Stability pact may be headed for redundancy

The European Commission has declined to discipline breaches of the German innovation designed to impose discipline on member-states running large deficits

The Exchequer's fiscal position has certainly received its fair share of column inches in recent months but most of Ireland's European partners would welcome the problems facing Charlie McCreevy.

Budget deficits are the order of the day in the euro area and a number are likely to breach the terms of the Growth and Stability Pact. Indeed, the pact has been holed to the extent that some argue it is now dead as an effective policy instrument.

The pact was a German innovation, born in the years running up to the creation of the euro, and designed to placate a German public sceptical about relinquishing the deutschmark in favour of a single European currency.

To Germany, it was seen as necessary to impose fiscal discipline on countries such as Italy, running persistently large deficits and with a debt burden well over 100 per cent of GDP.

This would undermine confidence in the new currency, it was claimed, and raise the cost of borrowing for everyone in the zone, including those running more prudent fiscal policies.

Hence the agreement to limit fiscal deficits to a maximum of 3 per cent of GDP, binding on each member-state, with the threat of a fine payable by miscreants of up to 0.5 per cent of GDP.

Since the pact's birth, the European Commission has extended the original constraint, now arguing that governments should aim to run a balanced budget, so that in the event of an economic downturn deficits could indeed rise without threatening the 3 per cent ceiling, whereas if the starting point was already a deficit the room to manoeuvre would be circumscribed.

The pact was largely redundant in the late 1990s as buoyant growth kept most fiscal positions in surplus or small deficit, and first reared its head in farcical circumstances in 2000, with Ireland in the dock.

The Commission declared that Mr McCreevy's proposed budget surplus that year, exceeded 4 per cent of GDP, was not high enough in the economic circumstances of the day and urged spending cuts on the Minister.

He resisted. Some commentators saw this episode as less an attack on Ireland and more as a dry-run for more serious culprits down the line and hence supported the Commission.

Others took the view that the Commission would back down when faced with a serious breach of the pact by a leading player and events have since lent support to this interpretation.

First, Portugal announced its 2001 deficit was not 1.8 per cent of GDP as the outgoing Government had stated, but actually a whopping 4.2 per cent of GDP. A fine does not seem to be forthcoming however. In recent months the line-up of fiscal villains has grown; France and Italy are two that threaten the deficit target, but Germany, ironically seems certain to bust the 3 per cent ceiling, with its deficit likely to approach 3.5 per cent of GDP.

Again one doubts if any action will be taken by the Commission, and it is unlikely that euros will be winging their way from the German Treasury to the European Commission. Moreover, the Commission has recently pushed out from 2004 to 2006 the deadline for governments to deliver balanced budgets, which may be sensible in itself but is another nail in the coffin of the pact.

This puts some perspective on the Irish budgetary position which is likely to be in broad balance in 2002, or if there is a deficit it will be only around 0.2 per cent of GDP. Irish GDP is around €125 billion, so to break the 3 per cent limit the Irish deficit would have to be €3.75 billion. and to match Germany's relative deficit the figure would have to be €4.4 billion.

Critics of the pact argue it is too inflexible and that it takes no account of equally important fiscal constraints such as the amount of debt outstanding. If I owe €1 million. another €100,000 is an onerous burden but not if my outstanding debt is only €50,000. Furthermore, borrowing to build up the infrastructure as in Ireland's case, should not be treated the same as borrowing to fund current consumption, but the pact does not make a distinction.

Therefore one proposal doing the rounds is to modify the pact to exclude capital spending from the 3 per cent deficit figure, and another is to drop the 3 per cent figure altogether in favour of a requirement to avoid increasing the debt to GDP ratio. The latter would allow Ireland to run a deficit over 6 per cent of GDP, for example. And if capital borrowing is excluded, the Irish budget is in surplus to the tune of €5 billion, equivalent to 4 per cent of GDP.

However, the European Central Bank, for one, opposes any change and it would require agreement from all 15 member-states anyway to formally change the pact at this stage. Yet that might be preferable to the current situation, which has seen the pact devalued as a constraint on policy.

Ultimately the catalyst for change may well be the prospect of British entry to the single currency, as Britain would be unlikely to accept the pact in its current form.

• Dr Dan McLaughlin is chief economist with bank of Ireland