Chapter 11 International Financial Stability and Sustainable Development in EU Fiscal Policy

In: Global Public Goods and Sustainable Development in the Practice of International Organizations
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Agnieszka Kłos
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1 Introduction

The scale and accelerating pace of changes in the world’s economy and politics, which produce a number of risks to the economic and social order of the world, countries, and regions, make economic security, including financial security, grow in prominence and take on new meanings. Security and stability of public finances are two inextricable terms. One could say that financial stability determines financial security and vice versa: financial security determines financial stability.

Public financial stability, also referred to as fiscal stability, is the government’s ability to maintain ongoing expenses, tax policy, and other related policies in the long term, without compromising its solvency, and being able to meet all the liabilities and the promised expenses. Public financial stability is not a matter of circumstances. It significantly influences the sense of intergenerational justice while simultaneously delineating enduring principles that are universally relevant to state governments, irrespective of their extant fiscal debt. The maintenance of a prudent level of public debt, coupled with the ability to issue it when necessary, constitutes an essential prerequisite for the optimal operation of the economy. The member states of the European Union must be capable of embracing unexpected circumstances beyond the government’s control, such as high fluctuations of the economic cycle or economic crises. Failure to coordinate the decisions of respective EU member states could cause imbalance in the real economy and the financial system. Therefore, the rationale underlying the proposal for the construction of a sustainable Economic and Monetary Union (EMU) emphasizes the imperative of establishing frameworks for the harmonization of fiscal policies within the European Union.

This chapter is organized as follows. Section 1 deals with financial system as a public good as well as financial stability and security. Section 2 depicts the determinants behind the introduction of the Economic and Monetary Union in the European Union. Section 3 presents coordination of the fiscal policy at European Union level and Section 4 attempts to assess it.

2 The Financial System as a Public Good

2.1 Financial Stability and Security

In specialist literature, the definition of “financial system” may vary depending on the trend one favors. The interpretative approaches to the issues pertaining to financial system perspectives are not mutually exclusive, but rather overlap and complement each other. From an institutional and structural perspective, a financial system is a complicated mechanism of interconnected elements complementing one another. Hence, if a financial system is to be stable, its various individual links must interconnect. The most prevalent idea is that such stability is achieved when economic activity is not disrupted due to asset price changes or problems experienced by financial institutions. Laker (1999) broadly defines a financial system as an avoidance of such disruptions to the financial system that are likely to result in significant increases in actual production costs. Such disruptions may be traced back either to difficulties affecting financial institutions or to financial market disruptions. Crockett (1997b) indicates that as much as monetary stability refers to an overall price level stability, financial stability refers to the stability of the major institutions and markets that make up the financial system. In his view, two conditions have to be met to achieve financial stability:

  1. The key institutions in the financial system must be stable, with a high degree of confidence that they can continue to meet their contractual obligations without interruption or outside assistance.
  2. The key markets must be stable, so that participants can confidently transact in them at prices that reflect fundamental forces and that do not vary substantially over short periods when there have been no changes in fundamentals. (Crockett, 1997a, 1997b)

In addition, Svensson notes that it is necessary to distinguish between monetary policy and financial stability policy. In devising a better financial stability policy, it is important to understand that the monetary policy is distinct and different from financial stability policy. These two policies differ in terms of goals and the choice of various instruments. The responsibility for monetary policy and control of the monetary policy instruments rests with the central bank, but the responsibility for financial stability policy and control of the financial stability instruments are in most countries shared between several authorities (Svensson, 2011).

This difficult task of defining financial stability has also been undertaken by Padoa-Schioppa (2002), Schinasi (2004), Davis (2001), Foot (2003), Williamson (2000), etc. Notably, Schinasi (2004, pp. 8–10) points to key principles for developing a definition of financial stability. However, given the broad character of financial stability, two interconnected definitions come in handy: “A financial system is entering a range of instability whenever it is threatening to impede the performance of an economy” and “A financial system is in a range of instability when it is impeding performance and threatening to continue to do so” (Schinasi, 2004, p. 6).

Financial security is yet another issue related to financial stability (Shkolnyk et al., 2021). The level of a country’s financial security depends on the character of the financial architecture in place and the degree of its economic and financial advancement. For a high level of financial security and, consequently, stability of the financial system, the so-called economy “unshadowing” level becomes of importance. It means an effective financial monitoring, which primarily aims to employ appropriate resources to fight the shadow economy and money laundering (Bukhtiarova et al., 2020). There are internalities in every economy which can impact economic and financial security. They are: budget deficit, high unemployment or high inflation, as well as rising internal and external debt. It is natural for the factors to occur, but if a rising tendency is observed (of budget deficit, sovereign debt, unemployment, and inflation) over an extended time horizon, it could be indicative of a crisis. Therefore, public finance instability is named a potential threat to economic security. Given the state’s role in providing economic sovereignty and independence in making economic decisions, a question arises on the degree of such sovereignty, as globalization and global integration processes are constantly deepening. It is also about what options the state has in decision-making and the influence on economic functioning amid rising international links.

