ZEW President Franz on the Stability and Growth Pact

This piece appeared in the April 2003 edition of the ZEWnews.

Pact

In his policy statement on 14 March, the German Chancellor Gerhard Schröder commented on the Stability and Growth Pact (SGP): “For this reason, we will adhere to our goal of budget consolidation and to the framework agreed on in the stability pact. However, this pact cannot be interpreted in a static sense. It leaves us room to react to unpredictable events.” What does he mean when he says that it “cannot be interpreted in a static sense”?

It should first be noted that the SGP offers a high degree of flexibility. Firstly, the SGP leaves room for cyclical government deficits that do not exceed a limit of three per cent of the gross domestic product (GDP). In Germany, for example, this deficit ceiling corresponds to a debt level of 63 billion euros. This is a considerable amount, allowing Member States to compensate for revenue shortfalls or additional expenditure resulting from economic up- or downturns – provided that previous non-cyclical deficits have already been reduced to zero. Secondly, SGP regulations take “exceptional” economic downturns into account. As defined by the SGP, a downturn is considered “exceptional” if there is an annual drop in real GDP of at least two per cent. However, milder recessions with an annual drop of less than 2 per cent can also be considered exceptional. Thirdly, SGP regulations also take unusual events such as wars and natural disasters into account, if such an event is “outside the control of the Contracting Party concerned” and “has a major impact on the financial position of the general government”.

The problem is therefore not the SGP, but rather the insufficient consolidation efforts that have been made in the past few years. Many (scientific) institutions have made urgent calls for a reduction of structural deficits – unfortunately without success. According to calculations conducted by the German Council of Economic Experts, the German “structural” budgetary deficit amounted to 2.75 per cent in 2002, remaining, if only barely, below the deficit ceiling of three per cent. Naturally, there has provoked an enormous outcry, since there are no more reserves to level out revenue shortfalls or additional expenditures – as would be required under a countercyclical fiscal policy. On the other hand, economic booms have prompted policy-makers to come up with “reinterpretations” of the SGP.

By reinterpretations I mean, for instance, attempts to exclude public investment from deficit calculations because of their growth enhancing effect. Although it might be true that there are types of public investments – such as investments in the education sector – that have a positive effect on economic growth, it is easy to imagine how such reinterpretations might be received by “creative bookkeepers”, who could try to declare any form of public expenditure as an “investment” with a supposedly stimulating effect on economic growth. We all remember too well what happened when Member States engaged in such “creative bookkeeping” when they were trying to meet the convergence criteria.

Another proposal aims to define another, lower deficit level for “structural” deficits. This proposal might even have some potential. But in the case the same counter arguments listed above still hold as there is no universally accepted procedure to calculate these “structural” deficits. Furthermore, it should not be left to the creativity of the respective Member States to decide which deficits are cyclical and which are structural.

Now that the SGP is about to be put to its first test, it would be unwise to stretch the limits of its interpretation, as this might undermine trust in the euro. Having to increase our consolidation efforts might cause some inconvenience. But those who will – or did – not listen, will have to learn the hard way.