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The Myth of the Fiscal Straitjacket

Mises Daily: Friday, August 20, 2004 by

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About 23 years ago, reluctant Republican legislators acquiesced to increasing the statutory ceiling of the federal debt (then $1 trillion) at the behest of President Ronald Reagan, who assured congressmen that the measure would be a one-time event. The pledge has of course been broken repeatedly; America's sovereign debt stood at $6.9 trillion as of January 2004[i].

Across the Atlantic the parallels are striking. In the interests of safeguarding the credibility of the euro before its introduction in 1999, European Union (EU) member states committed to a set of rules that forbid them to borrow beyond specified limits. Since then, the rules have been buffeted by outright challenges, covert and overt evasion and near-universal disdain, implying that European politicians are intent on proving that deficits do not matter, a patently spurious notion made fashionable by America's late 40th president.

The Rulebook

The EU's fiscal guidelines are governed by two principle texts, the Excessive Deficit Procedure (EDP) and the Stability and Growth Pact (SGP). According to Article 104 of the 1992 Treaty on European Union (Maastricht Treaty) member states are obliged to hold annual budget deficits and debt ratios-as a percentage of GDP-below the reference values of 3% and 60%, respectively. The remainder of Article 104 outlines the sequence of EDP procedures, which are as follows: 

1. If the European Commission (the EU's supranational executive and civil service) finds a member state has posted an excessive deficit it prepares and issues what is commonly called an "early warning", which must be confirmed by the European Council (the formal intergovernmental group of finance ministers).

2. The Council recommends measures to the member state that would rectify the breach. The pact offender is given four months to take effective corrective action.

3. If the grace period allotted expires without effective action, the Council may apply peer pressure by publiscising its recommendations. If humiliation does not do the trick, the offender receives a final deadline to take action.

4. If the offender still refuses to budge, the Council may impose sanctions at the request of the Commission and solicit the European Investment Bank to suspend its lending policy with the rogue member state.

Should the Council choose to heed Commission advice (the crux of the court case, discussed below) sanctions begin as a non-interest bearing and non-refundable deposit lodged with the EU executive in Brussels. Varying in size, the yearly sum cannot exceed .5% of the offending country's GDP. Two years after the imposition of the EDP, the recalcitrant government's deposit is to be converted into a fine the following year and distributed to member states with sounder finances on a pro rata basis.

To address grave reservations regarding the voracity of the EDP, the SGP was adopted 17 June 1997 by the EU heads of state and government and supplemented by Regulation 1467/97 concerning speeding up and clarifying the implementation of the excessive deficit procedure. Crafted to buttress and refine the EDP, the pact committed signatories to punctual implementation of multilateral budget surveillance procedures, peer pressure to keep fiscal balances tidy and immediate rectification of any violations of the 3% deficit ceiling.

Loath to cast its lot with the likes of the profligate, debt-laden and devaluation-prone Italians, the German government demanded the SGP as its admission price for junking the country's beloved D-Mark in favour of joining a new currency, which went into full effect upon the introduction of the euro in 1999.

From adherence to abeyance

Like the EDP reference values, countries that wish to join the EU's monetary union must keep deficits and debt burdens below 3% and 60% of GDP. To varying degrees, the 11 countries that met the convergence criteria in advance of euro's debut met these targets, chiefly due to the brisk pace of America's bubble-led economic growth, which spilled across the Atlantic.

As America's boom turned to bust, EU economic fortunes took a turn south, precipitating a deterioration of the member states fiscal positions.

In July of 2002, Prime Minister José Manuel Barroso (recently confirmed as the next President of the Commission) divulged that the outgoing Socialist government had posted a deficit of 3.9% (later revised to 4.4%) of GDP, far exceeding what official accounts had suggested.

Having enjoyed the fruits of monetary union convergence-the country's borrowing rates fell from 20% in 1990 to single digits 12 years later) Portugal became the first member state to infringe the SGP as the global economic downturn and the country's chronic inability to restrain state spending depleted government coffers. Consistent with the EDP, the Commission identified the breach 24 September 2002 and the Council made recommendations to shore up Portugal's finances 5 November.