In every country, a financial system works in a strictly defined environment, which has a strong impact on the functioning of the very system and its components. Thus, a structured financial system falls into:

  1. A market financial system which, due to the participation of financial institutions, is a mechanism of money co-creation and cash flow.
  2. A public financial system as a mechanism ensuring that public authorities provide social benefits and public services. The public financial system is made up of fiscal and budgetary institutions, fiscal instruments, and public financial instruments. The existence of a public financial system is attributable to the recognition of financial stability as a public good, as well as to market deficiencies and external factors. (Dobrzańska, Kosycarz & Pietrzak 2016, p.22A review of global literature on the public sector economy allows for the formulation of quite a clear and precise definition of a public good. It is a good to serve the general public, universal, social, and non-private. The public good category is of particular importance for the science of public finance, and it is the need for such goods to exist and to be provided to society that underlies the accumulation and allocation of public funds.1

Holcombe defines a public good as a good characterized by the following two features: it can be consumed by an additional consumer at no additional costs, and none of the consumers can be excluded from its consumption (Holcombe, 1997, p. 1). These two characteristics are referred to as non-rivalry and non-excludability (Samuelson & Nordhaus, 1989, p. 45). In a similar vein, Musgrave (1959) and Buchanan (1965, 1968) point to the principle of a public good in providing public goods. The stability of a financial system meets the criteria to be classified as a public good, as it is a non-competitive good and it is practically impossible for anybody to be excluded. One may say it is a global public good, as it is up to international/state bodies to prepare the relevant legal framework to govern the financial system so that institutions have relevant supervising instruments to perform their functions in providing the public good and ensuring the financial security of society.

3 The Determinants behind the Introduction of the Economic and Monetary Union in the European Union

The concept of creating a single-currency zone in Western Europe has a long history. Following World War II, a federalist movement emerged in Europe. It promoted the idea of political unification of the Western Europe and a formation of the United States of Europe or a European Federation. These ideas can be traced back to the unique political and economic circumstances that the European states were facing at the time. They were rooted in the experiences of armed conflict, with ensuring the preservation of stability and peace throughout Europe as the main goal of the federalist movement. Adopting a federal system would have involved certain sovereign powers being relinquished by individual states interested in participating in such a union in favor of a supranational entity which would serve as the federal governing body and would be subject to democratic oversight by a parliament chosen in direct and universal elections. The federalist movement was based on the idea of first unifying the countries in political terms, followed by economic unification (George & Bache, 2001, pp. 46–49). This concept, however, was not welcome by the countries. It was decided to shift the focus from political integration to economic integration. In 1951 in Paris, following these decisions, six countries (France, Germany, Italy, Holland, Belgium, and Luxembourg) signed a treaty establishing the European Coal and Steel Community, while on 25 March, in the capital of Italy, the Treaties of Rome were signed, setting up the European Atomic Energy Community (Euratom), and the European Economic Community (EEG), which aimed to establish a common market of the member states, introduce a customs union, and set common economic policy.

When the Western European countries signed the said treaties back in the 1950s, the Bretton Woods currency regime was in place globally. The issues of currency integration were not given much attention at that time. On 15 August 1971 Richard Nixon, the then US president, decided to suspend the international convertibility of the US dollar to gold, which caused a breakdown of the Bretton Woods system and a shift to a floating rate system in the majority of countries. The foreign exchange (FX) market turmoil along with the oil crisis forced European leaders to intensify their efforts for currency integration. At that time attempts were made to devise plans for a monetary union (Barre Plan of 1969) or an economic and currency union, the so-called Werner Plan (1970), which was to be complete by 1980, It envisaged:

  1. Full convertibility of the member states’ currencies at irrevocably fixed rates
  2. Full freedom of the flow of goods, services, capital, and labor among the member states
  3. Centralized budgetary policy and uniform monetary policy pursued by a supranational central bank with an exclusive right to issue a common currency
  4. Strengthening and coordination of regional and structural policy
  5. Closer cooperation of social partners, i.e., trade unions, industry, and governments

As a result of the overambitious plans to centralize fiscal and structural policy, and difficulties in implementing the concept of the so-called European currency “snake,” whereby FX rates of six participant countries were to fluctuate within a range of ±2.25%, the countries started withdrawing their currencies from this commitment and the Plan failed (European Commission, 1970; Danescu, 2017; Van Esch, 2009).

