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Economic governance: the EU gets tough

Driving Reform: following the roadmap towards a new European economic governance © Mi Ran Collin

The crisis has exposed gaps in the current governance system and showed that existing instruments for economic policy coordination need to be used more fully. The Commission has put forward a comprehensive and coherent package of reforms that will strengthen the Stability and Growth Pact (SGP), particularly through an increased focus on public debt and fiscal sustainability, the extension of surveillance to macroeconomic imbalances and by making enforcement more effective through the use of sanctions and incentives. The Commission also proposes that national fiscal frameworks be strengthened and better aligned with the EU’s new economic governance rules.

Sometimes dark clouds have a silver lining. The financial and economic crises, as well as the more recent sovereign debt crisis, have caused considerable turmoil yet they have also provided valuable lessons. The crises exposed gaps in the current governance system and showed that existing instruments for economic policy coordination need to be used more fully. Before the crisis, good times were not used to reduce public debt sufficiently, and the build-up of macroeconomic imbalances was not sufficiently addressed, despite multiple warnings from the Commission. In several Member States, this translated into high current account deficits, large external indebtedness and high public debt levels, in many cases far above the 60% reference value set in the Treaty. The situation came to a head during the sovereign debt crisis, and as a result, for the first time, a consensus has emerged on the need to reform economic governance in the euro area and EU.

“The experience of the crisis has sharpened the sense of belonging together and at the same time encouraged critical scrutiny of what’s going on in other Member States,” says Reinhard Felke, Head of Unit, Economy of the euro area and EMU.

The Reform package

To improve economic governance, the Commission has proposed a comprehensive and coherent package of robust reforms, outlined in its Communication of 30 June, and based on Articles 121 and 136 of the Treaty1Enhancing economic policy coordination for stability, growth and jobs – Tools for stronger EU economic governance, COM(2010) 367. . The proposals include provisions for the European Semester which has already been approved and will be launched in January 2011. Newer proposals will strengthen the Stability and Growth Pact (SGP), particularly through an increased focus on public debt and fiscal sustainability. They will also extend surveillance to macroeconomic imbalances, including competitiveness divergences, and establish an effective surveillance of structural reforms. Finally, they will enforce economic surveillance through the use of appropriate sanctions and incentives.

The European Semester

European semester of policy coordination

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The European Semester is a period of policy coordination during which Member States will have the chance to review each other’s economic policies before they have been implemented (see Figure). The European Semester cycle will start early in the year with a horizontal review in which the Eurogroup, Council and European Council identify common economic challenges and give strategic guidance on policies. Member States will take these broad policy orientations into account when preparing their Stability and Convergence Programmes (SCPs) and National Reform Programmes (NRPs), submitted in April. The Council, based on the Commission’s assessment, will subsequently provide its assessment and guidance to Member States in June and July, when important budgetary decisions are still in a preparatory phase in most Member States.

Monitoring public debt levels: the Achilles heel of the SGP

One clear lesson from the crisis is the importance of public debt. Countries saddled with high debt were more severely hit by the fallout from the economic and financial crises. Yet fiscal surveillance which focused more on deficits than on debt overlooked the build-up of these vulnerabilities.

At the time of the Maastricht Treaty, it was widely thought that strong reliance on the deficit criterion of 3% of GDP would be sufficient to ensure sound public finances, including automatic convergence towards a 60% debt to GDP ratio. However, slower economic growth puts pressure on public finances and therefore necessitates increased scrutiny of fiscal policies to prevent slippages. To address this Achilles heel, the debt criteria, which has always been a part of the Pact, will now be made operational.

The Commission will establish a benchmark for debt reduction. Member States with debt ratios in excess of 60% of GDP could become subject to the Excessive Deficit Procedure (EDP) (which would now cover debt as well), if the debt reduction in a given preceding period falls short of the benchmark value. The EDP will not kick-in automatically, however. Judgement will be exercised before deciding whether a country should be placed in the EDP and the Commission will analyse factors which affect the quality of the debt and the country’s future prospects, as well as implicit liabilities such as costs related to an ageing population. Moreover, cyclical factors will be taken into account: a country falling short of the debt reduction benchmark owing to recession-induced low nominal GDP growth will not be placed in excessive deficit, if its fiscal position is otherwise relatively sound.

Current-account positions, euro-area Member States (as % of GDP) – Surplus and deficit countries (1991-2010)

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Surplus countries include DE, LU, NL, AT
Deficit countries include EL, ES, PT, CY, IE

Large macroeconomic imbalances made EU and euro-area Member States’ finances more vulnerable to economic shocks.

Source: Commission Services

Macroeconomic surveillance

Another lesson learned from the crisis is that fiscal policy should not be looked at in isolation. Broader macroeconomic surveillance can provide an early warning of trouble ahead as well as help in monitoring the correction of imbalances. The emergence of large macroeconomic imbalances, including large and persistent divergences in competitiveness and current accounts, proved highly damaging to the EU and in particular to the euro area when the crisis struck.

The new surveillance system will consist of a preventive arm and a corrective arm. The preventive arm relies on regular assessments of the risk of macroeconomic imbalances and includes an alert mechanism. The alert mechanism will use a scoreboard based on a small set of indicators. The indicators comprise measures of the external position and price or cost competitiveness as well as internal indicators (see box). A series of alert thresholds will be defined for each indicator. There will be different thresholds for euro area and non euro area Member States, given differences in exchange rate regimes and key economic characteristics.

