The SGP – Faulty by Design or Made Faulty by Politicians? An Assessment Based on a Simulation Model

Horáková, Šárka; Jahoda, Robert Article The SGP – Faulty by Design or Made Faulty by Politicians? An Assessment Based on a Simulation Model Review of Economic Perspectives Provided in Cooperation with: Masaryk University, Faculty of Economics and Administration Suggested Citation: Horáková, Šárka; Jahoda, Robert (2014) : The SGP – Faulty by Design or Made Faulty by Politicians? An Assessment Based on a Simulation Model, Review of Economic Perspectives, ISSN 1804-1663, De Gruyter, Warsaw, Vol. 14, Iss. 3, pp. 249-265, https://doi.org/10.2478/revecp-2014-0013 This Version is available at: https://hdl.handle.net/10419/179813 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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An Assessment Based on a Simulation Model 1 Šárka Horáková 2 , Robert Jahoda 3 Abstract: By joining the European Monetary Union (the “EMU”), member countries lost the ability to use monetary policy as a tool for macroeconomic regulation. The attention was then focused on regulation of fiscal policy and Stability and Growth Pact (the “SGP”) was the instrument agreed upon. The states of the EMU have agreed to meet the 3% of GDP requirement for the maximum annual public budget deficit. Based on evolution of public debt in member countries, we can say that the SGP has failed as a tool for fiscal discipline. In this paper, we answer the question of whether the failure was due to the incorrect concept of the SGP or whether the development of the debt was affected more by arbitrary disrespect of the agreed rules. The two reasons mentioned above are interdependent. To separate them, we construct a dynamic model of EU countries’ public debt. By using real data, we simulate the potential values of public debt in a situation where the SGP rules have been respected in recent years. Comparing the results for the potential debt given by simulation of the model with the current real values, we are able to quantify the impact of non-compliance for each country. The initial results indicate that there are both EU states where non-compliance led to a negligible increase in public debt – up to 7% of GDP – and other states where this factor caused the growth of public debt by more than 30% of GDP. Key words: Fiscal policy, primary balance, public debt, European Monetary Union, Stability and Growth Pact, fiscal sustainability JEL Classification: C63, E62, H62, H63 Introduction Establishment of procedures for the functioning of the single currency and the European Monetary Union (“EMU”) was one of the motives of the Maastricht Treaty. By joining the EMU, member countries surrendered one part of their sovereignty and entrusted monetary policy to the European Central Bank (ECB). Fiscal policy remained to them as a tool for macroeconomic stabilization. Coordination of fiscal policies is necessary to 1 The authors are thankful to the Grant Agency of Masaryk University for the grant No. MU- NI/A/0784/2013. 2 Masaryk University, Faculty of Economics and Administration, Department of Public Economics, Lipová 41a Brno 62100, [email protected] 3 Masaryk University, Faculty of Economics and Administration, Department of Public Economics, Lipová 41a Brno 62100, [email protected] REVIEW OF ECONOMIC PERSPECTIVES 250 ensure functioning of the common currency and the Stability and Growth Pact (SGP) was drawn up as a tool for fiscal discipline. It was expected that the Maastricht criteria together with the SGP would ensure fiscal discipline in the EU. However, as we have seen in the recent years, these expectations have not been met. Von Hagen and Wolff (2006) claim that the introduction of the SGP together with the Excessive Deficit Procedure (EDP) caused the use of “creative accountability” whereby member countries falsified the statistics or used non-standard fiscal operations to meet the reference values. The financial crisis, which has grown into a debt crisis in the euro area, clearly shows how important it is to pay more attention to the state of public debt. Despite the Maastricht criteria and the SGP, many states have failed to reduce the value of their debt to a sustainable level (Van Nieuwenhuyze 2013). Stoian and Alves (2012) also show in their study that the euro area does not follow any fiscal policy that would be compatible with the requirements of the SGP. One of the consequences of the debt crisis is that risk can be determined for each country separately, while bonds are denominated in the common currency. This contradicts the principles of the EMU which were established in the 1990s (Buiter 2006). Economy of the member countries is very heterogeneous and, furthermore, we cannot talk about fiscal federalism in the EU. The euro seems overvalued for the southern European countries (including France) and underestimated for countries in Northern Europe, especially Germany (Coudert 2013; Duwicquet et al. 2013). Financial markets may decide to refuse a loan to some countries, simply because the operation would be too risky. Consequently, heavily indebted countries may find themselves close to default. The concept of fiscal sustainability can be defined in various ways. Blanchard et al. (1990), for example, state that evolution of the debt/GDP ratio depends on the following factors: primary deficit reflecting the current spending, inherited level of debt/GDP from past times and the difference between the real interest rate and the economic growth. A sustainable fiscal policy occurs when the ratio of debt/GDP after some excessive deflection returns