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Reforming European Economic Governance

Introduction

For the last three years the global economy has been hit by a series of shocks following the banking and financial crisis of 2008.  The repercussions of these have been deeply felt in Europe where both eurozone and non-eurozone countries have experienced significant economic and fiscal difficulties.  The policies and institutions of the EU have had to adapt to an evolving situation and at times the EU has been criticised for appearing slow to respond. 

The agreements reached at two European Councils and a Eurogroup meeting in March 2011 laid down new rules and procedures to try to avoid some of the difficulties being repeated, strengthened economic governance and established a permanent stability (i.e. bailout) mechanism for the eurozone.  These agreements were the culmination of discussions over many months.  The background to these was covered in previous Senior European Experts group papers, including a longer paper entitled “Europe and the Eurozone: Stability Restored or Continuing Crisis?” which can be found on the website of the European Movement.

This paper does not cover the detailed background to the economic and fiscal crisis but focuses on the agreements reached in March 2011 and their implications for the both eurozone and non-eurozone EU Member States.

Background

By the middle of 2010 the Member States of the EU had experienced major economic and fiscal problems for over two years.  The exact problems varied from country to country but they commonly included over-leveraged banks, excessive public deficits, poor competitiveness and low economic growth.

The eurozone faced a crisis of confidence because of fiscal problems in a limited number of members, compounded by slow growth, rising levels of unemployment and concern about the impact of the austerity measures necessary to reduce public deficits.  The crisis exposed the interdependence of economies in the EU and the eurozone as well as the linkages between public deficits and the banking sector. [1]

Not surprisingly, given the past failure of the EU to enforce the excessive deficit procedure in the Stability and Growth Pact, there was concern that the EU had neither the political will nor the tools to tackle the combined impact of the problems.  The measures to bail out first Greece and then Ireland were a stop-gap, utilising imperfect mechanisms designed for other purposes.  Despite the establishment of special funds in May 2010 to provide support to eurozone members – and thus to try and protect other members against market speculation – it was feared that other eurozone members might need financial assistance in the near-term; and so it proved in the case of Portugal.  In short, there was an urgent need to restore confidence in the euro and the rules that governed it.

Reforming Economic Governance (1): EU-wide Measures

In September 2010 the European Commission proposed several legislative measures designed to address the various aspects of the crisis; Member States reached political agreement on them in the Council of Ministers on 15 March 2011.  It is important to note that while all EU Member States will be bound by the new rules for the surveillance of their economies, only those who belong to the eurozone will be subject to sanctions for non-compliance.  Other measures specific to the eurozone are dealt with below.

The term “economic governance” has been used with increasing frequency in the EU; it means the arrangements for the running of the euro area and the co-ordination of economic policies within the EU as a whole.  The measures put forward by the Commission in 2010 were designed to strengthen economic governance – in other words, to ensure fiscal responsibility within the eurozone and to make the existing arrangements for economic co-operation within the EU more effective.  These new measures built on the earlier legislation which established four new supervisory bodies for the EU banking and financial services sector: the European Systemic Risk Board; the European Banking Authority; the European Insurance & Occupational Pensions Authority; and the European Securities and Markets Authority.

Reform of the Stability & Growth Pact

Four of the six measures concern reform of the EU’s Stability & Growth Pact; the Pact is of great importance because it contains two fiscal rules designed to ensure stability in the eurozone area.  These rules state that no eurozone country should have:

- an annual budget deficit higher than three per cent of GDP;
- a national debt higher than 60 per cent of GDP.

Breaches of these fiscal rules have implications not just for the member country concerned but for the eurozone as a whole.  The Pact contains both preventive measures and corrective measures to deal with breaches of the Pact’s rules.  The rules on excessive deficits also apply to Member States not in the eurozone but they are not subject to sanctions if they break the rules.

On the preventive side, the proposed legislation would introduce for the first time an expenditure benchmark for each Member State which should not exceed a specified rate of GDP growth.  This would mean that any revenue windfall would have to be allocated to debt reduction.  This arrangement would be part of the economic policy goals of each Member State - known as their medium term objectives.  If a eurozone country failed to reach these objectives, and their expenditure deviated in a significant way from the specified rate of GDP growth, they could face sanctions.