In the 1970s, numerous economists undertook an analysis of costs and benefits of a currency union based on an optimum currency area (OCA) theory (Grubel, 1970; Ishiyama, 1975; Tower & Willet, 1975). The optimum currency area theory was formed in the 1960s, and was to address the question in what situation and under what circumstances adopting one currency or fixing FX rates by two currency areas would be a convenient solution. An optimum solution is deemed to be one that guarantees that the fundamental goals of the economic policy (price stability, full employment, and external equilibrium) are met. The founder of the OCA theory is said to be Robert Mundell (1961), who attempted to fix an optimum FX rate system under various economic circumstances. In analyzing the results of demand shocks, he tried to assort an optimum FX rate system to match the economic circumstances in place (Mundell, 1961, p. 658). As part of his research, he endeavored to construct a comprehensive set of tools for shaping economic policy with the ultimate objective of optimizing the attainment and perpetuation of favorable inflationary stability and low rates of unemployment. McKinnon, Kenen, Minz,2 Magnifico, and Fleming,3 and Frankel and Rose4 also contributed largely to the optimum currency area theory. McKinnon (1963) held that it is unprofitable for a small economy to create/maintain its own currency given its negligible importance globally and conversion difficulties in international trade. He also compared the effectiveness of two tools restoring external equilibrium: the liquid FX rate and internal fiscal and monetary policy, depending on how open an economy is. He maintained that the more open a country, the better a candidate to join the common currency area (with the notion of “economy openness” meaning trade integration with other economies measured by the share of goods and services exchanged versus the totality of goods produced and consumed domestically (McKinnon, 1963). Kenen (1966, 1969), in turn, was of the opinion that the current account balance is less likely to get upset as a result of terms of trade worsening when the export structure is more diversified. He emphasized that demand shocks affect the economies to a lesser degree when the latter’s output is more diversified, because the shock will only impact a portion of output. Thus, Kenen’s considerations lead to a conclusion that a currency union could be established by countries with a diversified economic structure as a more diversified economy will be less willing (than an economy with less diversified production) to use the FX rate as a tool to improve the terms of trade (Kenen, 1969, p. 46; Kenen, 1966, pp. 13–14). The most important stage in the history of the European currency union was the Delors Report of 1989, which features a plan to launch a common European currency. The genesis of the creation of the Economic and Monetary Union constitutes a multifaceted economic process encompassing distinct phases and stages that result in progressively more advanced causal relationships, known as stages of economic integration (Committee for the Study of Economic and Monetary Union, 1989).

The formation of the Economic and Monetary Union was to follow three stages:

  1. Stage 1 (1990–1993). Physical, technical, and fiscal barriers are to be removed, coordination of economic policies strengthened, regional and structural funds reformed, budgetary coordination and the process of surveillance of the performance of the practices agreed.
  2. Stage 2 (1994–1998). Community authorities undertake the first operational functions.
  3. Stage 3 (1999–). FX rates are irrevocably fixed and the Community launches its monetary policy. The procedure starts with budget deficit constraints.

These stages were to be implemented provided a new treaty was adopted. On February 7, 1992, the Maastricht Treaty was signed, which became effective in the beginning of 1993. The Treaty established the European Union, largely amended the earlier treaties, and, most importantly, specified convergence criteria to be met by a country willing to join the economic and monetary union.

Convergence criteria fall into two main groups: nominal and legal. The legal criteria regard the compatibility of the legislation of a country candidate with the community law (i.e., with the Treaty on the Functioning of the European Union, Statute of the European System of Central Banks, and the Statute of the European Central Bank). The criteria are set out in Article 140 (1) of the Treaty on the Functioning of the European Union and Protocol 13 to the Treaty (Treaty on the Functioning of the European Union, 2012).

The nominal criteria, commonly referred to as the Maastricht Criteria, include:

  1. FX rate criterion – a country willing to adopt the euro must join European Exchange Rate Mechanism (ERM II) at least 2 years ahead. Participation in ERM II means that the FX rate of a given country must fluctuate within a normal range versus the central bank rate (currently ±15%). In addition, according to this criterion, a given currency rate must not be devalued over the period nor must it undergo severe tensions.
  2. Price stability criterion – an average yearly inflation rate (in the year prior to the test) must not exceed more than 1.5 percentage points of an average inflation rate of three countries with the lowest inflation. All EU countries are taken into account in this respect, even those from outside the eurozone.
  3. Interest rate criterion – in the year prior to the test, an average long-term interest rate must not be higher than by 2 percentage points than the average rate determined for three countries with the lowest inflation. Again, all of EU countries are taken into account, not just the eurozone.
  4. Fiscal criterion – it comes down to the eurozone candidate’s assessment with respect to excess deficit. Two economic indicators are taken into account to find whether a given country is subject to an excess deficit procedure:
    1. The level of the country’s budget deficit: it may not exceed 3% of the country’s GDP.