to its original value, i.e. the initial value before the significant bulge in the trend. Afonso (2005) simply claims that in order to achieve a sustainable fiscal policy, the government deficits have to be compensated for by deficit surpluses in the future. The ECB (2012, p. 55) notes that fiscal sustainability is “a country’s ability to service all accumulated government debt at any point in time”. Deviations from the equilibrium are permitted; the important point is that the level of the debt remains stationary or decreases in the long run. According to Collignon (2012, p. 7), the concept of fiscal sustainability is associated with the concept of dynamic equilibrium. Such equilibrium does not necessitate any important changes in fiscal policy and ensures long-term financial stability, i.e. the markets borrow to cover needs of the state. Temporary deviations from the sustainable level are permitted if they are fully corrected. To ensure debt sustainability in the long run, it is necessary to follow fiscal rules that are able to guarantee such a state. Afonso and Rault (2010, p. 11) add that to describe the fiscal policy as sustainable, the level of debt has to converge to zero in infinity and at the same time it cannot rise faster than the real interest rate. Such rules have been established in the SGP specifically to ensure the sustainable fiscal discipline of the signatory countries. The value of the 60% debt/GDP ratio was determined based on the average of the members, and the 3% threshold for the deficit/GDP Volume 14, Issue 3, 2014 251 ratio is based on a simple dynamic model for public debt. According to De Grauwe (2003, p. 2), “it is well known that the 3% deficit norm will ensure that the 60% debt ratio can be kept constant provided the nominal growth of GDP happens to be 5%”. It is necessary to respect this value to avoid constant growth of debt and the snowball effect. In our paper, we use the simple public debt dynamic model to answer the question of whether the failure was due to incorrect concept of the SGP or whether the development of the debt was affected more by arbitrary disrespect of the agreed rules. The two reasons mentioned above are interdependent. To separate them, we construct a dynamic model of EU countries’ public debt. Using real data, we simulate the potential values of public debt in a situation in which the SGP rules have been respected in recent years. Comparing the results for the potential debt given by the simulation of the model with the current real values, we are able to quantify the impact of non-compliance for each country. Stoian and Alves (2012) use a similar model to calculate the level of government surplus that would be necessary to stabilize the public debt. Stoian (2011) believes that economic crisis may have been instigated due to improper fiscal policy. He uses a dynamic model of debt to determine whether the conduct of fiscal policy is vulnerable or not. Afonso (2005) uses the model of a stationary test to determine fiscal sustainability of all the eurozone member countries and, like most authors, he agrees that implementation of fiscal policy is not sustainable. Using this model, Izák (2009) confirms that a government that runs a budget deficit faces significantly higher costs of borrowing. Van den Noord (2010) attempts to quantify the costs of the financial crisis and the impact it has on the sustainability of public finance. The Stability and Growth Pact and Its Evolution The SGP is an essential tool established in order to sustain sound public finances within the EU. The Maastricht Treaty of 1993 is the principal document for the SGP’s constitution. It provides that – as part of the economic and monetary integration – EU member states will form European economic and monetary union (hereinafter referred to as the EMU) and adopt the euro as a single currency. Furthermore, the fulfillment of the requirement to follow commonly known rules is a necessary prerequisite here: the GDP share of public deficit should not exceed 3%, and the GDP share of public debt should not amount to more than 60%. As stated by Fischer et al. (2006), Germany in particular was deeply concerned that these criteria were insufficient, and feared that failure to follow the criteria of budgetary equilibrium would cause inflation to rise, as was the case in the inter-war period. The stability of the common currency would thus be threatened. Furthermore, this brought about the conflict of monetary policy, assigned to the newly born European Central Bank, and fiscal policy, which remained the competence of individual nation states. While the Maastricht criteria served as an indicator for EMU accession, what was missing was any tool to enforce the observation of the rules by the states already within the EU. This is why Germany initiated that the Stability and Growth Pact be created. The pact was adopted at the Amsterdam European Council summit in 1997. It consists of three documents: • Resolution of the European Council on the Stability and Growth Pact Amsterdam, June 17, 1997 (1997); REVIEW OF ECONOMIC PERSPECTIVES 252 • Council Regulation (EC) No. 1466/97 (1997); • Council Regulation (EC) No. 1467/97 (1997). The aim of the SGP is to maintain the public finance deficit within 3% of GDP and the public debt under 60% of GDP. To achieve these objectives, the SGP consists of two mechanisms: a preventive arm and a corrective arm. As its name implies, the preventive mechanism aims to ensure absence of excessive deficits. Therefore, the EU member states submit their stability (for eurozone members) and convergence (for