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World / Europe Print article | Email
Towards a superior stability pact
By Mickey Levy
Published: September 29 2003 20:23 | Last Updated: September 29 2003 20:23

Europe's policymakers are in a bind: core European nations face recessionary conditions and dismal long-term prospects that cry out for aggressive fiscal reform. But the eurozone stability and growth pact caps deficits at 3 per cent of gross domestic product and thus severely constrains governments' ability to enact the necessary pro-growth tax cuts. Instead, the fiscal debate has involved counter-productive budget trickery, diplomatic disharmony and disregard for the pact that harms its credibility. It is particularly ironic that Germany, France and Italy constitute nearly half of the member nations that drafted the recent Group of Seven communiqué urging pro-growth fiscal reforms, while their own reform efforts are thwarted by self-imposed, misguided rules. With important budget debates looming, the stability pact must be reformed and refocused.

Germany now faces recession and possibly deflation, while France and Italy are not faring much better. This underperformance is not new: Europe's economies have grown more slowly than the US since 1980, and the recent weakness has contributed to rising global imbalances and widening growth differentials within the EU.

The European Central Bank's monetary policy is often blamed, but Europe's biggest problem is low potential growth resulting from excessive government spending and taxation, unsustainably generous pensions and a wide array of burdensome regulations and institutional structures.

Recent deregulation initiatives in the labour, product and capital markets have generated positive results, but significant cuts in government spending and taxes are essential for growth.

Relying on a deficit-GDP ratio to guide fiscal policy - and coordinate policies across EU nations - allows the tail to wag the dog. A focus on deficits (and the stock of debt) has its place, but it is frequently a distraction from the underlying spending and tax structures, the shares of the economy they represent and their implications for the allocation of national resources and household and business decisions. Consider the following: Germany's deficit is about 4 per cent of GDP - not quite as large as the US ratio - but its spending and taxes as a share of GDP are roughly 50 per cent higher than in the US. Obviously, these two nations have different fiscal policies, with different economic implications.

Not surprisingly, research shows that higher government spending is inversely correlated with economic growth, and higher tax burdens harm both economic growth and job creation. By contrast, the impact of deficits on economic growth and jobs is ambiguous, depending on a host of factors. So why rely on deficits as the exclusive fiscal policy trigger? The Maastricht Treaty imposed the deficit limitation to promote fiscal responsibility and rein in government debt. Along with the other criteria, the deficit cap successfully contributed to a convergence toward narrower budget imbalances, lower inflation and interest rates. But in recent years the deficit cap has not led to lower spending and taxes. Rather than promoting fiscal responsibility, it has been an obstacle to fiscal reform. Moreover, the deficit cap is rigid, so when tax receipts fall and spending rises, during economic slumps, it may lead to destructive pro-cyclical policies.

The pact should be altered to make it easier to enact the pro-growth initiatives highlighted by the G7, particularly tax cuts. As well as allowing the deficit cap to fluctuate to reflect economic conditions, the pact should be modified by adding several new fiscal guidelines that would cap government spending and taxes - the true sources of Europe's malaise. These caps should be set well below EU nations' current average ratios of spending and tax ratios to GDP. They should be phased in over a number of years, as the Maastricht criteria were. A formula that eased the deficit ratio in response to tax cuts would also be established.

This would be radical, but these changes would address the most pressing economic and fiscal issues facing EU nations. Pension reform is a necessary component of spending reduction, but it must be implemented over a long period to allow older workers to adjust. Tax cuts, on the other hand - particularly reductions in marginal tax rates that stimulate economic growth and job creation - cannot wait.

This new formulation would provide incentives and flexibility to fiscal policymakers and re-establish the credibility of the pact. I am aware of the fierce political opposition to pension reform and fiscal restraint. Technical details would need to be ironed out. Some EU nations face high government debt-GDP ratios, and even temporary increases in deficits may be perceived as negative. However, Europe can learn from the dramatic fiscal reforms in the US in the early 1980s, which lifted economic performance and standards of living. Fiscal reform that increases potential growth and jobs is the best way to reduce the long-term problems of high deficits and debt - and the most positive strategy for reducing global imbalances.

The writer is chief economist of Bank of America

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