    2. The sovereign debt level: it may not exceed 60% of GDP. (European Council, n.d.-a)

What deserves attention is that every country willing to adopt the common currency had to meet the said criteria as at the adoption date. On the other hand though, if a currency union member exceeds the agreed criteria, no exclusion will ensue.

The countries that decided to adopt the common euro currency and met the necessary criteria had to accept the fact that they would not be able to conduct their own monetary policy, as henceforth it was to be conducted at the EU level. Since January 1, 1999, the European Central Bank has been in charge of the monetary policy. The Bank’s primary goal is to keep stable prices, whereas the implementation of the main areas of the monetary policy, including money supply control and FX and interest rate policies, is aligned with the primary goal. In addition, the ECB, along with the central banks of all the EU 27 countries, form the European System of Central Banks. In turn, in the eurozone, there is the Eurosystem, which includes the ECB and the central banks of the member states of the Economic and Monetary Union.

As the common euro currency was launched, the monetary policy was delegated to a supranational level. It did not concern fiscal policy, which remained with the eurozone countries’ domestic governments. The division was due to the nature of fiscal policy, which depends on a given country’s administrative system, system of revenue collection and spending, economic and social situation, geographical location, and many other complex factors. The idea of a common fiscal policy emerged, but it faced strong opposition by some governments in response to the excessive constraints of the individual countries’ authority over their own budgetary policies. In addition, there is the problem of possible financing of state-assigned tasks (such as social, health, or pension policies) with the state budget’s funds. And then there is the potential coordination of tax systems. What would it look like if every country had a distinctive administrative system and varying needs? So far, only indirect taxes (such as VAT or excise tax) have been harmonized at EU level with regards to their maximum and minimum rates; direct taxes are the exclusive responsibility of the member states’ central authorities.

Even if the fiscal policy is not centralized, it does not mean that every country is free to spend public funds by irresponsible fiscal policy, bearing no consequences. The principles, or rather, constraints, concerning the fiscal policy were included in the Maastricht Treaty, but still numerous countries find it problematic to observe the criteria in practice. In spite of the convergence criteria being formulated in so much detail, once countries met them and joined the eurozone they became less motivated to comply and pursue the correct fiscal policy, in particular, as regards eschewing excess budget deficit Therefore, 3 years after the adoption of the Maastricht Treaty, in order to make the criteria from the Treaty more specific, the Stability and Growth Pact (SGP) was drafted, which included a precise provision on the fiscal criterion, its implementation, observance, and enforcement. Adopting the Pact5 was to prevent the eurozone countries from approaching the convergence criteria too leniently.

The principles on public financial stability as laid down in the treaties are an answer to the sustainable development concept. In line with the fundamental principles of sustainable development, financing of investment projects should be aligned with the development results, which integrate and synergize three dimensions of sustainable development, i.e., economic, social, and environmental, as expressed in the Rio+20 outcome document (United Nations, 2012) to ensure intra- and intergenerational equality.

A full implementation of the sustainable development concept is chiefly due to the observed climate change which calls for increasing financial outlays and the necessity to incur ever higher costs in both private and public sectors. The institutions of the EU (being an international organization) prepare the relevant legal framework to ensure the proper conditions for lasting and sustainable development, not only in the EU, in general, but also in the individual member states. Therefore, it is important for member state governments to remain prudent with respect to the potential macroeconomic challenges of financing sustainable development favoring social inclusion by maintaining fiscal balance and price stability. Within the development-oriented macroeconomic framework, the decision-makers are required to manage the domestic and external sovereign debt prudently so as to minimize its negative impact on inflation, the FX rate, the interest rates, and growth with respect to a potential risk. The requirement’s important element is for the governments to accumulate funds necessary to invest in sustainable development. It is the governments’ responsibility to unblock the fiscal space for investment-oriented expenditure for sustainable development. Countries may, for instance, increase their debt at home or abroad. They may also create fiscal space by increasing the effectiveness of public spending in place and/or changing the priorities of public spending to make it more development-oriented. Countries may also mobilize their domestic funds by adapting the public income structure accordingly (e.g., tax and non-tax income) (United Nation, 2014, pp. 2–4, 14).

4 Coordination of the Fiscal Policy at the European Union Level

One of the pressing problems in the development of the global financial system is the excessive growth of sovereign debt, which has numerous negative consequences for the financial system of any country. Therefore, the spotlight should be turned to creating an effective state debt management system based on the debt’s projected values (Zhuravka et al., 2021, p. 65).

The Stability and Growth Pact is among a few mechanisms ensuring the coordination of economic policies in the urozone. However, member states have always found the principles for economic policy coordination to be controversial. On the one hand, individual member states are keen to preserve the sovereignty of their fiscal policies, especially considering what has already been lost in terms of monetary policy. On the other hand, an economic and monetary union formed by 12 different countries implies that the actions of one member state necessarily affect the others. That is one reason why economic policies need to be coordinated. The belief is that only better coordination can provide for the policies growing more coherent, which would ultimately result in a better policy mix for the entire EMU (Zsolt de Sousa, 2004, p. 3).