non-eurozone members) programmes. These programmes are then evaluated by the European Commission which subsequently makes recommendations to the Council of the European Union. The Council then adopts the opinion. The preventive mechanism is based on two measures. Based on recommendations by the Commission, the Council is authorized to give an early warning when preventing an excessive deficit. Still, if the limit is exceeded, the sanction mechanism, or more precisely the Excessive Deficit Procedure (EDP), should come into play. This is known as the corrective arm. The pact commenced use only after finishing the third stage of economic and monetary integration in 1999, the year in which the euro was adopted. Its suitability as a tool to sustain fiscal discipline within the EU has been questioned since the beginning of its implementation. Even the two basic criteria were considered as arbitrary and insufficiently supported by theoretical foundations (Calmfors 2005). Wenzel et al. (2004) argue that the Stability and Growth Pact does not allow an adequately flexibly response to economic fluctuations, especially if fiscal policy is the only instrument suitable for their mitigation. Buti and Martinot (2000) add that there is a lack of prevention of pro-cyclical expenditure increases or tax reduction during growth periods. Alesina and Giavazzi (2002) object to the fact that states with a low (Portugal) and high debt level (Greece or Italy) are treated equally. An example could be the early warning for Ireland in 2001. Ireland was punished because its predicted growth was higher than its real growth. The EDP was launched despite the non-existence of an excessive deficit. The authors take the view that the mechanisms of the SGP should primarily target the states with high debt ratios, make them reduce their public debt and strive to restore stability of public budgets. They also criticize the SGP for undue collegiality. They point out that the mechanisms are used only with minor states, whereas for larger states like Germany, France or Great Britain, they remain a mere formal admonition since all procedures are blocked by the qualified majority within the Council. Buti et al. (2003) are concerned with the same problem when they argue that enforceability is the weakest point of the SGP. This issue is connected with the event of 2002 in which the public deficit indicator was exceeded by two founding EU countries, Germany and France. That is why the Commission suggested that the EDP be initiated, which was, however, rejected by the Council in both cases. It may be assumed that the Council’s decision was driven by political reasons since both countries remain influential when enforcing their interests. Nevertheless, employment of “creative accounting” is probably the most significant problem. Governments deliberately distort their statistical data to avoid the EDP (von Volume 14, Issue 3, 2014 253 Hagen and Wolff 2006, p. 9). It is fair to say that the SGP is not to blame here, as data alteration was voluntary decision of the states, after all. In 2005, the Council prepared a proposal for SGP reform, which was approved. The reform introduced some new elements, but none of them represented a fundamental systemic change. Schuknecht et al. (2011, p. 10) argue that it brought “greater discretion, leniency and political control into procedures. The strictness of the 3% limit and the time frame for correcting excessive deficits were relaxed, while procedural deadlines were extended. The greater complexity of the rules made monitoring by markets and the public more difficult.” The biggest deficiency of the SGP – disrespect of the agreed rules, lack of consistency in the application of sanctions and weak enforcement provisions – were not dealt with even with the reform. In 2005, ECOFIN expressed its uneasiness towards the frail institutional framework and the results of the reform. Considering the above, it is no surprise that Schuknecht et al. (2011, p. 10) call the period 1999–2007 as “wasted good times”. The member countries should take advantage of favourable economic development and reduce their deficits or create surpluses. However, neither happened. Hauptmeier et al. (2010, p. 9) describe the ongoing fiscal policy as “broadly relaxed”. As the recession struck in 2008, the situation further deteriorated and in 2009–2010, none of the euro area countries was capable of drawing up a balanced budget. During 2010, all EU countries, whether euro area members or not, fully faced the consequences of crisis. As a response to the crisis, national governments adopted several measures to mitigate the impact of the crisis and start the economy. At the same time, it was necessary to take action at the European level and restore credibility of the financial framework in the European Union. The efficiency of the SGP was underestimated and the coordination of the fiscal discipline had to be strengthened. In autumn 2010, the Council signed the project of the so-called European Semester. It aims to provide a structural framework within which the member states will coordinate their budgetary and economic policies in accordance with the Stability and Growth Pact and the Europe 2020 strategy. As a result, the states are provided with more space for implementing the recommendations of the Council and the European Council; on the other hand, such policy recommendations are given to the states before the approval of their national budgets (European Commission, 2013). Euro Plus Pact (European Union Law 2011 Is another agreement strengthening fiscal discipline. It aims to foster the