EMU and the Public Sector

Fiscal policy affects aggregate demand, economic growth and the rate of inflation. It is therefore important for monetary authorities to follow fiscal policy developments closely. There are many channels through which fiscal policy influences the economy and prices. The level and composition of government expenditure and revenue, as well as budget deficits and public debt, are key variables in this process.

In Stage Three of EMU, budgetary policies remain the competence of Member States. However, a number of institutional arrangements have been made at EU level to ensure sound public finances. In particular, the Treaty’s excessive deficit procedure, further developed and clarified in the Stability and Growth Pact (SGP), aims to limit the risks to price stability that might otherwise arise from unsound public finances. 

For example, an excessive increase in government spending at a time when the economy is already operating at close to full capacity could, by stimulating aggregate demand, lead to bottlenecks in production and generate inflationary pressures. Fiscal imbalances, with large budget deficits and mounting public debt, have characterized many inflationary episodes in history. Fiscal discipline is therefore a basic component of macroeconomic stability. Just like unbalanced budgets, high levels of government debt can be detrimental to stability. If a government has to meet sizeable interest expenses every year, the fiscal situation can become unsustainable and jeopardize price stability. High levels of debt may also have adverse effects on the real economy and the financial environment. In particular, excessive recourse to capital markets by governments tends to raise the cost of capital and this may reduce private investment ("crowding out"). Given the potential problems associated with fiscal imbalances, avoiding excessive deficits represents an important commitment to maintain fiscal policies conducive to overall macroeconomic stability.

While the Treaty on the Functioning of the European Union (TFEU) institutes a single monetary policy, it maintains national responsibilities for other economic (e.g. fiscal and structural) policies. However, it stipulates that Member States shall “regard their economic policies as a matter of common concern” (Article 121 TFEU). A set of rules and measures are designed to ensure that EU Member States abide by this principle in fiscal, structural and exchange rate policymaking.

Since fiscal policy matters remain in the hands of national governments, several provisions aimed at ensuring sound government finances in Stage Three of EMU have been established in the Treaty. Thus, the excessive deficit procedure, as defined in Article 126 TFEU and in a protocol annexed to the Treaty, lays down the conditions that must prevail for a budgetary position to be judged sound and commits all Member States to avoiding excessive government deficits. Compliance with this requirement is assessed on the basis of a reference value for the government deficit-to-GDP ratio of 3%, and a reference value for the government debt-to-GDP ratio of 60%. Should the Ecofin Council find an excessive deficit to exist in a certain country, the excessive deficit procedure provides for further steps to be taken, including sanctions.

The Stability and Growth Pact (SGP) clarifies the implementation of the excessive deficit procedure. The SGP was adopted in 1997 and entered into force July 1, 1998. Technically, the SGP consists of two EU Council regulations and one Council resolution plus another two Council regulations by which it was amended in 2005. By agreeing to the SGP, Member States have committed themselves to pursuing the medium-term objective of budgetary positions “close to balance or in surplus.” The idea is that having such positions would allow them to deal with the budgetary impact of normal cyclical fluctuations without breaching the 3% of GDP reference value.

The SGP comprises preventive and corrective elements. The preventive element is basically the medium-term budget target, which is established flexibly and individually for each Member State. Depending on the size of aggregate debt (higher debt levels require more determined consolidation efforts) and potential growth (higher potential growth requires less of a consolidation effort) of the Member State, the medium-term target for the budget should be between a deficit ratio of at most 1% of GDP and a slight surplus. To prevent fiscal policy from reinforcing cyclical fluctuations, the adjustment path to this target is set in line with cyclical developments: when business activity is strong, budget consolidation should be much speedier. If these targets are not met, the European Commission makes a policy recommendation. Deviation from the medium-term target or the adjustment path is permissible provided structural reform – for example a basic reform of the pension system aimed at introducing a partially funded system – is the reason for the deviation.

The medium-term budget target, the prescribed adjustment path and additional key budget figures must be stated in the stability programs to be submitted annually by the euro area countries and in the convergence programs to be prepared by the non-euro area EU countries. Both programs contain the information needed to assess the budgetary adjustments envisaged over the medium term to reach the close-to-balance or in-surplus position; they are evaluated by the European Commission.

The corrective arm of the SGP establishes in more detail the procedure to be followed in the event of an excessive deficit and defines sanctions. As long as the deficit is close to 3% of GDP and exceeds this value only temporarily, "other relevant factors" may be given due consideration in determining whether an excessive deficit exists. These factors include in particular the medium-term economic situation and the medium-term budgetary position as well as other factors of relevance for the Member States, such as a basic pension system reform.

If a country is found to have run up an excessive deficit, the Ecofin Council issues a recommendation to eliminate the deficit as soon as possible. Normally, an excessive deficit is to be eliminated within a year after it is determined. If a severe economic downturn is under way or if "other relevant factors" apply, the competent bodies should refrain from establishing the existence of an excessive deficit. If unexpected negative economic events with a very unfavorable effect on public finances should arise after a Member State has taken effective measures to address an excessive deficit on which the Council has issued a recommendation for its removal, the deadline for its elimination may be extended by one year, taking into account "other relevant factors."

If the Member State should have failed to follow the recommendation to eliminate the excessive deficit in the first place, and if it still fails to act or to respond appropriately within a specified time limit, in the Council’s view, after having been given notice, the Council may issue sanctions against the Member State. The penalties for failure to comply with the target consist in a non-interest-bearing deposit made up of a fixed component (0.2% of GDP) and a flexible component (1/10 of the difference to 3% of GDP). The annual deposit is limited to 0.5% of GDP. If the excessive deficit has not been redressed two years after the deposit is made, the deposit is converted into a penalty payment.

Under the Treaty, excessive government debt or failure to reduce the government debt ratio may also trigger an excessive deficit procedure.

Complementing these instruments to promote stability-oriented fiscal policies, the Treaty contains three important provisions which aim at amplifying market sanctions for excessive deficits. First, the “no bail-out” clause (Article 125 TFEU) ensures that the responsibility for repaying public debt remains national and prevents risk premiums caused by unsound fiscal policies from spilling over to partner countries. The clause thus encourages prudent fiscal policies at the national level. Second, the prohibition of monetary financing of budget deficits (Article 123 TFEU) and, third, the prohibition of any form of privileged access for the public sector to financial institutions (Article 124 TFEU) also contribute to fiscal discipline. In addition to increasing the incentives to pursue sound public finances and prudent fiscal policies, these provisions contribute to the credibility of the single monetary policy in the pursuit of price stability.