11.3 Attitudes to public debt in the European Union

evidence of a sustainable government nancial position; and the insistence that any

members unable to meet their debt repayments would not be rescued by the ECB. The

evidence of a sustainable government nancial position according to the Maastricht

treaty was that of (a) a general government budget decit no greater than 3 per cent

of GDP at market prices, and (b) a ratio of gross public debt to GDP at market prices no

greater than 60 per cent – unless this debt ratio was falling ‘at a satisfactory pace’.

This concern was carried into monetary union itself with the Stability and Growth

Pact of 1997, which set limits to public sector decits. This is an agreement among

EU members to limit budget decits under normal circumstances to less than 3 per

cent of GDP. The agreement resulted from the fear that countries with past records

of high ination would be tempted, once they were within the monetary union, to

operate expansionary scal policies with high budget decits, especially since they

would be issuing debt in euro. Euro-denominated debt does not bear the foreign

exchange risk premium that had been borne by lira- or drachma-denominated debt

before the beginning of the monetary union. Excess borrowing by some govern-

ments might increase their total public debt sharply and cause the nancial markets

to increase their estimate of the default risk attached to the debt of these countries.

This might cause the markets to believe that the ECB would need to follow a looser

monetary policy to reduce the chance of these countries having to renege on their debt.

The fear was that this would lead to a weaker euro, with inationary consequences

for the monetary union as a whole. The Stability and Growth Pact converted the 3 per

cent of GDP limit on budget decits into a permanent ceiling that might be breached

only under exceptional circumstances. ‘Exceptional circumstances’ were dened as

a natural disaster or a very severe recession, such that the country’s GDP falls by

at least 2 per cent over a year. In June 2005, the rule was weakened by redening

‘exceptional circumstances’ to include any fall in GDP over a year.

The European Commission may report a member state that does not observe the

3 per cent limit to the European Council and an ‘excessive decit procedure’ (EDP) may

then be started against the member state. This may lead to policy recommendations

that the member state is obliged to follow. A deadline may be set for the member state

to bring its decit down below the 3 per cent limit. Failure to do so may ultimately lead

to the imposition of nancial sanctions in the form of a non-interest-bearing deposit

with the ECB or a ne. However, no one has yet been disciplined in this way although

many member states have breached the limit (12 were outside the 3 per cent limit

in 2005) and some have regularly done so. For example, Germany’s decit has been

above 3 per cent in every year from 2002. It has now been given a deadline of 2007 to

conform to the rule and we will need to wait to see what follows if it again fails.

From one point of view, the rm application of the Pact would make little sense

since nes levied would make it more difcult for governments to get their borrow-

ing back within the 3 per cent of GDP limit and would lead to the tightening of scal

policy when economies were at their weakest. The restriction of scal policy in this

way would remove an element of exibility in the management of national economies

and would increase the costs associated with the loss of freedom to change exchange

rates. In late 2002, Romano Prodi, the then President of the European Commission,

caused controversy by saying that the Stability and Growth Pact was ‘stupid’ because

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Chapter 11 • Government borrowing and nancial markets

it was too inexible. Various proposals for loosening the terms of the Pact were put

forward, including tighter budget limits on countries with a high level of public debt,

paying greater attention to structural decits, and allowing countries to run decits

to nance public sector investment. None of these proposals have been accepted in

relation to the 3 per cent limit of the Pact, but in March 2003, the European Council

endorsed a report by EU nance ministers on strengthening budgetary co-ordination,

which emphasised the importance of taking into account the economic cycle, long-

term sustainability and the quality of public investment in assessing the state of

public nances in member states. In June 2005 it was agreed that countries would be

given longer deadlines to correct their decits if they were made subject to an EDP.