“We want to avoid moving to too much automatism,” warns Felke, however. The level beyond which changes in a variable constitute a risk varies over time and across countries. A current account deficit of 3% may be acceptable in a converging country with strong investment needs, for example, but not in a more advanced country with an ageing population. Thresholds, therefore, are indicative values and should not be interpreted in a mechanical way.

With this in mind, alerts will always be interpreted by country experts to minimise the risk of sounding false alarms or drawing the wrong policy conclusions. Moreover, the alert mechanism would only be the first stage of macroeconomic surveillance. Once an alert is triggered, experts will perform an in-depth country analysis. When an emerging risk is confirmed, the Commission will make country-specific recommendations to the Council on how to tackle the imbalances, and could also issue an early warning directly to the Member State. In particularly serious cases, the Commission will recommend placing the Member State in an “excessive imbalances position”. This will trigger the corrective arm of the mechanism in which the Member State is subject to stricter surveillance of corrective action.

Apart from the surveillance of macroeconomic imbalances, structural reforms will also be subject to surveillance. The objective of this surveillance is to facilitate the attainment of the Europe 2020 objectives, and in particular the five headline targets, while ensuring that the objectives are attained in a manner that is consistent with macroeconomic and fiscal constraints.

National fiscal frameworks: go local

The new EU governance rules and procedures will be more effective if national fiscal frameworks are strengthened and better aligned with them. National budgetary or fiscal frameworks include numerical fiscal rules, independent public institutions acting in the field of budgetary policy and procedures governing the budget process, in particular medium-term budgetary frameworks. They play a crucial role in strengthening fiscal consolidation and sustainable public finances.

The Commission proposes that statistics and reporting be improved to ensure the reliable and timely availability of budgetary data, that budget forecasts are supplemented with alternative scenarios and that Member States adopt national fiscal rules to entrench the SGP provisions in their fiscal governance regimes. The Commission wants Member States to back up these rules with monitoring and enforcement mechanisms as well as escape clauses. Monitoring should be carried out by a non-partisan domestic body, if possible. Multi-annual budgetary frameworks should also be implemented and include budgetary projections at a sufficient level of detail, to show the adjustment path and pave the way for effective and timely medium term fiscal planning. Finally, measures need to be taken to ensure that all general government sub sectors are covered by the fiscal framework.

Scoreboard indicators

  • Current account balance
  • Net foreign asset position
  • Real effective exchange rate based on unit labour costs
  • Real effective exchange rate based on the GDP deflator
  • Construction real value added
  • Real house prices
  • Banking credit to the private sector
  • Government debt ratio

Enforcement gets teeth

Changes in both the preventive and corrective arm of the SGP are backed up by a new set of gradual financial sanctions for euro-area Member States. In order to strengthen the preventive part of the Pact, an interest-bearing deposit should sanction significant deviations from prudent fiscal policy making. As to the corrective part of the Pact, a non-interest bearing deposit amounting to 0.2% of GDP would apply upon a decision to place a country in excessive deficit which would be converted into a fine in the event of non-compliance with the initial recommendation to correct the deficit. To reduce discretion in enforcement, a “reverse voting mechanism” is envisaged when imposing sanctions at every step of the Excessive Deficit Procedure: the Commission proposal would be considered adopted unless the Council turns it down by qualified majority. Overall, these changes will give teeth to enforcement and limit discretion in the application of sanctions.

Like in the fiscal field, enforcement procedures are also foreseen to support the Excessive Imbalance Procedure. If a euro-area Member State repeatedly fails to act on Council EIP recommendations or to present a sufficient corrective action plan to address excessive imbalances, it will have to pay a yearly fine. The fine should, as a rule, be equal to 0.1% of GDP of the Member State concerned.

Will this time be different?

The Commission’s economic governance package must still be approved by the Council and the European Parliament, but the proposals have the advantage of not requiring any changes to the current Treaty. Moreover, the Commission’s proposals are largely in line with proposals developed by EU finance ministers in the Taskforce on economic governance headed by Herman Van Rompuy. But will the reforms make a difference? “The introduction of the euro changed the rules of the game, and the crisis has now made us aware of these changed rules,” says Marco Buti, Director- General, Economic and Financial Affairs DG. “Implementation of the proposed governance reforms will reinforce the economic leg of EMU and create solid foundations for a stable euro and sustainable growth of the European economy.”

Average primary cyclically - adjusted balance, as a percentage of GDP

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Analysis of fiscal rule index shows that quality of national fiscal frameworks leads to better budgetary outcomes

According to the available evidence, there is a positive relationship between the quality of national fiscal frameworks and budgetary outcomes across EU Member States. For instance, in the 2006 and 2009 Public Finance Report it was shown that the strength of fiscal rules has a positive impact on the conduct of fiscal policy, resulting in lower deficits or higher surpluses. These results are based on the use of a fiscal rule index that encapsulates the features of national fiscal rules considered more conducive to fiscal discipline (e.g. the existence of an effective monitoring of compliance, enforcement mechanisms in case of non-respect of the rule, legal basis, etc.). Overall, higher index values are associated with better and stronger rules while lower values indicate weaker fiscal rules. The graph suggests that EU Member States scoring higher index values show on average better budgetary results in terms of the primary cyclically adjusted balance over the period 2000-2008.

Source: European Commission

Further information

Further information

Brussels Economic Forum 2009