The fiscal framework of the EU is an institutional safeguard against the externalities of the domestic fiscal policies in the economic and monetary union. Commonly agreed principles and institutions aim to ensure the long-lasting stability of public finances so as to protect the autonomy and effectiveness of the centralized monetary policy (Larch et al., 2020, p. 3).

There are many institutional participants in the fiscal policy coordination process and many procedures have been devised to achieve this goal (Treaty on the Functioning of the European Union, Articles 121, 126, 136). Among the institutions participating in the coordination process, the European Commission (EC) holds the central position, participates in the meetings of all the other bodies, and sets forth procedures on the financial stability of the member states. The Council (Council of the European Union) shall, on a recommendation from the Commission, formulate a draft for the broad guidelines of the economic policies of the member states and of the Union, and shall report its findings to the European Council. The European Council shall, acting on the basis of the report from the Council, discuss a conclusion on the broad guidelines of the economic policies of the member states and of the Union. On the basis of this conclusion, the Council shall adopt a recommendation setting out these broad guidelines. The Council shall inform the European Parliament of its recommendation (Treaty on the Functioning of the European Union, Article 121). The Economic and Financial Affairs Council (ECOFiN) is a section of the Council of the European Union dealing with government deficits, spending, and taxes, and is a center for coordinating economic policies of the member states. The European Central Bank (ECB) holds the right to participate in the meetings of the ECOFiN in order to foster dialogue on economic policy between these institutions. At the same time, the president of the ECOFiN sits on the EBC Governing Council. Although the president holds no voting rights, he or she may submit notions to this body (Panico & Vàzquez Suàrez, 2007, p. 6).

The Stability and Growth Pact consists of three elements:

  1. A resolution of the European Council on the Stability and Growth Pact (Resolution of the European Council, 1997) (a resolution is an act that is not legally binding) – this is a political commitment of all the parties implementing the Stability and Growth Pact (the European Commission, the member states, and the European Council) to fully implement the process of budgetary surveillance while respecting the predefined dates.

  2. Council Regulation (EC) no. 1466/97 of 7 July 1997 on the strengthening of the surveillance of budgetary positions and the surveillance and coordination of economic policies (Council Regulation, 1997a); the provisions included in the regulation are preventive in nature.

  3. Council Regulation (EC) no. 1467/97 of 7 July 1997 on speeding up and clarifying the implementation of the excessive deficit procedure (Council Regulation, 1997b); the provisions included in the regulation are corrective in nature. This regulation allows for sanctions for countries with excessive deficits in order to prevent the occurrence of such deficits. Whenever the Council decides to impose sanctions to a participating member state, a non-interest-bearing deposit is, as a rule, required. If the excessive deficit results from non-compliance with the criterion relating to the government deficit ration, the amount of the first deposit comprises a fixed component equal to 0.2% of GDP, and a variable component equal to one-tenth of the difference between the deficit as a percentage of GDP in the preceding year and the reference value of 3% of GDP. Each following year, until the decision on the existence of an excessive deficit is abrogated, the Council shall assess whether the participating member state concerned has taken effective action in response to the Council notice. If, following the assessment, an additional deposit is decided upon, it shall be equal to one-tenth of the difference between the deficit as a percentage of GDP in the preceding year and the reference value of 3% of GDP. Regulation (EC) no. 1467/97 specifies the upper limit of the deposits, which should not exceed 0.5% of GDP.

The provisions laid down in the Stability and Growth Pact cover all EU countries, while its correcting part only refers to urozone countries (Panico & Vàzquez Suàrez, 2007, p. 3). The purpose of the preventive function is to ensure that fiscal policy is sustainable throughout the business cycle, i.e., that the medium-term budgetary objective, individual for each member state, is achieved. On the other hand, if the domestic budgetary deficit exceeds 3% of GDP or the sovereign debt exceeds 60% of GDP (values as laid down in the Treaty), EU states shall undertake correcting measures. Under the Stability and Growth Pact, the financial policy rests on the medium-term budgetary objective. During the European Semester it is assessed whether the member states meet this objective or what correcting measures they undertake to meet it. Hence, a medium-term budgetary objective refers to a structural budgetary balance (between public income and spending), which is to protect against exceeding the treaty-based budget deficit threshold of 3% of GDP over the economic cycle and to ensure a long-lasting stability of public finances. The way each country should every year pursue this objective is called “adjustment paths to the medium-term budgetary objective.” Each country figures out their own path individually. During the European Semester not only is the path’s progress assessed, but the issue of whether the increase in public spending is fully covered by budget revenues is also analyzed (the benchmark for expenditure). In accordance with the Stability and Growth Pact, the member states are required to submit their stability (urozone countries) and convergence (countries awaiting urozone entrance) systems for assessment at EU level (European Council, n.d.-b).

