Proposals could cause conflict among member-states and diminish the role of the National Development Finance Agency, writes Colm McCarthy

Restrictive fiscal and monetary policies have contributed to Europe's sluggish economic performance this past year, in contrast to the timely loosening of policy in the United States.

But changes are on the way. The European Central Bank seems on the verge of an overdue interest rate cut, and the deflationary bias in the Stability and Growth Pact, which constrains member-states' fiscal policy, is acknowledged in the measures announced yesterday by the EU Commission.

The Commission has proposed five measures.

(i) The 3 per cent ceiling on borrowing as a percentage of GDP will now be interpreted in a way that would allow countries to borrow more if their economies are in deep recession.

(ii) Those deemed to be structurally out of balance (too far away from the desired average zero deficit over the economic cycle) will be expected to cut their deficits regardless - tough for France, Germany and Portugal.

(iii) Those guilty of loosening in the good times will face sanctions. Ireland could be deemed to have acted in this way over the past two years.

(iv) Those with debt ratios below 60 per cent of GDP (includes Ireland) would be permitted to borrow more, possibly even more than the 3 per cent ceiling, for "structural reforms", which could cover infrastructure investment.

(v) Those with debt ratios above 60 per cent (Belgium, Greece and Italy are over 100 per cent) would not benefit from any easing, and would be expected to bring the debt ratios down, through running surpluses.

Items (i) and (iv) represent a loosening of the existing regime. The first item involves adjusting the measured deficit, the General Government Borrowing (GGB) requirement, to reflect the position in the economic cycle.

A ceiling of 3 per cent could translate into, say, 4 per cent if the economy in question were deemed to be at the trough of a recession.

This proposal from the Commission contains the potential for serious conflict with member-states. The reason is that the actual GGB deficit is relatively easy to measure but the cyclically adjusted deficit will become a matter of controversy.

Eurostat, the EU's statistical office in Luxembourg, has been given the task of measuring the GGBs and has agreed common rules. Everyone appears to accept Eurostat's authority and independence.

But cyclical adjustment is more a matter of opinion. The EU Commission has computed cyclical adjustments according to a statistical formula, based on the history of deviations from trends in GDP in the various countries.

But those who breach the limits, now to be defined by the Commission as well as Eurostat, will face sanctions including large cash fines.

They will argue that the Commission's formula is wrong, too mechanical, does not take account of special factors and so on.

They might even be right and will certainly be able to find economists to disagree.

This reform, while it makes sense in terms of stabilisation policy, intrudes the Commission's judgment into an area where cash fines will arise.

It runs the risk of a politicisation of fiscal policy and a muddled prosecutor, judge and jury role for the Commission.

Item (iv) will be welcomed by countries that have low debt ratios and are close to fiscal balance, such as Ireland.

They will be allowed to borrow more than under the old rules provided the proceeds go to purposes such as infrastructure investment.

Rather than remove funding off balance sheet, the Government could do more straight Exchequer borrowing, the cheapest kind, while staying within the rules.

The amounts are significant: the GGB has been estimated at €1 billion or so next year, but the full 3 per cent ceiling would be almost €4 billion.

This Commission proposal could diminish the potential role of the Government's new National Development Finance Agency.

Colm McCarthy is managing director of DKM Economic Consultants

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