Mr. Joaquín Almunia
European Commissioner for Economic and Monetary Affairs

Stabilitätspakt - Quo Vadis?

German Chamber of Commerce - DIHK
Berlin, 2 March 2005

Ladies and Gentlemen,

A few weeks ago we celebrated the sixth anniversary of the Euro. When the project of EMU was launched in the early 1990s, many believed that euro would help Europe to come politically closer together. To some extent, it effectively did. The fact that we are now discussing the adoption of a constitutional treaty - an idea that was taboo - is not unrelated. Sharing the same currency was a huge political step. But it is also true that our debate on the Stability and Growth Pact today may sometimes give a less positive impression. A lot of this is perception. The European Council has strongly reaffirmed in June 2004 its will to preserve it and the draft constitutional treaty has kept unchanged its main mechanisms. In fact, there is a lot of common ground concerning the design of the key features of the fiscal framework. But budgetary policy goes to the very heart of political priority setting and it is little surprise that the governments take strong views when the future of these supranational rules is being discussed.

Any thought about necessary changes to our economic governance framework must be based, of course, on our experience. There can be no doubt that the EU framework improved fiscal behaviour of Member States. Current budgetary trends compare favourably with the past when economic downturns were typically accompanied by a more serious deterioration in budgetary positions. Let me briefly remind you: in 1993, the general government deficit exceeded 5.5% of GDP on average in the euro area and in the EU. In 2004, in a comparable cyclical position, the average deficit remained below 3% of GDP both in the euro area and in the EU.

Many economists and policy makers are today engaged strongly in the debate about fiscal rules in the context of EMU. Before elaborating on why and how the fiscal rules in the EU should be strengthened, let me briefly recall why effective fiscal rules are so important in the context of a monetary union, and how our fiscal governance framework is set up in response.

1. The economic rationale for a fiscal policy framework in EMU

Ladies and Gentlemen,

Sound public finances are an essential condition for sustainable growth. Permanently high deficits weigh on market confidence; create inflationary pressures, lead to increasing debts which drive interest rates up. Also, the capacity of public finances to help smoothing economic slowdowns is significantly reduced if the fiscal position is not held within prudent safety margins in good times.

In the context of a monetary union, additional aspects need to be taken into account. The potential negative effects of unsound fiscal developments in one Member State are felt throughout the entire union. In EMU both the single monetary authority and financial markets look at developments for the euro area as a whole. Today, when exchange rate adjustments are no longer possible, the impact of a fiscal deterioration in one Member States on interest rates is shared across all Members of the currency union, and across the whole spectrum of the yield curve. The integration of our economies fostered by EMU also implies that unsound fiscal policies in one country are likely to adversely affect consumers and investors' confidence - and hence economic growth - not only in that country, but across the euro area, especially if the country in question is a large one.

This is why we need a strong fiscal policy framework: to provide the right incentives for sound policies, and thereby contribute to create the conditions for higher growth.

2. The fiscal framework of EMU

Our fiscal framework aims at providing an adequate mix of autonomy, discipline and coordination.

Member States retain full responsibility for the conduct of their fiscal policies subject to numerical limits on deficit and debt levels, and to procedural rules regarding the multilateral surveillance of fiscal policies.

The Treaty requires Member States to keep their deficit and debt levels below 3% and 60 % of their respective GDP.

The Treaty also lays out the basic rules for identifying the existence of an excessive deficit in a Member States and for the procedure aimed at correcting this situation. These rules include several steps to increase pressure on the Member State to take effective measures to curb the deficit.

The Stability and Growth Pact clarifies the Treaty provisions. The Pact requires government budgets to be `close to balance or in surplus' over the cycle. This is meant to encourage prudent budgetary policy in good times so as to bring the debt levels down and create margins for a possible deterioration in nominal balances during slowdowns.

To strengthen the credibility of the commitment to fiscal discipline, the Pact also clarifies the procedures for multilateral surveillance.

I must insist: the main elements of the pact stem from the Treaty itself, notably its article 104. And this article remains almost unchanged in the draft constitutional treaty.

3. Our experiences and changing conditions call for a reform of the Pact

As you all know, we encountered problems in implementing the fiscal framework. The peer pressure among Member States to encourage compliance with the rules was not always as strong as the Commission would wish for. We were not able to avoid pro-cyclical policies during the good times in 1999 and 2000 and as you certainly remember, we had serious problems in 2003 as deficits went well beyond 3%.

