15 January 2019

Vox EU: The mixed success of the Stability and Growth Pact

This column shows that the corrective arm of the SGP, which is procyclical by design, is an important driver of euro area fiscal policy. The preventive arm, which is designed to avoid the need for such procyclical policies, is much less effective - reform of the pact should focus on addressing this.

The corrective arm of the Stability and Growth Pact: Effective but procyclical

In essence, this debate revolves around the question of whether the so-called corrective arm of the SGP is effective in guiding national fiscal policies. Under the corrective arm, EU member states with planned or actual budget deficits exceeding 3% of GDP in principle end up in an Excessive Deficit Procedure. Countries in an Excessive Deficit Procedure receive binding recommendations from the European Council on the annual fiscal adjustment (usually defined in terms of the structural budget balance) to be undertaken, with the aim of bringing the budget deficit below the 3% threshold.

Remarkably, the effect of the Excessive Deficit Procedure recommendations on fiscal behaviour has never been analysed in a direct manner. Some authors use the 3% threshold to define the applicable fiscal governance regime, generally finding that at least forecasted deficits fall faster when this threshold is exceeded (Beetsma and Giuliodori 2009, Cimadomo 2012). However, this does not do justice to the fact that Excessive Deficit Procedure recommendations vary in size and timing among countries, depending on economic circumstances, for instance.

In a recent paper we aim to close this gap. To this end, we first construct a real-time database of all country-specific Excessive Deficit Procedure recommendations since the introduction of the euro, tracking all revisions and changes in these recommendations. The first Excessive Deficit Procedures were launched in 2003, for France and Germany. Until 2017, 22 Excessive Deficit Procedure recommendations were launched for EMU member states, yielding a total of 88 individual country-year targets. As Figure 1 shows, the (GDP-weighted) average requiring fiscal adjustment in the euro area as a whole peaked during the sovereign debt crisis years, reaching almost 1% of GDP in 2012.

In the next step, we estimate real-time fiscal reaction functions for a panel of Economic and Monetary Union (EMU) member states over the period 1999-2017. We relate changes in the structural budget balance to the usual determinants of fiscal policy found in the literature, such as the lagged debt level, the output gap, budget balance and planned elections. Additionally, we include the Excessive Deficit Procedure recommendations applicable at a specific forecast vintage as an additional explanatory variable to gauge their impact.

This approach comes with a challenge – countries with Excessive Deficit Procedure recommendations almost by definition have budget deficits exceeding 3% of GDP, and high deficits may be correlated with factors (other than Excessive Deficit Procedure recommendations) inducing a change in fiscal behaviour. We control for such factors in three ways:

• We allow the effect of recommendations to be different for countries in financial support programs, as they are subject to a different and more stringent governance regime.
• We control for interest rate spreads, which have been found to correlate with having an Excessive Deficit Procedure recommendation (Diaz Kalan et al. 2018). 
• To the extent that deficits above 3% might solicit a change in fiscal behaviour for any remaining reasons, we allow the shape of the fiscal reaction function to vary with the level of the deficit.

We estimate the fiscal reaction functions using both real-time and ex-post data taken from the European Commission’s spring and autumn forecasts. This approach allows us to compare planned versus actual fiscal policy. 

We find that Excessive Deficit Procedure recommendations significantly affect both planned and actual fiscal policy. An Excessive Deficit Procedure recommendation that is larger by 1% of GDP leads to close to 1% of GDP of forecasted additional fiscal consolidation, and around 0.8% of actual consolidation. These findings imply that in particular during 2010-2014, when recommendations were large and frequent, Excessive Deficit Procedure recommendations significantly shaped fiscal policy in the euro area.

The preventive arm is weak 

Anticipating the procyclical effects of the corrective arm, the designers of the Security and Growth Pact also created a preventive arm. This arm of the pact requires countries which are not in the corrective arm to improve their budget balance towards their medium-term objective (a country-specific number close to budget balance), with the aim of creating a safety margin towards the 3% threshold in bad economic times and achieving long-term sustainability of public finances. 

The preventive arm was significantly reformed in 2005, when medium-term objectives were first introduced, and in 2011, when it became (legally) possible to sanction non-compliant member states. It is still quite early to judge the effectiveness of especially the latter of these reforms. However, overall, the track record of the preventive arm in terms of pushing countries towards their medium-term objective is weak. As documented in Hessel et al. (2017), a significant number of euro area countries have never met their medium-term objective. The European Court of Auditors (2018) finds that even during good economic times, progress towards the medium-term objective is often insufficient. Perhaps most remarkably, despite rising debt levels, even the medium-term objectives themselves have mostly become less ambitious over time .

Concluding remarks

The corrective arm of the SGP has both been ridiculed by those highlighting that despite non-compliance sanctions have never been imposed, and vilified by those blaming it for having caused procyclical fiscal tightening. This column suggests there is probably more truth to the latter than the former criticism. While we find indications that forecasted compliance is a bit stronger than actual compliance – in line with the literature on forecast biases in the proximity of the 3% threshold (Frankel and Schreger 2013, Gilbert and De Jong 2017) – Excessive Deficit Procedure recommendations significantly affect fiscal policy in the euro area. 

In interpreting these findings, some nuance remains warranted. After all, even absent any Excessive Deficit Procedure recommendation, most governments would – at least to some extent – eventually correct large deficits. As such, the effect of Excessive Deficit Procedure recommendations may partly reflect a forward shift of fiscal adjustment rather than an additional effect. 

As a final remark, note that the procyclical effects of the Excessive Deficit Procedure partly reflect the failings of the preventive arm, which has contributed to a lack of buffer creation in good times. A number of recent proposals effectively aim to make the preventive arm look more like the corrective arm, in terms of clarity and possibility for sanctions, or merge the two altogether (e.g. European Fiscal Board 2018, Bénassy-Quéré et al. 2018). Our findings on the – perhaps surprising – effectiveness of the corrective arm suggest that this could be a fruitful way forward.

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