economic pillar of monetary union, improve quality of the coordination of economic policies and boost competitiveness, which will result in greater convergence. Annual measures will be implemented in stability and convergence programmes to establish a connection between the Euro Plus Pact, the SGP and the European Semester. A major contribution of the Euro Plus Pact is to provide an obligation to introduce the SGP fiscal rules in the member states’ legislation, which, in fact, gives rise to budgetary responsibility. So far, the latest strengthening of the SGP is represented by the signing of the Treaty on stability, coordination and governance in the economic and monetary union in late Jan- REVIEW OF ECONOMIC PERSPECTIVES 254 uary 2012, known as the European Fiscal Compact (see European Commission 2012). The signature commits euro area members as well as all the remaining countries, with the exception of the Czech Republic and United Kingdom. The treaty aims to strengthen budgetary discipline at the national level. The maximum medium-term structural deficit is set to 0.5% of GDP (or 1% of GDP under specified conditions). The treaty also provides that the European Court of Justice will act as an arbitrator. In the case of rule infringement, the court will have the right to fine member states. Methodology and Data The following part of the paper presents a simulation model to assess the impact of deviating from the terms agreed in the SGP. When constructing the model, we follow the literature on fiscal sustainability, especially the works of Blanchard et al. (1990) and Izák (2009) already mentioned. This chapter also contains a brief description of the data used in the model. We use two basic indices for the variables. The upper index t always marks a year for which the value is calculated or simulated. We have two possibilities when it comes to the lower index. In the first case, the lower index of variables is missing; in this case, the variable is calculated from the data available (see the end of this section). In the second case, the lower index S is used to describe the simulated variable which is determined as described below. The root of model (1) is based on the equation of time for the public debt which stipulates that the level of public debt in the current year (marked as   ) is equal to the level of debt in the previous year and this year’s change in debt. Ideally, the change in this year’s debt (equation 2) is equivalent to the level of public deficit in a given year (  ). Afonso (2005) draws attention to the fact that the transfer of public deficit into debt is not necessarily time-consistent within one year. He also notes that the government policy can raise the debt in extra budgetary ways. Eurostat (2013) discusses stock-flow adjustment (SFA) and states that it is the difference between the change in the stock of government debt and the flow of the annual deficit/surplus. Since 2009, Eurostat has distinguished SFA into the following components: net acquisition of financial assets, debt adjustment effects and statistical discrepancies. The importance of SFA has been emphasized many times because it can highlight data quality problems. It has been argued that since great attention is paid to the deficit under the current EU multilateral fiscal surveillance (EDP and Stability and Growth Pact), governments may have an incentive to underreport their deficits by reporting transactions under SFA. Accordingly, we can draw the conclusion that the line between SFA and “creative accounting” is very thin and unclear. Therefore, we introduce and compute the variable which captures all situations in which the growth of public debt in the reference year is different from the size of the public deficit. At the same time, we could not make use of the Eurostat data on SFA since data of the required quality are available only from 2009.       Δ  (1)    Δ     (2) Volume 14, Issue 3, 2014 255 The public deficit (in equation 3a) can be expressed as the sum of the primary balance (  ) and the interest on public debt (  ). At the same time, we follow the standard practice of using capital letters to indicate the nominal values of the monitored variables and lower-case letters to denote their share in the gross domestic product (see equation 3b).         (3a)        (3b) In the real economy, the amount of interest on public debt depends on a combination of instruments used by the government to finance the debt and their cost. We use a simplified relationship in the model (equations 4a and 4b) to show that the amount of interest in a given year depends on the amount of the debt at the end of the previous year and the implicit interest rate (  ) of the debt. Equation 5 calculates the annual real growth of the gross domestic product (  ) from data on GDP at constant (2005) prices ( ∗ ).      ∗   (4a)        (4b)     ∗   ∗   1 (5) The rules of the SGP assume that the public deficit in the medium term has to converge to zero and must not exceed 3% of GDP in a given year. While we cannot clearly interpret what “the public deficit in the medium term has to converge to zero” means, the 3% limit is easily controllable. We use therefore the 3% limit rule which was set at the beginning of implementation of the SGP. If the conduct of budgetary policy does not respect this limit, we cannot blame the approved rules of the SGP for the consequences. Equation 6 therefore provides a basic assumption on which the model stands, namely that the value of the public deficit in each year should be lower than 3% of GDP. As such, we simulate this policy in the form of the ratio indicator (   ) or nominal indicators (   ) in equation 7. The S indicates that these values are simulated to satisfy the rules of the SGP, and at the same time not to reach worse values than those achieved with the actual policy.     