However, as it turned out in the late 1990s and early 2000s, Europe’s observance of the principles of the economic and budgetary policy was rather ailing. It was a time of stagnation in Europe, with almost non-existent economic growth. In the majority of countries, deficits would rise as a result of automatic stabilizers employed. Some of the countries exceeded the deficit ceiling set by the Stability and Growth Pact (Portugal, Holland). What is more, employment also failed to reach the rate set in Lisbon, and investments declined. Moreover, in the consecutive periods GDP growth lost its momentum, which meant that, in spite of recovery signs, the urozone officially plunged into recession. For most of the time inflation was above the 2% ceiling, and some claim that the ECB failed to reduce the interest rates as aggressively as it should have. During that time France and Germany surpassed their deficit limit6 while being the urozone’s largest economies. Nevertheless, the principles of the Stability and Growth Pact were still valid. Since that time and given the constrains on both monetary, as well as fiscal, policy, the key urozone countries insisted that the Pact principles be made more flexible, as the countries themselves were struggling to observe them (Zsolt de Sousa, 2004, pp. 7–8).

In 2005 the Stability and Growth Pact was reformed. The conditions for the assessment whether a given country has been affected by excessive deficits were eased and the timelines for the procedure were extended. As a result of the reforms, a safe margin for a possible surpassing of budgetary deficit threshold was introduced. The margin was so broad that it could accommodate the public sector’s investment projects, pension reforms (both for the urozone, as well as ERM II) necessary for a given country.7 The acceptable deficit was to fit into a range of –1% of GDP and the budgetary balance or surplus (Council Regulation, 2005a, 2005b). Pursuant to the Pact’s amendments, the member states were obliged to present, inter alia, one-off factors which came to be listed among points to consider in the assessment of public finances. Such measures taken by the EU were dictated by the fact that some countries were using creative accounting or introducing one-off measures to improve public finances (e.g., levying one-off taxes) in order to avoid sanctions while ignoring adjustments (Beetsma & Debrun, 2004). In due course, following the onset of the crisis in the United States in 2007, a number of European Union member states experienced the repercussions of utilizing creative accounting methods in their public finances. As a result of high debt and deteriorated rating, in Spain, Greece, and Portugal there was a sharp slowdown in foreign capital inflow and debt rollover problems appeared. With a deficit (Eurostat, 2022a, 2022b) of more than 10% of GDP in Greece in 2009 and 2010 (as well as in Ireland, Portugal, and Spain), or approaching 10% in other EU countries, it was necessary to provide new solutions as regards fiscal policy coordination. In 2001 the so-called Sixpack legislative measures (five regulations and one directive) were adopted, including provisions for EU countries both inside and outside of the urozone. The Regulations (Regulation (EU), 2011a, 2011b, 2011c, 2011d), apply to EU countries, except for Regulations no. 1173/2011 and no. 1174/2011, which are meant for urozone countries. Two out of five regulations (Regulations no. 1175/2011 and no. 1177/2011) are concomitantly regulations that amend the Stability and Growth Pact, which they are a part of. Under the preventive arm (Regulation (EU), 2011b, 2011d) the focus was on the member states achieving and maintaining medium-term budgetary objectives. They are defined in the structural dimension, by adjusting the nominal balance by the effect of the economic cycle and following an adjustment by one-off and interim events. They are defined individually for each country given its economic and budgetary situation and with financial stability in mind. They may deviate from the general government balance requirement at the same time allowing for a safety margin before the 3% of GDP threshold for deficit is surpassed.

The scope of the information required to be disclosed in stability and convergence programs was broadened. The programs should additionally include the following: the planned growth path of government income and spending; information on implicit liabilities related to population ageing; and contingent liabilities, such as public guarantees. In addition, the stability and convergence programs should emphasize the assessment of the measures taken under the budgetary and economic policy. The assessment should cover cost–benefit analysis of significant structural reforms that give rise to improved public finances in the long term. Under the corrective arm (Regulation (EU), 2011e), the excessive deficit procedure was specified in more detail and made more restrictive. Where the general government debt exceeds the reference value, the debt-to-GDP ratio should be considered as sufficiently diminishing and approaching the reference value at a satisfactory pace, provided that over the previous three-year period its distance from the reference value has declined at an average rate of 1/20 per year, based on the trends over the preceding 3 years for which data are available.