Ironically, the SGP's champion, Germany, joined Portugal as the first countries to court Commission scrutiny over deficits. Before Barroso confessed his country's fiscal sins in July, his predecessor and Chancellor Gerhard Schröder's government, which ran a deficit of 2.7% in 2001, faced the embarrassing prospect of "early warnings" from Brussels. Unwilling to rap their Teutonic colleague over the knuckles, EU finance ministers-save those from Austria, Belgium, Finland and the Netherlands- pocketed Hans Eichel's assurances that the books would be EDP-compatible. Portugal was also issued a pass. The message from the encounter, however, was clear:  Germany would not hesitate to defy nor lobby to scrap its own rules.  

By October 2002, the German government admitted that it would exceed the deficit limit for the year, thereby launching the EDP the following month. Across the Rhine, France was also treading dangerously close to breaching the SGP in mid-2002 after an audit of the state's books by the incoming centre-right government discovered the preceding socialist administration had understated the quantity of red ink.

Rather than rein in expenditures, President Chirac, who had just secured another term at the Élysée Palace, pledged to bolster the countries defence capabilities and tap the state to spend the economy out of the doldrums. The French President tied deficit reduction to economic growth, refusing to contemplate spending cuts unless 3% GDP growth was achieved for the year. By early 2003, France's economic growth rate had failed to perk up and spending continued unabated, prompting the European Commission to issue its report 2 April 2003 and the Council to specify measures to remedy the breach.

Notwithstanding the formal censure for the supposedly grave eurocrime, the French government remained as defiant about its bulging deficits as it had the moment the Commission originally detected potential profligacy. Chirac dedicated a part of his Bastille Day 2003 comments to deriding the pact, insisting that the SGP be interpreted "flexibly" to permit sluggish EU member states to revive their economic prospects.

Chirac's comments are not surprising. Since the SGP and the euro convergence criteria's inception, he has loathed the accompanying fiscal austerity and ensuing political ramifications. French Prime Minister Alain Juppe was required to slim a bulging deficit of 5% of GDP down to 3% in order to comply with the acceptable reference values. Many of Juppe's decisions were deeply unpopular, prompting rioting in Paris in December 1995. French disenchantment spilled over into the March 1997 as Juppe incurred the voters' wrath and was summarily ousted, dashing the president's scheme of having a loyal government in power coinciding with the duration of his own term. From 1997 to 2002, Chirac was compelled to endure an uncomfortable cohabitation with his Socialist foes.

In fact, the French government objected to the SGP so virulently that their German counterparts diluted early draft texts, specifically striking a provision that would have made sanctions automatic instead of deferring to member states' concurrence (as one will see below this amendment makes a pivotal difference). Moreover, to deflect perceptions that the eurozone's budgetary rules were merely cutting spending and destroying jobs, the word "growth" joined the phrase "stability pact" at French insistence[ii].

Due to an uninterrupted succession of broken promises, evasions, and outright defiance of the SGP by France and Germany matters eventually came to a head in November 2003. In the preceding two months, the Commission had made two recommendations to Berlin and one to Paris asking each government to enact deeper budget cuts in 2004 while extending the deadline to bring the deficits under the 3% ceiling to 2005. The Council convened 25 November 2003 to consider the Commission's recommendations 

Heretofore uncharted territory in applying the EDP, a qualified majority of finance ministers in the European Council agreed over dinner to place the procedure in abeyance, instead of voting to tighten the noose around France and Germany. Not only had the German government reversed, in Hans Eichel's words a year earlier, its "complete and undivided support for the stability and growth pact" by convincing his fellow exchequers to suspend the EDP, it along with France promised only modest self-policed spending cuts in 2004, economic growth permitting.

Eurotussel

Irked by France and Germany's unapologetic flouting of the SGP and the Council's decision to freeze the EDP, the European Commission lodged an action before the European Court of Justice (ECJ) 27 January 2004 challenging:  1) the Council's failure to adopt the decisions recommended by the Commission 2)the conclusions adopted by the Council.

For two hours on 28 April 2004, the 14-judge panel in Luxembourg considered Commission and Council representatives' claims to primacy over governing member states' budgets.

Commission advocate Michel Petite argued that eurozone finance ministers had acted indiscriminately and precariously, departing from the rule of law by failing to enforce the EDP and essentially permitting egregious pact defenders to define the terms of their observance[iii].

Council representative Jean-Claude Piris retorted that member states were under no obligation to abide by Brussels' recommendations, much less apply sanctions. He pointed to the fact that the EDP text indicates that finance ministers "may" adopt Commission recommendations, a product of Germany's decision to adulterate the deficit and debt rules at France's behest.

