Economics: Stability and Growth Pact's borrowing limitations are hampering growth in the the euro zone writes Jim O'Leary.
We've heard a lot about the Stability and Growth Pact (SGP) over the past few years, and I suspect we'll be hearing a good deal more about it in the months ahead.
For those readers who, despite all the hype, don't know what exactly the SGP is and have been afraid to ask, here's a quick bluffer's guide.
It is essentially an agreement amongst the governments of European Monetary Union member-states to conduct their budgetary policies within defined parameters.
More particularly, it prescribes upper limits for budget deficits (3 per cent of gross domestic product (GDP)) and for levels of government debt (60 per cent of GDP), and provides for penalties in the event that these limits are breached.
The rationale for its existence is the view that a well-functioning monetary union requires that governments pursue prudent fiscal policies - a view that was especially strongly held in Germany when the pact was negotiated in the mid-1990s.
The pact has assumed a higher-than-average public profile over the past 12 months or so, because it has essentially broken down and is in obvious need of an overhaul.
The Germans have been running budget deficits in excess of 3 per cent of GDP since 2002, and seem likely to do so again in 2005. The French have been, and seem set to remain in precisely the same position.
But thanks to decisions by the European Council of Finance Ministers, both countries have been spared the pain and ignominy of having the sanctions provided in the pact for such breaches of the rules imposed on them.
Not surprisingly, this has undermined the pact's credibility and has been read by other countries as an invitation to breach the limits too.
In general, any worthwhile scheme to restrict the size of budget deficits must strike a balance between two desiderata: preventing excessive borrowing on one hand, and affording governments some room for manoeuvre in the face of slow growth or recession on the other. Striking this balance prompts a whole load of questions, but two are particularly important.
The first is: what is a reasonable amount of borrowing for a government to engage in on average over the business cycle? And the second is: what fluctuation around this average is tolerable within the business cycle? Or, put another, way: how much additional borrowing might a government be permitted to engage in during the lean years?
The SGP provides a fairly restrictive answer to the first of these questions. It enjoins member-states to run budgets that are "close to balance or in surplus" over the medium term. Whether this is an appropriate policy prescription is a matter of some controversy.
It implies an unsympathetic view of the general proposition that governments should borrow for capital purposes and, as such, may be interpreted as particularly indifferent to the investment needs of those euro-zone economies, such as the Republic, where the stock of public infrastructure is most acutely deficient.
Essentially, what the SGP is saying is that public capital spending should be financed entirely from current receipts and that government borrowing should only occur as a response to economic slowdown.
This brings us to the second question posed above: how much room for manoeuvre does the SGP provide for a government faced with slow growth or recession? The answer is that it depends on how the government in question behaves on average over the business cycle.
If it's a government that tends, on average, to run a budget close to balance, then the SGP provides room for manoeuvre amounting to the equivalent of 3 per cent of GDP; if it's a government that tends on average over the cycle to run a deficit of 1-2 per cent of GDP, then the room for manoeuvre is correspondingly less.
How much room for manoeuvre do governments need? Well, in attempting to answer this, we need to recognise that, in periods of slow growth, budgets come under pressure from two sources.
First, tax receipts are automatically dampened and certain government outlays (e.g. spending on unemployment benefits) are automatically boosted by the weakness in economic activity. Does the equivalent of 3 per cent of GDP provide a sufficient buffer to absorb the impact on budgetary positions of these effects?
In general, the answer is yes, unless the recession is unusually severe. So, for governments whose budgets tend to be in balance over the medium term, and who are only concerned with passively absorbing the effects of the business cycle on their public finances, adhering to the SGP is unlikely to be a problem.
Of course, some governments are not happy to adopt a passive fiscal posture in the face of economic downturn and this brings us to the second source of pressure, namely government decisions to cut tax rates and/or raise public spending in an attempt to offset the weakness in (private sector) activity.
Does 3 per cent of GDP provide sufficient room to accommodate a meaningful fiscal response of this type as well as absorbing the automatic effects discussed already? The answer to this question is a good deal less definitive than the answer to the question posed in the preceding paragraph.
It is clear however that, if the automatic effects are sizeable, a 3 per cent of GDP envelope will not allow much room for an active response and will certainly not permit the kind of fiscal expansion that has occurred in the US and UK in recent years.
It is estimated that, between 2000 and 2003, the fiscal policy boost to the US and UK economies amounted to the equivalent of 6.2 per cent and 4.3 per cent of GDP respectively.
The corresponding estimate for the euro zone for the same period is less than 1 per cent of GDP. The spirit of Keynes, it seems, is very much alive in the Anglo-Saxon world, but has been all but exorcised from the corridors of power in Europe. Is this really what the Stability and Growth Pact was designed to achieve?
Jim O'Leary currently lectures in economics at NUI-Maynooth. He can be contacted at jim.oleary@may.ie
