increase. In terms of sectors within the economy, service sector will see increase in income followed by tourism, transport, construction and public sector.

From the brief outlook in these two countries, we can conclude that within the union itself since the expansion, there have been wide disparities in terms of economic growth and budgetary balance. It is, therefore, necessary for reforms to be introduced that takes into consideration the economic realities in these countries. One positive attributes of the SGP is that it allows for countries to breach the reference mark of 3 per cent if the breach can be sustained and corrected within reasonable time.

4.0 Conclusion, Problems and Opponents of the SGP

It is often argued that the main reason for many of the SGP guidelines failure is largely due to inconsistent policy reforms which dissipate resource during economic upswings thus foregoing an improvement in the budgetary balance to cushion the effect of an eventual downturn. Timely reforms are essential to adapt to changes in the macroeconomic environment. Reforms can be as seen as the outcome of continuous effort to adapt market and public institutions to changing fundamentals: technological progress, evolving needs of individuals and the society, demography, etc.

At times of economic slowdown, the risk of pro-cyclical fiscal policy is high and countries are known to adopt pro-cyclical policies that penalise investment spending since it can be restrained more easily or to large extent resort to one-off operations, securitisation of government assets, or creative accounting that would worsen the future prospects for sustainable fiscal policy. Reforms to the current state of SGP is essential because the Pact, as of now, pays too much attention to the deficit but overlooks the quality of public finance as well as the problem posed by the downturns.

On the downside, there has been increased debate over the effectiveness of SGP in bringing out fiscal measures to correct macroeconomic disturbances. Some of these criticisms have been highlighted below –

1) Though SGP provides more procedures to assist countries breaching the 3 per cent reference mark, it does not provide any corrective measures to tackle cases of a serious slowdown and mild recession. Members are in fact advised to take “preventive” measures and avoid profligate policies during upswings.

2) It is often criticised that while SGP has been unable to bring fiscal discipline and credibility of the government’s commitments, thugs has focused more on short term deficits and rather less consideration is given to debt levels and long term fiscal challenges.

3) One criticism comes from the fact that some countries would be unable to use automatic stabilisation to operate fully within the constraint of the 3 % deficit reference value

4) The effectiveness of the SGP has been questioned due to its lack of appreciation for cyclical factors when economies experience upswing phase of the cycle.

5) Though it provides for increased access to a country’s fiscal positions, it lacks consistency in the treatment of countries and its economic rational.

6) Difficulties in policy co-ordination characterised by a single monetary authority with a number of decentralised fiscal authorities. The need for coordination and information sharing among the various fiscal authorities as well as effective co-ordination between the fiscal and monetary authorities needs more addressing and efficiencies. There still appears to be asymmetric flow of information between the fiscal and monetary authorities.

7) The Pact has also been criticised on the ground that it fails to take corrective measures before a problem sets in. The flexibility provided by the Treaty and the Pact is of ex-post nature and reduces the incentives for countries to implement fiscal reforms, encourages moral hazard behaviour and reduce credibility.

8) It is very common to manipulate economic forecast and is very often done to suppress true facts and figures. Over-optimisation of forecast is typical of governments with public budget problems.

References and Bibliography

1) Public Finance in EMU 2005, European Commission, Directorate General for Economic and Financial Affairs.

2) Structural Reforms and Budgetary Objectives, Public Finance cinema 2005, European Commission, Directorate General for Economic and Financial Affairs.

3) Current Development and Prospects, Public Finance in EMU 2005,European Commission, Directorate General for Economic and Financial Affairs.

4) Fiscal Challenges during Convergence in the Recently Acceded Member States, Public Finance in EMU 2005, European Commission, Directorate General for Economic and Financial Affairs

5) Member States Development, Public Finance in EMU 2005, European Commission, Directorate General for Economic and Financial Affairs

6) Mathew B. Canzoni and Behead T. Diva, the Stability and Growth Pact Visited: A Delicate Balance or an Albatross, Georgetown University,

7) The Stability and Growth Pact: A Discussion Paper, HM Treasury, March 2004,

8) Antigo Verde, “The Stability and Growth Pact In Rainy Days – an Alternate View”, Bank of Valletta Review, No. 30, Autumn 2004,

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