3% (6)      !    (7) Assuming that the simulated policy of the state in each year complied with the rules of the SGP and would not achieve worse values than real policies, it is expected that the simulated level of public debt ( "  ) should be reduced, or at least be at the same level as the actual debt. In this situation, however, the level of simulated interest on the public debt ( "  ) was also on a lower or at the same level as the actual level of public debt. We assume (see equation 8) that the simulated level of interest on public debt is due to the simulated level of public debt and the amount of the implicit interest rate.       ∗  "  (8) REVIEW OF ECONOMIC PERSPECTIVES 256 The simulated level of public deficit in a given year is determined by simulated interest on the public debt and the amount of simulated primary deficit (equations 9a and 9b). If the government succeeds in maintaining the public deficit below the reference value of 3% of GDP, there is no reason for the simulated primary balance to be different from the real state. However, if the budgetary policy of the government does not comply with the rules of the SGP, we simulate the primary balance in such a way that it reaches, together with the simulated interest on public debt, the worst permissible level – 3% of GDP. Another constraint for the simulated primary balance asserts that it cannot be worse than the actual primary balance (such a term is described in equation 9a). #$%   3%;  "     ;  "   '(%  ; 3% ∗     "  )) (9a) In this situation, overall deficit is equal to the sum of simulated primary balance and simulated interest on public debt. This deficit never exceeds 3% of GDP in the given year and is in accordance with the rules of the SGP. The rules, however, allow an exception for the 3% reference limit in the case in which the real GDP growth is negative 0.75% or lower (see Article 2 (3) in European Commission (1997a) and the corresponding explanation in European Commission (1997b)). For such situations, the model allows the simulated value of public budget deficit to equal the actual value of the primary balance and simulated interest on the public debt (this exception is described in equation 9b). #$%%  * 0,75%);  "    /   "  ;  "    /   "  ) (9b) Equations 1 and 2 are used to describe the decomposition of the actual government debt; equations 10 and 11 then return to compose the simulated level of debt. Equation 10 therefore states that the simulated increase in public debt is equal to the simulated deficit and the “time discrepancies” that we have excluded in equation 2 from the other calculations. Finally, equation 11 describes the simulated amount of debt at the end of the budget period as equal to the simulated value of the debt at the beginning of the period and the simulated growth of public debt in the given period. ∆ "    "     (10)  "    "   ∆ "  (11) In order to perform the calculations mentioned above, it is necessary to set the period from which the quality of the budgetary policy of the government will be followed up. Due to the date of the introduction of the Stability and Growth Pact and the availability of the necessary data for each country, the first simulation of the public deficit is for the year 1996. At the same time, we set the same level for simulated and actual indebtedness in 1995 (equation 12). The most recent data in our model obtained from the Eurostat server are for the year 2012. We evaluate the quality of the fiscal policy of each country in the past 17 years when we compare the amount of the real and the simulated level of public debt (equation 13). For reasons of comparability, we always use a GDP ratio.  " 112   112 (12) 1 3   4 565  565  565 (13) Volume 14, Issue 3, 2014 263 policies had been followed between 1995 and 2012, we would observe an average increase in the level of public debt by 12% of GDP. The disrespect of the 3% rule caused an increase in the level of public debt of 8% of GDP in the reference period. We should also notice the influence of variable stock-flow adjustment, which in some countries was used to conceal the real state of public finances. The rules of the SGP were set simply and uniformly; decline in interest costs on public debt was one of the outcomes. Nevertheless, the countries were not forced to profit from this favourable situation and did not reduce their public deficit. It should be noted that even occasional compliance violations resulted in a decrease in the debt level of most of the countries in the first period (until 2007). The greatest rate of debt growth occurred in the last 5 years when countries came to terms with the consequences of a prolonged economic crisis. While the model does not indicate that exceeding the permitted deficit of 3% of GDP should be a problem, from the perspective of public finance, a prolonged deficit of 6–10% of GDP is essential. It seems to us that this is a negative consequence of the low degree of attention that was paid to the condition of a balanced budget in the medium term. Therefore, the current efforts to link the SGP rules with the structural component of the deficit seem logical. If we summarize what has been mentioned above, we must conclude that the actual setting of the SGP does not guarantee adequate decrease or stabilization in the level of public debt. 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