17 July 2012

European Commission: 2012 Report on Public Finances in EMU – Ongoing consolidation and reforms of the EU's fiscal governance

Following the deep contraction the EU economy went through in 2009, modest growth had returned in the third quarter of 2009 and with it came an expectation that an albeit slow return to normality had begun. While this seemed to be the case in 2010, by the end of 2011 the outlook had taken a downward turn. The expectation now is that real GDP will stagnate or go into slightly negative territory this year before picking up again in 2013, based on an appeasement of uncertainties linked to the situation in Greece and Spain. While there are some encouraging signs on the global stage in terms of the outlook for the world economy, the continued need for profound macro-economic adjustment as a consequence of the imbalances that have built up during the last decade in the public and private sector weigh heavily on the growth outlook.

The macro-economic environment is thus characterised by considerable variation within the European Union. In 2011, economic growth exceeded 3 per cent in several Member States, but was negative in others like Greece, Portugal and Slovenia. Despite weaker growth in 2011 than forecast a year ago, overall public deficits were reduced thanks to strong consolidation efforts. In the euro area, the average general government deficit fell from 6.2 per cent of GDP in 2010 to 4.1 per cent of GDP in 2011, and a similar improvement also occurred in the EU27.

In the euro area, budget balances vary widely. While the highest deficit amounted to 13 per cent of GDP (Ireland), two countries were able to bring their deficit below the 3 per cent-of-GDP Treaty limit in a sustainable manner (Bulgaria and Germany). Yet, 21 Member States remain subject to the Excessive Deficit Procedure. Overall, the reduction in deficits is forecast to continue in 2012 and 2013. According to the Commission services' Spring 2012 forecast, public deficit is set to shrink to 3.8 per cent of GDP in 2012 and then to fall further to 3.4 per cent in 2013 for the EU as a whole. The combination of continued falling deficits alongside a widening output gap for 2012 means that overall the fiscal stance is expected to turn pro-cyclical this year, before turning counter-cyclical again in 2013 with the anticipated return of stronger growth, although in an environment of large and negative output gap.

In view of the substantial debt increase induced by the crisis, the Member States plan for pursuing ambitious fiscal consolidation plans. Their Stability and Convergence Programmes (SCPs), which were submitted to the Commission and Council in spring as part of the European Semester, show that they have broadly the same expectations on growth as the Commission. They broadly maintain their nominal fiscal targets in spite of the foreseen protraction of the cyclical slowdown currently underway. On aggregate, both the EU27 and the euro area are projecting that they will significantly improve their fiscal positions every year between 2011 and 2015, with the time profile of the consolidation being relatively front-loaded.

It is evident, that economic growth is a key concern: this is the reason why the EU, in line with its Europe 2020 growth strategy, proposed in the context of the European Semester, country-specific recommendations for the reforms that need to be undertaken to deliver stability, growth and jobs. However, the weak growth environment poses a challenge to fiscal consolidation. One element that plays a role in the relationship between growth and consolidation is the composition of the consolidation. Consolidations based on expenditure rather than revenues tend in general to be more lasting and more growth-supporting in the medium term, but more recessive in the short term. Indeed, the improvements in the budgetary positions in the euro area between 2010 and 2011 have been primarily engineered via expenditure restraint. However, this has been also achieved through phasing out the stimulus programmes of 2009, including reductions in public investment. According to plans set out in the SCPs, Member States project to base further fiscal consolidation on expenditure cuts, thus aiming at making it as durable as possible.

The need to restore the credibility in the public finances and the danger posed by large deficits and debts are obvious, and even more so now that growth prospects are looking weak again. However, while weak growth causes larger deficits, the effect of consolidation on growth must also be taken into account. As a country consolidates, in the short-term aggregate demand falls and this has a negative impact on growth before the positive impacts from reduced interest payments and reduced taxation kicks in.

The aggravation of market tensions for some euro area countries led to the creation of financial backstops of last resort in order to safeguard stability of the euro area. The temporary firewalls that were gradually developed in the course of 2010 are currently providing financial support to Greece, Ireland and Portugal. At the end of 2010, the European Council decided to establish a permanent crisis resolution mechanism. Following technical and political decisions to enhance the mechanism's flexibility, euro area Member States signed a Treaty establishing the European Stability Mechanism (ESM) in February 2012. The strict conditionality attached to the financial support provided by all these mechanisms implied a significant strengthening of economic and fiscal surveillance on the Member States concerned.

The supervisory and regulatory framework of the banking system also underwent significant reforms. A new EU financial supervisory framework became operational in January 2011. In response to G20 commitments, the EU continues its financial regulation programme, notably by strengthening the capital requirements for banks and by presenting a European framework for bank recovery and resolution. The proposed framework sets out the necessary steps and powers to ensure that bank failures across the EU are managed in a way which avoids financial instability and minimises costs for taxpayers.

Moving towards a genuine banking union based on a single banking supervision mechanism, the June 29 Euro Area Summit confirmed that the Commission would present proposals to that effect. A major overhaul of the EU economic governance framework was proposed by the Commission in September 2010, and adopted by European Parliament and Council in the second half of 2011 (the so-called 'Six Pack'). With its entry into force in December 2011, the EU is now equipped with much stronger rules than before the start of the economic and financial crisis.

The Six Pack legislation has strengthened a wide range of existing aspects of economic governance and introduced new ones. A new Macro-economic Imbalances Procedure has been set up to prevent or correct macro-economic imbalances to reduce the risks of their unwinding resulting in sudden rises of government deficits and debt. In addition, the Six Pack introduced wide reforms to the Stability and Growth Pact (SGP) which sets out the provisions according to which the Treaty requirements to ensure fiscal discipline are implements. The SGP contains two arms – the preventive and the corrective – with the former setting the requirements for policy-making under normal circumstances, and the latter dealing with the consequences of gross errors in fiscal policy-making.

Full report

© European Commission