Another important step to strengthen the public finance discipline of urozone countries and to step up the mechanisms of economic and budgetary surveillance was the Council adopting two regulations referred to as “two-pack” and signing the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union, referred to as the Fiscal Compact. “Two-pack” regulations (Regulation (EU), 2013a, 2013b) introduce certain obligations and procedures concerning all urozone countries, as well as urozone countries subject to excessive deficit procedures. Among other things, a system of gradual monitoring by the Council and the Commission was introduced to ensure timely and sustainable correction of excessive deficits, and the possibility of early identification of risks associated with a member state’s failure to comply with the Stability and Growth Pact. Another document to govern fiscal policy is the so-called Fiscal Compact (Treaty on Stability, Coordination and Governance, 2012), which is an international agreement of March 2, 2012, signed in Brussels, outside the EU legal framework, by the leaders of 25 EU countries. Out of the then EU member states it was the Czech Republic and the United Kingdom that failed to sign the Treaty. The Czech Republic adopted and ratified the Treaty in 2014, aiming to incorporate it into its domestic legislation later on. Croatia was not a signatory either. It failed to sign it on joining the EU, which took place on July 1, 2013. The Fiscal Compact became effective on January 1, 2012, after the ratification condition was satisfied by 12 EU member states, the urozone participants. The fiscal treaty introduces the so-called “budgetary pact,” which incorporates guidelines having an immediate relationship with the procedures stipulated by Articles 119–144 of the Treaty on the Functioning of the European Union (TFEU), Protocol 12 to the TFEU, the provisions of the Stability and Growth Pact, and the Sixpack. The economic parameters referred to in the Treaty are also governed by the Compact, the Sixpack and the TFEU being a faithful reflection.

5 Coordination of Fiscal Policy at EU Level versus Ensuring Sustainable Development Conditions: an Assessment Attempt

As mentioned in the second section of this chapter, within the monetary union the monetary policy is centralized while fiscal policy is shaped by member states on an individual basis. Normally, each country’s policy is based on discretionary measures, the strength of which may be determined by decision-makers shaping economic policy.

Undertaking discretionary measures in the area of fiscal policy should be preceded by an identification of an economic shock in place, analysis of its triggers, and a preparation of an action plan with the instruments intended to mitigate the shock. For the discretionary measures to succeed it is important whether, in the initial phase, its triggers are correctly analyzed and whether the tools for its reduction and the action plan are adequately selected. This is because, at the next stage, they will be the basis for developing relevant legislative solutions so that they could be used in practice.

It should be noted that between the stage of economic shock identification and the preparation of legislative solutions, months-long lags may occur. In addition, the adopted legislative solutions may prove to be incorrect or underdeveloped, which will translate into their ineffectiveness in practice. Moreover, attention should also be paid to the relationship between the state’s debt and externalities. Demertzis and Viegi (2021) argue that a heavily indebted country, in running its fiscal policy, will adversely affect the EU. In turn, a low-debt country will have a positive external effect (Demertzis & Viegi, 2021).

In theory, striving for the long-term stability of public finances in line with the rules should be coherent with the finances’ short-term stability. Still, there is ample evidence that a discretionary fiscal policy on the domestic level does not follow the intended or ideal path. On the contrary, numerous countries have high debts and their discretionary fiscal policy will amplify rather than stabilize the cyclical fluctuations of output (Larch et al., 2020, p. 2). Studies on the performance of the Stability and Growth Pact conducted in the 1990s by Buti et al. (2003) and Kopits and Symansky (1998) show that the sanctioning mechanisms did not meet the desired criteria (Buti et al., 2003; Inman, 1996; Kopits & Symansky, 1998). The economic situation of the EU and the respective EU member states is evolving as affected by changing global, regional, or national circumstances. Therefore, the studies on the coordination of fiscal policy at the EU level should be deepened, and enhanced with new observations, depending on the goals in place or the analyzed factors.

In the early 21st century Debrun (2007, pp. 5–6) devised a politico-economic model of fiscal policy aimed at identifying the relationship between policymakers’ actions and the fiscal policy pursued. He claims that electoral uncertainty is endogenous and rooted in asymmetric information about policymakers’ motivations and competence. Rational voters re-elect the incumbent administration only if the latter demonstrates sufficient ability to deliver a quantity of public goods deemed commensurate to tax revenues. In fact, policymakers themselves are uncertain as to whether their actions will be successful in delivering enough public goods, and there is no systematic difference in the level of competence between political parties. The less tolerant the voters vis-à-vis policy failures, the greater the electoral uncertainty and the larger the deficit bias. In this context, a simple balanced-budget rule can be enacted, with its enforcement strict enough to discourage the policymaker from deviating from the optimal policy. The problem is that a credible enforcement of the rule can only result from the decision of a non-partisan body, because a partisan decision-makers will always have an incentive to revert to the discretionary outcome (Balassone & Franco, 2001). Larch, Orseau, and Van der Wielan (2020) conducted a study analyzing the stabilizing effects, whether pro- or counter-cyclical, of the implemented fiscal policy, as well as the primary determinants thereof. They conclude that discretionary fiscal policies tend to be pro-cyclical both in the EU and beyond. They note that the alternative cyclical indicators that are observable in real time (less susceptible to revisions and politically more meaningful) also point to ill-timed discretionary fiscal stabilization. This suggests that pro-cyclicality is first and foremost a matter of political economy, not uncertainty. They also stress the crucial role of sustainability development constraints, because they may prove more important than the stabilization objective.

