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Some Pact!

January 19, 2005

As a precondition to joining the European currency, member states had to abide by quantitative fiscal criteria, explained below, sharply limiting their room to maneuver. Since the adoption of the fiscal pact and the launch of the euro, many countries chose to flaunt it, to the chagrin of others that steadfastly adhered to it. This article explains how over the past 14 months a seemingly indomitable EU budgetary instrument has been rendered redundant.

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 levels—as a percentage of GDP—below the reference values of 3% and 60%, respectively.

The sequence of the pact[i] roughly corresponds to the European Commission (the EU's supranational executive and civil service) notifying the European Council (the formal grouping of national exchequers) that a member state has posted an excessive deficit. In turn, the Council gives the offender several chances to rectify the breach, and may impose hefty fines in the cases of protracted intransigence.

The German government demanded the SGP as its admission price for junking the country's beloved D-Mark and joining a currency with debt-laden and devaluation-prone Mediterranean countries.

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

As the chart shows, since 2002, beginning with Portugal, about half of the current EU member states have breached the SGP.[ii]

Ironically, the SGP's champion, Germany, joined forces with its trusted EU partner, France, to emasculate the SGP when both broke the rules in November 2002 and April 2003, respectively.

Together, the French and German governments convinced a qualified majority of finance ministers in the European Council to concur in placing the procedure in abeyance, instead of tightening the noose around the incorrigible countries. The subsequent eurotussel pitted the Commission against member states before the European Court of Justice (ECJ) over conflicting claims to ascendancy governing fiscal policy.

Although the ECJ ruled 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, placing victory squarely in the hands of fiscal miscreants, France and Germany. The German Finance Ministry crowed that the ruling repudiated the notion of automatism in deficit procedures, a volte-face from the SPG negotiations of Dec. 1996, when Berlin grudgingly withdrew its proposal to make fines for excessive deficits reflexive.

A Greek tragicomedy

Already reeling from the ECJ ruling in July 2004, the veracity of the SGP has been cast into further doubt by revelations aired by the Greek government in September 2004. The center-right party elevated to office in March 2004 audited the public books left by the outgoing Socialist administration, discovering substantial budget irregularities. Military expenditures and interest payments had been serially under-recorded and the surplus recorded in the social security account had been over-stated. Eurostat, the EU's statistical agency, was summoned to investigate the findings, which were published late in November.

The upward revisions to Greece's deficit and debt levels (as a percentage of GDP) from 1997 to 2003 are as follows:

The revisions are significant in that Greece was the only candidate country out of 12 excluded from joining the euro in 1999 on account of its inability to bring its deficit below the 3% reference value, joining a bit later on 1 Jan. 2001. Not only has Greece been in breach of the EU budget rules every single year since 1997, it was permitted to join the euro via false deficit figures. This fiscal embarrassment was foreseen; indeed, the dubious reliability of annual Greek statistics attracted Eurostat attention on more occasions than any other member state. The November report[iii] notes several reservations about the quality of Greek deficit figures.

On the heels of Greece's disclosure, the Commission also alleges in an unreleased report that Italy has been underestimating its deficit since 1997. Once likened by the chief of Eurostat to Enron's shoddy accounting, the Italian government's sums have fallen under the 3% reference value every year, though barely, on the back of many one-off payments and other budgetary feints (e.g., arbitrarily taking a pubic firm and its debts off government accounts), just avoiding a formal censure by the Commission in 2004. According to Eurostat's projections, the Italian deficit will jump from 2.7% to 4.4% this year unless slippery Silvio Berlusconi's government can conjure some expense-cutting ploys in the annual budget.

Were it not for the ongoing depreciation of feckless America's dollar, the Greek and Italian misdeeds would have adversely affected the euro's value. Consequently, the fiscal basket case across the Atlantic has rendered the SGP less relevant.

