Should we reform the Stability and Growth Pact?

Written by Chris Huhne MEP and published in Parliament Magazine on Fri 1st Mar 2002

The compromise in the Euro-group of the EU finance ministers on the embarrassing matter of Germany's budget deficit was not edifying, but it does not call for a fundamental review of the Stability and Growth Pact. Indeed, it demonstrates the need for precisely the supplementary measures that the Liberal group has previously backed as a way of reinforcing the SGP and making its 3 per cent limit more credible.

Germany's budget deficit is projected to be 2.7 per cent of gdp this year, perilously close to the 3 per cent limit set in the Stability and Growth pact on which Germany itself insisted as a condition of monetary union. Was it a euro-fudge?

A year ago, Ireland suffered a public reprimand from both the Commission and the Council for cutting taxes when its economy was booming. This year, the Council flunked approval of the Commission's early warning even though Germany is skirting the line. For small countries - Austria was voluble - this shows that there is one rule for the small, and another for the big. Especially when the big ones face elections, as Germany does on 22 September.

The Commission says that it is happy with the outcome because it never sought a change in German policy (whereas it had objected to Irish tax cuts). The idea was to warn Germany to meet its existing plans, rather than to raise taxes or cut spending. The Commission can also point to new pledges from Hans Eichel, the German finance minister, to use any unexpected revenue to cut the deficit. And once the recovery is under way, Germany agrees that it may need to rein back spending or raise taxes.

The financial markets judged this to be credible: bond yields and the exchange rate hardly changed. That is probably the right judgement. After such a pre-electoral and public wigging, the German government is unlikely to take any risks with fiscal policy. Measured by the likely outcome, the Commission's 'early warning' should be effective.

If there is a fault in the system, it is that Germany was not warned two years ago when it began to cut taxes despite its boom. Like other euro-area countries, it entered the system with a sustainable budget position, and could have happily weathered a normal recession. The Berlin government then cut taxation (particularly reforming corporation taxes) by a net 1.1 per cent of national income over the two years to 2000. Without those tax cuts, its projected budget deficit today would be a comfortable 1.6 per cent of gdp rather than scraping the limits of the SGP 3 per cent.

In monetary union, there has to be some limit to countries' borrowing as the markets do not on their own exercise enough discipline (look at New York). The principle of the SGP is right. Moreover, there is no inherent problem with a limit of 3 per cent. Recent research has showed that, providing that euro-area members aim normally through the business cycle to have their budgets in surplus or close to balance, any normal recession will not push them outside the 3 per cent.

But the euro-area clearly needs an agreed way of measuring budgets allowing for the business cycle. If the council, commission and the ECB had agreed a method of adjusting the budget for the state of the economy in each member state, this would have provided a genuine early warning to Germany that it was cutting taxes inappropriately in the upturn.

Otherwise, there is little option but to insist that countries respect the limits despite the state of their economy. Those who call for countries to be allowed to let their deficits expand in a recession however irresponsible they may have been in the upturn have not thought their position through. The full automatic stabilisers should be allowed to work, but only within a framework of responsible finance.

There is also a separate and unique British problem: there is now enormous political pressure to raise public investment. This was cut to 1.5 per cent of gdp in the last Conservative years between 1992-7; then it was cut again by Labour to average 0.6 per cent of gdp between 1997-2002, its lowest post-war level. No other EU country has cut public investment to such depressed levels.

Normally, it is sensible to borrow to fund extra investment. That in turn runs up against the requirement of a budget position 'close to balance or in surplus' which is in both the SGP and the convergence programmes (although for 'out' countries there are no potential penalties). So Gordon Brown now needs extra flexibility to borrow if he is to fund the build-up without raising taxes. Without it, as his officials briefed, Britain could have to cut £10 billion from public spending to meet the deficit targets even though British public debt to gdp is low and falling.

However, the Treaty may help. Article 104 allows temporary or exceptional deficits and specifically asks the Commission to take into account whether the deficit exceeds government investment. If the Chancellor wants to join the euro - thereby making the UK liable for fines it we fail to keep within the borrowing limits - there is surely the flexibility here with the Commission to allow extra borrowing to catch up on Britain's past under-investment.

Chris Huhne is Liberal Democrat MEP for South East England and a member of the European Parliament's economic and monetary affairs