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The hidden structural features of the fiscal rule: a European saga.

Article Excerpt
Abstract

This paper addresses the question of the reform of the Stability and Growth Pact (SGP). More and more authors and policymakers are bringing to light the negative impacts of the European deficit rule on the countries and their ability to respond asymmetric economic shocks, and some are asking for a redefinition of the pact. If the focus of the SGP is only fiscal, and two of the biggest countries in Europe have failed to abide by the pact since its implementation, it seems clear that the SGP needs at least a re-examination. Yet, on the contrary, if we introduce into the analytical framework the SGP's impacts on the European Union's structural policies, the conclusions are far different. Abolishing the SGP could hinder the presently up-to-date convergence prospective. This paper proposes a theoretical analysis of the SGP that emphasizes a new feature of the SGP: a strong incentive to structural reforms. (JEL E61, E62, E63, F02, F42)

Introduction

European Union leaders have reached an agreement on a new Constitutional Treaty for Europe at the European Council in Brussels on June 17 and 18, 2004. Interestingly enough, the European Fiscal rule--the so-called Stability and Growth Pact (SGP)--is included in the Constitution and thus, reaffirmed after having been criticized. The Heads of State or Government at the European Commission [2004] state, "With regard to Article III-76, the Conference confirms that raising growth potential and securing sound budgetary positions are the two pillars of the economic and fiscal policy of the Union and the Member States. The SGP is an important tool to achieve these goals. The Conference reaffirms its commitment to the provisions concerning the Stability and Growth Pact as the framework for the coordination of budgetary policies in the Member States of the European Union."

After Portugal was put under the red lights of the European Commission in 2001, Germany and France have also been watched with close scrutiny. With a deficit of 3.5% in 2002 and 3.8% in 2003, Germany did not respect the SGP for the second year running. France owned up to its projected deficit of 4% in 2003, following a deficit of 3.1% in 2002. Both governments are likely to breach the SGP for a third time in 2004. The German government is campaigning for a [euro] 16 billion tax cut in 2004, and France will not abide by the fiscal rule before 2005. Thus, there is a prevalent European paradox: France and Germany asked for fiscal stability, while they are the first big economies not to respect the Pact. Indeed, the French and Germans have never had the same priorities. For the Germans, fiscal stability is a pre-requisite for upholding the credibility of the euro, while for the French, the first priority is growth, the second is fiscal discipline, and the third is sound monetary policy.

This paper addresses the question of whether the SGP is only a fiscal rule or whether it has the potential to create strong incentives for the implementation of structural reforms to benefit France, Germany, and other members of the European Union. Assuredly, discarding the SGP would loosen the fiscal pressure placed on the individual countries, yet it would come at the cost of one less incentive to reform the European economies. The remainder of this paper is organized as follows. The next section ("Historical overview") presents an historical overview of the SGP. Then the paper introduces...

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