By July, the ECJ announced its decision. Although the court agreed with the Commission that the Council had illegally frozen the EDP, the Council was within its rights to disregard Commission recommendations. In other words, the Commission polices the SGP and EDP, but the Council retains the prerogative to enforce them.

All interested parties to the case were quick to seize on the aspects of the ruling that suited their purpose. Commission President Romano Prodi, who called the SGP "stupid" in October 2002, altered his position slightly by hailing the ECJ decision for confirming, "the essential role of the Stability and Growth Pact regulations in European budgetary surveillance."  The Dutch and Austrian governments, who, along with Spain and Finland voted against suspending the EDP in November 2003, welcomed the ruling as a verification of the rule of law.  

Meanwhile German officials pointed to the section of the ruling that acknowledged the council possessed discretion in the field of modifying Commission recommendations based on differing assessments of economic data, measures to be taken and timetable to be met. The German Finance Ministry gleaned from the ruling that there is no automatism in deficit procedures, and that flexibility pervades the pact's rules, which the council rightly utilised. French officials, who all but ignored the EDP since it was applied to their government, took note of the outcome and reiterated that it did not challenge existing state budget policies to eventually trim its deficit.

Are Germany and France poised to be fined for their transgressions, as stipulated by the EDP?  Quite unlikely, given the necessity for a qualified majority of finance ministers to authorise punishment and that the Commission is reluctant to press the issue -meaning the EDP and SGP are in de facto abeyance. Berlin and Paris are too politically influential to pay fines. Rather, as implied by the ECJ ruling, both sides will have to revise the pact to arrive at a consensus on how member state budgets will be monitored and enforced in the EU.

Straitjacket no longer

Prior to the ECJ ruling the European Commission had already distanced itself from debilitating rows with prominent member states, admitting the "nuclear" option of fines was devoid of creditability. In late June Brussels SGP supremo, Economic and Monetary Affairs Commissioner Joaquin Alumnia, said application of the EU deficit rules over the past five years had perhaps been, "too stringent and reduced member states' ability to manoeuvre."

Alumnia's comments came on the eve of Commission discussions concerning a handful of reforms to the union's budget guidelines, including requiring governments to run budget surpluses during periods of economic growth and earmarking a portion of those proceeds to combating future economic downturns. Brussels is also mulling a liberal interpretation of the EDF's "exceptional circumstances" clause whereby member states are granted license to run an excessive deficit, at present defined as an uncontrollable event outside the purview of a member state government or an acute decline of annual economic growth of at least 2% of GDP.

In place of sanctions, the Commission would like to augment the system of peer pressure, using member state pressure to bring an errant government back into line. Another idea suggested has been lengthening the periods between stages in the EDF process[iv].

Anyway, the present Commission's mandate expires in October and EU finance ministers have decided to shelve a rewrite of the EDF and SGP until the beginning of 2005. So far, member state exchequers have advocated reinterpreting deficit rules to account for each country's unique financial situation and structural conditions and focusing on long-term debt levels, especially as pension and health obligations loom.

Debt-laden America has heartily endorsed the overhaul, particularly Treasury Secretary John Snow, who agreed with Chirac's critique of the EDF and said that it is foolish for countries to "put themselves in straitjackets."[v] 

With respect to the draft constitutional treaty agreed in mid-June by EU heads of government the EDF and SGP have been incorporated into the text, albeit with a crucial amendment championed by current and impending deficit miscreants Germany, Poland, Greece and Italy. The clause would require merely a blocking majority of finance ministers, as opposed to all of them, to disregard Commission budget recommendations.

Even if the Constitutional Treaty passes ratification muster in parliaments or referendums across the EU, just how the EDF and SGP are applied in practice will be hashed out by member states primarily and the Commission secondarily, as demonstrated by all of the manoeuvring described above. The constitutional text merely reflects the balance of power over EU deficit rules.

Addicted to debt

Notwithstanding all of the carping between member states and the supranational Eurocrats in Brussels, do all of these spats really ameliorate European government finances, and more importantly taxpayers' burdens?  Barring a few isolated examples of concerted budget balancing, attenuating deficits has never been a priority in the EU -now or in the past- as austerity has been subordinated to political expediency, Keynesianism and subterfuge.

Admittedly, EU members averaged budget deficits of 4% in the early 1990s and were able bring that mean below the 3% reference value before the 1998 euro selection deadline. Out of the 12 countries keen to adopt the new currency (Britain, Sweden and Denmark chose not participate on domestic political grounds), only Greece exceeded the 3% deficit target, joining the monetary union a bit later (1 January 2001).