Fuzzy math

A sensible measure to remedy suspect accounting would be to enable Eurostat to increase its oversight of member state accounts, rather than just supervising implementation of EU rules and relying on national governments for data. To that end, EU Monetary Affairs Commissioner Joaquin Alumnia has tabled proposals to empower Eurostat to inspect national accounts, employing expert national auditors and augmenting the agency's manpower and resources.[iv]

Naturally, member states recoil at increased EU control over national prerogatives. More than an issue of pride, ceding auditing authority to Eurostat would expose more budgetary skeletons, particularly the colossal off-the-book pension and healthcare liabilities European governments bear that leave them technically bankrupt. Alumnia's adjuration, "I ask member states to give Eurostat the real figures," will likely go unheeded.

Moreover, Eurostat is no paragon of rectitude. Indeed, Olaf, the EU fraud-detection agency, is investigating what it claims was "a vast enterprise of looting." Senior managers are accused of handing out inflated contracts to former employees and passing money on to them via covert accounts, as revealed by a whistle-blower in Eurostat.

Lax EU financial controls also feature in a case brought by Marta Andreasen, the former EU chief accountant, who claims she was wrongfully terminated for saying publicly that the EU's accounting system was susceptible to fraud. The EU tacitly validated Andreasen's claim, albeit almost three years later, when it switched this month to an accrual accounting system. Previously, Eurocrats were unable to determine how many contracts were being awarded to individuals; nor was a centralized system of monitoring in areas such as research or humanitarian aid[v] available.

The EU's 2004 budget alone amounts to approximately 109 billion euros ($148 bn); by contrast, in 2001 Enron's assets totaled $63.4.

The Commission asserts that the existence and credibility of the stability pact hinges on, "the "quality, timeliness, and reliability of fiscal statistics." Considering the depths of financial chicanery practised by the Commission and EU member states (discussed further below), the pact is worthless.

The Franco-German exception

Nevertheless the madness continues. In the case of France and Germany, both will breach the pact again in 2004. The Commission, disinclined to confront two of the EU's most influential states while the pact is in disrepute and awaiting reform, has lifted what is now a tattered noose from around their necks. The Commission held 14 Dec. 2004 that the deadline of 2005 for the Franco-German tandem to get their fiscal acts in order remained valid, despite the ECJ's repudiation of the SGP suspension of Nov. 2003, when the deadline was originally issued.

With respect to France's budget, the Commission was equally generous. Paris will purportedly post a deficit of 3% of GDP in 2005 on the back of a one-off payment courtesy of a transfer of responsibility for the pensions of public electricity and gas companies' employees. For a well-timed lump sum payment from the firms in 2005, the French social security system will assume these liabilities. Had it not been for a similar one-off payment in 1997, France would not have made the first cut to join the euro.

The Germans' exercise in fiscal fiddling is even more egregious. Starting with an unrealistic assumption of 1.7% GDP growth, the 2005 budget secures €18bn ($24bn) of future payments former state monopolies will pay toward the pensions of their employees—assumed by the German state—until the year 2090. As a condition of privatizing Deutche Telekom and Deutche Post, the government promised to pay roundabout €150bn ($200bn) for pensions over the next 85 years in exchange for the aforementioned levies. Compelled by a high time-preference for cash, the federal treasury will tap €5.5bn ($7.31bn) worth of the future payments in 2005.

Berlin is in a tight spot. The hulking welfare state ensures 70% of the budget is ensconced in nondiscretionary spending. Reunification transfers, more than €1.5 trillion ($2 trillion) over the past 15 years and partly financed off budget, further exhaust beleaguered German taxpayers.

Since the German states (Länder) account for a considerable proportion of the total public sector deficit, their political leaders too have been scraping the barrel for fantastic financial sleights. Abiding by a EU decision that ruled transfers to Landesbanken constituted illicit state aid, the Länder will reclaim €4.1bn ($5.45bn) from those public sector banks they own. However, the regional governments will re-inject these receipts back into the banks, a manipulation accepted as investment—not expenditure—under budget rules, and not yet prohibited by the Commission. In another example of what passes as studious stewardship and accounting of taxpayers' money, Lower Saxony's government will pocket €450m ($600m) in revenue from a stake in a public sector entity sold to another holding company that is completely owned by Lower Saxony and intent on purchasing the stake through debt![vi]

Compare the accommodating stance the Commission takes toward France and Germany to other pact offenders. Greece deservedly faces infringement proceedings stemming from its accounting transgressions. Coupled with Hungary, Greece was publicly notified by the Commission three days before Christmas that Brussels intended to proceed with the excessive deficit cases initiated against them in May 2004. Likewise, Portugal is again at pains to trim is bulging deficit, so as not to incur another rebuke from the Commission, as it did in 2002.