The need for revisiting the Pact was also motivated by some structural changes in the European economic and political environment. First, the link between the deficit and debt criteria has weakened in some Member States. Given low potential growth in several EU countries, even deficits below 3% do not ensure sustainable developments of the debt. Second, the European Union now consists of 25 countries, characterised by considerable diversity. An enriched common framework, with a stronger emphasis on the economic rationale of its rules, would allow better catering for differences in economic situations, which are relevant already among the Member States belonging to the euro area. Finally, the issue of ageing populations has surfaced more prominently on the economic and political agenda. It will have a large impact on public finances, and on economic developments more in general, which needs to be taken into account.

Ladies and Gentlemen,

Some have argued that the problem with the Pact is the lack of its implementation and not the formulation of the rules. The Commission has thought long and hard about this question. To find an answer, we considered two main aspects.

The first consideration is an economic one. We need to better take into account country specific conditions, in particular with respect to their cyclical position, growth potential, debt level and sustainability risks. In addition, the existing framework lacks appropriate incentives for prudent behaviour in good times, raising the risk of undesirable pro-cyclical fiscal behaviour.

The second consideration is credibility. Despite its successes, the Stability and Growth Pact has suffered from the fact that some member states have breached repeatedly the reference values, mainly because they didn't respect Council recommendations We have witnessed considerable deviations from planned adjustment paths, with the achievement of a budgetary position close to balance or in surplus becoming a moving target and excessive deficits becoming more frequent.

These developments revealed not only a loss of ownership of the rules in some Member States. They also generated institutional uncertainty at the European level. We reached a point where we have asked ourselves: is it better to stretch the interpretation of the rules or to go through a reform to adapt them to the economic reality?

4. Main axis of a reform

Ladies and gentlemen,

In the view of the Commission, the considerations I have just described argue for a strengthening of economic governance and, in particular, the Stability and Growth Pact. The economic rationale of the system has to be increased, with more room for economic judgement. Compatibility with the respect of a system based on well-defined, observable and transparent rules, implying predictable actions must also be ensured. This is the best safeguard for the effective implementation of the rules, the achievement of its objectives and equal treatment across countries.

The Treaty's two nominal references - a ceiling of 3% of GDP for the deficit and 60% of GDP for the debt - have to continue to play the central role in the EU's fiscal framework. Breach of the 3% reference value should - as a rule - trigger the excessive deficit procedure.

Introduction of uncertainty about the decision on the existence of an excessive deficit should be avoided, for three reasons: (i) first, this would weaken the transparency of the fiscal framework and therefore its credibility; (ii) second, this would jeopardise equal treatment across countries; (iii) finally, some countries could sustain deficits above 3% without being submitted to an enhanced surveillance. Debt levels would most likely rise, with negative consequences on the sustainability of government finances.

This being said, the Commission defends a number of ideas to strengthen economic governance and to improve the functioning of the Stability and Growth Pact. I will now elaborate on these ideas.

(1) More focus on debt and sustainability

The first one suggests placing more focus on debt and sustainability in the surveillance of budgetary positions. When the Pact was developed, we believed that by focusing on the deficit, debt levels would automatically decline. However, in several countries, we have experienced a weakening of the link between budgetary balances and debt dynamics, due to the decline in potential growth. This implies that for these countries deficit levels below 3% may not mean that the debt will converge to below 60% of GDP. In the future, therefore, an increased focus on debt developments would complement continued rigorous attention to deficit developments.

Provisions for the application of the debt criterion are already in the Treaty. According to article 104, the Commission has the possibility to recommend to the Council to decide on the existence of an excessive deficit in case of non-compliance with the debt criterion. But we consider that a well-defined framework for the assessment of developments in the debt would enhance transparency, avoid surprises and ensure equal treatment. Such framework should not involve a mechanistic approach and leave room for judgment in the process, so to be able to assess the elements which may affect the changes in the debt ratio.