The corrective part of the Pact, usually referred to as the excessive deficit procedure, would be substantially modified.  An important change is that, while maintaining the existing rule that a national deficit should not exceed three per cent of GDP, greater emphasis will be placed on Member States taking action to reduce their debt if it exceeds 60 per cent of GDP.  A Member State with a debt exceeding 60 per cent of GDP will be required to take action to reduce it, even if their deficit is below three per cent.  The basis of this would be whether the debt was falling sufficiently towards the 60 per cent figure; it would be if the debt had fallen over the previous three years at an annual rate of one-twentieth.  Other factors would also be taken into account, including implicit liabilities related to private sector debt (e.g. the debts of banks rescued by the state but which may return to the private sector in future) and the net cost of implementing pension reform.

Enforcement measures for eurozone countries will be tightened as part of the new measures.  Financial sanctions in response to an excessive deficit would apply at an earlier stage than previously and operate on a graduated basis.  The first step would be to require a non-interest bearing deposit of 0.2 per cent of GDP from a country made subject to the excessive deficit procedure.  If the deficit were not corrected in accordance with the requirements laid down by the Council, a fine would be imposed.  Further sanctions could follow, in accordance with existing procedure, if the deficit is not then reduced. 

A key element in the more rigorous approach to excessive deficits will be the introduction of the so-called “reverse majority” rule; this means that where the Commission recommends to the Council that a deposit or fine should be applied, the proposal will automatically be adopted unless it is rejected by a qualified majority.

The final element in the reform of the Stability & Growth Pact is the adoption of common standards and practices so that accounting, statistical and forecasting practices will be carried out to a common standard.  This is a response to the difficulties caused by Greece’s past failure to provide the European Commission with accurate statistical data on its national debt.

Surveillance of economic policies

Member States of the EU have long had treaty obligations to co-operate with one another on economic policy issues.  Every year the Council draws up what are called “broad economic guidelines” and the European Council then considers and adopts them.  This is part of a process of shared economic policymaking that the Commission monitors.  Such economic co-operation is important when 27 countries are jointly operating a single market but it becomes even more important in a single currency area. 

One of the issues identified after the 2008 crisis was the fact that there were considerable imbalances between the macro economies of EU and eurozone members.  Some Member States had built up large trade deficits and lost competitiveness whilst others had generated considerable surpluses by becoming net exporters but had low levels of domestic demand.  These macroeconomic imbalances, particularly within the eurozone, were seen as a de-stabilising factor.  Part of the legislative package agreed by the Council in March 2011 addresses this issue.

The surveillance of Member State economies will be widened to include a mechanism to prevent macroeconomic imbalances and to correct them if they occur.  Imbalances will be assessed against a range of economic indicators and through expert qualitative analysis.  If the imbalance is considered to be excessive, an excessive imbalance procedure would be triggered; this is similar to that for excessive deficits but contains more flexibility as governments have less direct influence over imbalances.  In the case of eurozone countries, failure to comply with Council’s recommendations to tackle the imbalance could lead to a yearly fine equivalent to 0.1 per cent of the Member State’s GDP.  Such a decision to levy a fine would be adopted through the “reverse majority” procedure referred to above.

Reforming Economic Governance (2): the Euro Plus Pact

As part of reforming and strengthening economic governance in the EU, the members of the eurozone agreed in March 2011 a pact covering a wide range of economic policy areas in which they should co-operate closely.  The Pact applies to all eurozone countries and to Bulgaria, Denmark, Latvia, Lithuania and Romania; the remaining EU Member States have chosen not to join.  The Pact is a response to concerns that the eurozone lacks the high degree of economic convergence necessary to achieve an optimal single currency area. 

As the text of the Pact recognises, it focuses on areas of economic policymaking that are generally within the competence of Member States rather than the EU but which are critical to improving competitiveness and “avoiding harmful imbalances”. [2]  The Pact has four guiding rules:

- it is meant to be in line with and to strengthen existing EU economic governance measures; national reform and stability programmes will set out the concrete actions to be taken by member countries;- it will cover priority areas essential to fostering competitiveness and convergence; Heads of State or Government will agree on common objectives but the detailed implementation will be for national governments;- national commitments will be agreed annually by member governments and monitored by eurozone governments and the Commission;- it is line with the commitment to the single market of the EU.

The Pact sets out four goals that the member countries wish to achieve: to foster competitiveness; to foster employment; to contribute further to the sustainability of public finances; and to reinforce financial stability.  It then sets out in considerable detail actions to achieve these goals. 