As far as the lax application of EU budget rules goes, bigger is better, just ask France and Germany.

Destroy in order to save

How then, does one go about fixing a pact that has been repeatedly infringed, covertly subverted, roundly derided—called "stupid" by former Commission President Romano Prodi—and overtly assailed by member states?

Dilute it, of course.

Touted as "more intelligent" by Prodi, The Commission's proposals, announced in Sept. 2004, retain the 3% deficit and 60% debt reference values and the excessive deficit procedure as well.[vii] In addition, more scrutiny will be affixed to debt levels, an aspect of the pact that has never been enforced. In 2004, Greece, Belgium and Italy all reported debt levels above 100% of GDP and the EU average debt load, excluding the 10 Eastern and Central European countries that joined in May 2004, was 71% in 2003.

As sensible as these suggestions are, member states ultimately rewrite the pact. National governments will seize on aspects of the Commission's recommendations that advocate defining "country-specific" deficit objectives, obligations and immunities.

The German, French and Italian governments are auguring to exempt member state net contributions to the EU budget, military spending, and state R&D, respectively, from official deficit calculations, vaguely posited in the Commission's proposals. Italy and other countries also balk at the notion that debt levels should be rigorously monitored and that relatively heavily indebted governments should be treated more brusquely than less profligate debtors (or better at hiding their debts).

More to member states' liking are the proposals that the EDP will be interpreted and enforced more flexibly, removing the few existing fetters to Keynesian pump priming. The term "exceptional circumstances," whereby a state can be relieved from sanction when a GDP contraction of 2% or greater is posted within a year, is likely to be broadened to encompass instances where growth is positive, but short of Commission projections. Member states would merely be obliged to seek peer approval to invoke exceptional circumstances, a petition that will surely be granted liberally.

Considering that a compelling incentive to fudge budget numbers existed already, the payoff of reporting misleading figures to the Commission would, under this mooted expansion of "exceptional circumstances," grow tremendously.

Throughout the SGP proposal, the Commission emphasizes the importance of peer pressure in dissuading national governments from flouting their legal obligations, underscoring their pivotal role in naming, shaming, and blaming. Consistent with the ECJ ruling, Brussels concedes that it can only recommend action be taken against fiscal miscreants, whereas implementation resides with member states.

However, as demonstrated by the French and German finance ministers' ability to induce fellow exchequers to vote the stability pact into abeyance and the numerous instances in past years when the Council declined to take up Commission recommendations to wield the EDP against offending member states, the Commission's peer review adjuration rings hollow. Burdened by the welfare state, colossal debt and wedded to creative accounting, EU countries are unlikely to aggressively police each other for fear of recompense.

The overhaul of the pact is slated to begin later this month and be complete by March 2005 at the latest. Ironically, the Duchy of Luxembourg's government, which possesses by far the lowest debt level in the EU, 4% of GDP, will chair the affair.

Grant M. Nülleis a Research Fellow with the Ludwig von Mises Institute. Contact him at grantn007@yahoo.com. Comment on this article on the blog.

[i]Nülle, Grant M. "The Myth of the Fiscal Straitjacket." Mises.org. 20 Aug. 2004.

[ii]European Commission, Economic and Financial Affairs. Ongoing Procedures under the Excessive Deficit Procedure. 2004.

[iii]European Commission, Economic and Financial Affairs. Report by Eurostat on the Revision of Greek Government Deficit and Debt Figures. 22 Nov. 2004.

[iv]European Commission. Towards a European Governance Strategy for Fiscal Statistics. 22 Dec. 2004.

[v]"Commission to switch to new accounting system." Financial Times. 30 Dec. 2004.

[vi]"Germany struggles with the stability pact." Financial Times. 12 Dec. 2004.

[vii]European Commission. Strengthening economic governance and clarifying the implementation of the Stability and Growth Pact. 3 Sept. 2004.

 


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