Stability and Growth Pact compliance mainly good when economy is in bad shape

The Stability and Growth Pact (SGP) is regularly criticised for forcing austerity on countries with large deficits when the economy is in difficulty. At the same time, the failure of Member States to comply with European fiscal rules is also often criticised. How do these two observations relate to each other? 

Usually strong compliance with corrective arm

Under the corrective arm of the SGP, Member States enter an excessive deficit procedure (EDP) when their budget deficit exceeds 3% of GDP, or when their public debt is too high. At the recommendation of the European Commission, the European Council issues guidance to countries facing an EDP about the extent and pace of measures (austerity measures and tax increases) that are required to bring the deficit below 3% of GDP. The first EDPs were imposed in 2003 on Germany and France. Since then, all the countries in the euro area have been subject to an EDP at some point. This was the case for the Netherlands in 2004-2005 and 2009-2014. 

In practice, countries often enter EDPs during economic downturns. After all, during a recession the budget deficit usually goes up, and is therefore more likely to exceed 3% of GDP. As a result, EDP recommendations are procyclical. In other words, governments are asked to tighten their belts during times of economic difficulty. 

Whether the recommendations actually have a procyclical effect depends on the level of compliance. When subject to an EDP, Member States are required to implement austerity measures that will result in the required improvements to their structural budget balance (the budget balance adjusted for cyclical and non-recurrent developments). Figure 1 shows the required improvements to the structural balance of the twelve original euro area countries, compared to the actual improvements realised in the years under an EDP. A percentage of 100 therefore means a country has met the recommendations of the European Council exactly, while a percentage above 100 means that the structural budget balance improvement even surpassed European Council requirements.

Note: Luxembourg is absent from Figure 1 because it has never been subject to an EDP recommendation. Figures for Greece are until 2013.

We can make two notable observations. Firstly, a substantial proportion of Member States comply with the recommendations. Although no causal relationship has been established – it is after all conceivable that Member States would also have introduced austerity measures even without these recommendations – this does suggest that the corrective arm of the SGP has at least some effect. The differences between Member States are also notable. Italy, the Netherlands, Germany and Finland in retrospect fully met the recommendations, while France and Belgium in particular did not perform as well.  

Weak compliance with preventive arm

Even when Member States do not exceed the 3% threshold, the budget still has to meet certain other requirements established by the EDP's preventive arm. A key requirement is that the structural budget balance is at least equal to the medium-term budgetary objective (MTO) or, since 2005, improves by at least 0.5% of GDP. The MTO is roughly equivalent to a balanced budget. 

Compliance with preventive arm requirements is limited, as opposed to with those from the corrective arm. Six of the twelve original euro area countries have never met their MTO (Figure 2). There is virtually no compliance with the requirements for adjusting the structural balance towards the MTO. There is almost no connection between improvements required by the preventive arm and the actual changes to the structural balance.

Note: Figures for Greece are until 2013.

The SGP's corrective and preventive arm are inextricably linked. Deficient compliance with the preventive arm raises the likelihood of countries coming under the corrective arm in times of economic difficulty. In this regard, the procyclical effect of the corrective arm is to a certain extent partly the result of weak compliance with fiscal rules for favourable economic times. In recent years a great deal has changed in the preventive arm, such as the possibility to impose financial sanctions and the introduction of rules to control public spending. It is still too early to assess the effects of these reforms. However, it is clear that better compliance with the preventive arm is essential.