Under fostering competitiveness, the member countries agree to monitor unit labour costs, review centralised pay negotiation systems and to ensure that wage settlements in the public sector “support the competitiveness effort in the private sector”.  They also promise action to raise productivity through opening up sheltered economic sectors to competition, to improve education and to improve the environment for business.

They seek to foster employment by making work pay through tax reform, use labour market reforms to tackle the hidden economy and to increase labour market participation and through encouraging life long learning.

As part of improving the sustainability of public finances, the Pact calls on member countries to incorporate the fiscal rules of the Stability & Growth Pact into their national legislation.  It also proposes raising retirement rates and adopting other measures to ensure the sustainability of pension and social security systems.

In terms of financial stability, the Pact notes the importance of a strong financial sector to the euro area and that reforms to financial supervision and regulation are already under way.  The Pact’s members commit to enacting national legislation on banking resolution – that is, ensuring banks are capable of meeting their obligations.  The Pact members agreed that strict stress tests for banks would take place regularly at EU level.

One area where the Pact’s member countries were not able to reach agreement was on the proposal for a common corporate tax base.  Ireland in particular was deeply unhappy at such a proposal, seeing it as a threat to its low corporation tax rate.  The Pact refers to the possibility of such a development, whilst noting that “direct taxation remains a national competence” and adding that “pragmatic coordination of tax policies is a necessary element of a stronger economic policy coordination in the euro area to support fiscal consolidation and economic growth”.

The European Stability Mechanism

The European Council of 24/25 March 2011 agreed that the following amendment should be made to Article 136 of the Treaty on European Union:

“The Member States whose currency is the euro may establish a stability mechanism to be activated if indispensable to safeguard the stability of the euro area as a whole.  The granting of any required financial assistance under the mechanism will be made subject to strict conditionality”.

There is political agreement that this will be the permanent replacement for the temporary bailout funds established in mid-2010 and that it will come into operation after June 2013.  It will have €500 billion at its disposal, a figure that will be reviewed at least every five years.  The Treaty amendment is necessary because there is no provision in the existing treaties for such a permanent mechanism.  The UK is not affected by the Treaty change as it is not in the eurozone.

Access to those funds will be subject to strict conditionality, involving an economic adjustment programme for the eurozone member country concerned under the direction of the IMF and the European Commission.  Apart from the additional funds that will be sought from the IMF, non-euro Member States will not contribute unless they wish to do so.  The structure of the European Stability Mechanism will be in the form of a treaty among the euro area Member States; it will be an intergovernmental organisation established in Luxembourg.  It will have the same sanctions available as those in the Stability & Growth Pact and in the new legislation on macroeconomic imbalances. 

Assessment

It is too early to assess the value of these measures; the European Parliament has yet to agree the legislation and the treaty ratification process in some Member States may produce unexpected difficulties.  The outlook for the EU economy in general and the eurozone in particular remains uncertain because of the on-going problems in the global economy, the nervousness of the markets as to the possibility of further shocks and the upward trend in commodity prices.  The fiscal problems of some eurozone members are not yet resolved and market scepticism that they will be without sovereign debt defaults remains. 

Nonetheless the agreements of March 2011 were positive because the EU had to address these problems; its credibility as well as the stability of the euro was at stake.  The process of reaching these agreements may have been too slow in the eyes of some commentators but the outcome was positive overall.  The Stability & Growth Pact is to be strengthened by being made more enforceable; the issue of macroeconomic imbalances in Europe has been addressed for the first time by the eurozone countries; and the Euro Plus Pact provides for an enhanced degree of economic co-operation.  The European Stability Mechanism is an improvement on the current ad hoc arrangements and ought to provide reassurance that the euro is properly supported. 

Issues remain, including whether the excessive imbalances procedure can really overcome difficulties such as low domestic demand in Germany or a lack of competitiveness in some other eurozone members.  The enhanced level of co-operation that eurozone countries have committed to through the Euro Plus Pact has the potential to narrow the gap in economic performance between the members but that gap is now very wide.  Unit labour costs in Spain, for example, have been estimated to be 30 per cent higher than those in Germany.  To be competitive with Germany, Spain, Portugal and Greece are all going to have to sharply reduce their labour costs and increase labour market flexibility.  While they have all taken some steps to achieve those changes, the scale of the challenge they face inevitably makes for market scepticism as to whether all Member States will be capable of reaching the desired level of economic convergence. 

April 2011

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[1] Discussed in a recent House of Lords report: The Future of Economic Governance in the EU, HL124

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