(2) Better take into account economic conditions

The second idea is to take into account the different economic conditions of Member States. As I mentioned earlier, the Pact requires governments' budgets to be `close to balance or in surplus' over the cycle. . So far, this provision of the SGP has been interpreted as a requirement for all Member States to have in cyclically-adjusted terms a balanced budget at all times, at most accepting a small deficit of half percent of GDP. Such a uniform specification for all countries is no longer adequate, in particular given the increased economic diversity in a EU of 25 countries. The medium-term budgetary objective should be derived from the two factors that determine debt developments: the debt position and economic growth. [This means that some countries with high potential growth and low debt ratios could maintain small deficits in cyclically adjusted deficits without problems, while others with high debts and low growth should aim for a balanced budget or small surpluses.]

Moreover, when assessing the deviation from the medium-term objective and/or the path to achieve it, specific economic circumstances and developments could be taken better into account. This could include considering factors such as the impact of some structural reforms or the existing implicit liabilities related to ageing populations.

More importance should also be paid to economic conditions in the implementation of the excessive deficit procedure. The principle that an excessive deficit should be corrected promptly will of course remain. But the influence of economic developments on the budgetary outcome could be considered more systematically, notably when deciding on the initial deadline for the correction of an excessive deficit. The legal arrangements should also allow a revision of this deadline in the course of the procedure, under the condition that the country has acted in compliance with recommendations. At this stage, it would be very useful to have in mind the "relevant factors" that the Commission considers when preparing the report mentioned in article 104.3 of the Treaty.

(3) Budgetary policy and the Lisbon agenda

Budgetary policies should better contribute to achieving the economic objective set in the Lisbon strategy . They should be conducted in such a way that, while respecting the objectives of the EU budgetary framework, they contribute to increasing the growth potential. This can be achieved by improving the quality of budgets on both the expenditure and the revenue side. For this purpose, the link between the central EU instruments for co-ordination of economic policies, the Broad Economic Policy Guidelines and the Stability and Growth Pact should be reinforced.

Structural reforms should be better taken into account in the fiscal framework. We think that a limited number of reforms should qualify for special treatment in the budgetary framework. In particular, major reforms with up-front budgetary costs and direct benefits on future explicit and implicit liabilities may justify a temporary deviation from the medium-term objective or delayed adjustment towards the medium-term objective. Under certain clearly established conditions, structural reforms could also be taken into account in the context of the excessive deficit procedure.

(4) Strengthen the governance of the system and enforcement of the rules

The last issue I would like to deal with is the need to strengthen the governance of the system and enforcement of the rules . This is part and parcel of an acceptable reform package.

The experiences since the start of EMU have demonstrated the need to use promptly and effectively the available enforcement mechanisms. Sound implementation of the EMU fiscal framework notably requires a closer surveillance of public finances during "good times".

A more effective enforcement also requires better co-ordination . In this context, a renewed and shared commitment to the objectives of the fiscal framework should increase the Member States' ownership of the Stability and Growth Pact. The enforcement also requires an efficient functioning of peer pressure in order to deliver the appropriate policies and budgetary outcomes.

Additional avenues to improve the functioning of the EU budgetary surveillance process include improving governance at the national level, building national institutions for budgetary surveillance, and improving the quality, timeliness and reliability of statistics. We are continuously encouraging Member States to make progress in these directions.

The Commission believes that improvements along these lines would reinforce the link between the EU fiscal framework and economic reality and lead to greater ownership in the Member States. This is a necessary condition for effective peer pressure and enforcement of the rules.

5. Conclusion

Ladies and Gentlemen,

Let me conclude my intervention by saying a word on the reform process.

Following the Commission proposals in September, EU Finance Ministers engaged in in-depth discussions in the Eurogroup/Ecofin meetings. When necessary, they mandated the relevant Council Committees to collaborate with the Commission in further elaborating the elements for strengthening, clarifying and better implementing the Pact. Consensus is now emerging on a number of key issues, although there is not full agreement yet on all of them. But I am confident that we can reach conclusions soon.

The Luxembourg Presidency is seeking a common position within the Ecofin in time for the 2005 Spring European Council of 22/23 March. If agreement is reached, the legal texts, namely revised regulations, could then be prepared by the Commission. After consultation of the European Parliament, the new regulations could be endorsed by the European Council of June and subsequently formally adopted by the ECOFIN. We hope that all parties involved in such process will contribute to the achievement of a coherent and balanced package, which is essential both for stability and for growth.

Thank you for your attention.