However, the acceleration of European growth, in large part sparked by America's bubble-induced economic dynamism, filled EU member states's coffers, easing the formidable task confronting exchequers. Implicit in this development is that an upsurge in tax receipts-quite obviously the wrong way to go about it- not drastic reductions in expenditure brought European budgets close to balance.

Why a 3% limit for budget deficits was chosen (as opposed to 1% or 2%) as the yardstick for profligacy is not altogether clear. However, its apparent sanctity in relation to the euro stemmed from political debates over European Monetary Union, chiefly that the German and French governments, the avant-garde of the currency, chose 3% as the absolute limit.

On the other hand, the 60% cap on government debt (as a proportion of GDP) has never been seriously enforced. The Maastricht Treaty provided substantial leeway to member states, permitting the reference value to be exceeded if the ratio is "sufficiently diminishing and approaching 60% at a satisfactory pace."  At the time of the first cut for the euro admission only France, Luxembourg and Finland had debt levels below the proscribed level. Belgium and Italy's debt loads were 122% apiece and Greece registered 109%. In 2003, the average debt load for the first 15 EU countries was approximately 71%, well above the target value.

Similarly, the deficit situation across the union is becoming increasingly precarious. Greece and the Netherlands recently joined France and Germany in the transgressor column. Facility and infrastructure cost overruns arising from Olympics preparations widened a gaping hole in Greek accounts while the Dutch government, which happens to hold the rotating presidency of the European Council and is the staunchest defender of the SGP against Franco-German wiles, ironically has surpassed the EU borrowing limit.  

At the same time, six of the ten new Central and Eastern European EU member states (Poland, Czech Republic, Malta, Slovakia, Cyprus and Hungary) have been given until 2006 to bring their excessive deficits to heel. Italy is on the cusp of transgressing EU rules, having narrowly avoided a formal censure from the Council twice this year by promising vague spending cuts.

Much like the entire Keynesianism system of national income accounting, it is impossible to believe the fiscal balances that countries report, especially when one considers the colossal off-the-book pension and healthcare liabilities European governments bear. Obviously, an incentive exists, if only for domestic political reasons, to understate deficits or hold fast to targets via suspect accounting methods.

In order to bring its deficit under 3% in the run-up to joining the euro, the French government successfully petitioned the Commission in 1997 to apply a one-off payment from France Telecom to the state's books. That same year the Bundesbank rejected the German government's attempt to revalue its gold holdings and employ the proceeds to meeting its deficit obligation. Eurostat, Brussels statistical arm, rejected Portugal's initial 2001 deficit estimate of 2.2%, which turned out to be a whopping 4.4% upon closer scrutiny. Italian governments are notorious for cooking the books; the chief of Eurostat likened Rome's bookkeeping to Enron's[vi].

This is not to say the EU's supranational institutions are beyond reproach. The previous European Commission resigned en masse amid a corruption scandal implicating the guardians of the EU treaties in authoring dodgy contracts and practicing lax financial oversight. For years, top Eurostat officials opened covert bank accounts to pass EU money on to contractors with which they had financial affiliations.

Lastly, the European Commission is no paragon of fiscal rectitude. Indeed, it is seeking a substantial augmentation of its budget from 109 billion euros this year to 1 trillion euros over the 2007-2013 spending period to finance egregious agricultural subsidies, regional transfers and other inherently wasteful expenditures. It has not been lost on European governments that the same supranational institution that chides member states for spending money over and above what they were able to seize from their populaces likes to think that it too knows how to spend other people's money better than individual taxpayers do themselves.

Doubtless there will be acrimonious and protracted negotiations during the next 20 months to determine how much money EU member states are willing to place at the Commission's disposal. No matter which side prevails, Europe's taxpayers lose.

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Grant M. Nülle is a Research Fellow with the Ludwig von Mises Institute. Contact him at grantn007@yahoo.com



[i]Rothbard, Murray N. "Repudiating the National Debt."  Mises.org. 16 Jan. 2004.

[ii] Dinan, Desmond. Ever Closer Union. 2nd ed. 1999.

[iii]"Institutions Grapple for Economic Control."  EU Observer. 28 April 2004.

[iv] "Brussels prefer peer pressure to fines."  Financial Times. 22 June 2004.

[v] "Chirac Storms the Stability Pact."  The Economist. 17 July 2003.

[vi] "Roll Over, Enron."  The Economist. 1 August 2002.