Moreover, the trade-off between stabilization and stability is not dealt with in the same manner for all levels of debt. Fiscal rules based on nominal aggregates, such as the nominal budgetary balance and the debt-to-GDP ratio, do not allow for the automatic effect of the economic cycle. In practice, the stability of public finances is an ill-defined and not a unique condition to apply to every country. It also depends on the economic governance framework – for instance, whether the central bank is independent, how credibly governments correct slippery fiscal trends, and what budgetary instruments are available to stabilize the economy in addition to national budgets. The researchers also emphasize that there is no central fiscal capacity, which implies that national budgets are directly exposed in case of major shocks. In comparison with a fully-fledged monetary union, such a solution may, on the other hand, impose stricter conditions for sustainable development, which renders the trade-off with fiscal stabilization difficult (Larch et al., 2020, pp. 29–30).

A special report is also worth mentioning here. It was prepared by the European Court of Auditors, which in 2018 audited whether the European Commission used the powers granted to it by a regulation to ensure adequate implementation of the preventive arm. The control of procedures under the preventive arm focused on six member states (five from the eurozone and one from outside of it). The Court also analyzed the interaction between the preventive and corrective arm of the Stability and Growth Pact, as far as it regards the preventive arm. It was concluded that the effectiveness of the preventive arm largely depends on how it is implemented by the Commission. The implementation rules decided by the Commission and its operational decisions do not ensure that the main objective of the regulation is met – i.e., that member states converge toward medium-term objectives in a reasonable period. Implementation rules on flexibility stem from 2005 reforms of the regulation but were not formally operationalized until 2015, when they reflected considerations prompted by the Great Recession. Moreover, the rules set by the Commission do not distinguish enough between those member states that do have a high level of debt and others. Instead of tightening the framework as the economic recovery was progressing, the Commission further weakened it in 2017, introducing a new “margin of discretion.”

The structural reform allowance is no longer linked to the actual budget costs of the reform, but it is used as an “incentivizing instrument.” All allowances (except for the pension reform) increase spending not only in the particular year for which they are granted, but also in the following years. The cumulative effect of all these allowances have resulted in multiyear delays in effective deadlines for reaching medium-term budgetary objectives. The credibility of the preventive arm was further eroded by the developments in the corrective arm. The Commission considers that the requirements of the corrective arm can be fully met just by cyclical recovery, which is also facilitated by the Commission’s practice of proposing to Council granting multi-year extensions for exiting excessive deficit procedures. As a result, member states under excessive deficit procedures do not have to fulfill the requirements for improving their structural balances they would otherwise have to observe if they were under the preventive arm (European Court of Auditors, 2018, pp. 11–13, 73).

On March 13, 2020, in response to the outbreak of the COVID-19 pandemic, the European Commission announced a “coordinated economic response to the COVID-19 epidemic” (European Commission, 2020), in which, amid macroeconomic and financial effects of the COVID-19 epidemic, it called for a bold and coordinated response to mitigate the pandemic’s negative impact on the overall economy. The EC ruled it was necessary to use all available EU tools and a flexible EU framework for member states action used to its full (European Commission, 2020, p. 4). Pursuant to the Communication, the budgetary effect of one-off social measures used to counteract the economic effects of COVID-19 was excluded. The Stability and Growth Pact can accommodate targeted exceptional expenditure. Support measures such as these urgently needed to:

  1. Contain and treat the pandemic
  2. Ensure liquidity support to firms and sectors
  3. Protect jobs and incomes of affected workers

This can be considered as one-off budgetary spending. The Commission considered that the flexibility to cater for “unusual events outside the control of the government” is applicable to the current situation. When an unusual event outside the control of a government has a major impact on a member state’s fiscal position, the Stability and Growth Pact envisages that member states can be allowed to temporarily depart from required fiscal adjustments. As a result, this clause can also accommodate exceptional spending to contain the COVID-19 outbreak. In particular, the clause can apply to health care expenditure and targeted relief measures for firms and workers, provided they are temporary and linked to the outbreak. The Commission stood ready to propose to the Council that EU institutions activate the general escape clause to accommodate a more general fiscal policy support. This clause would suspend the fiscal adjustment recommended by the Council in case of a severe economic downturn for the euro area or the EU as a whole (European Commission, 2020, p. 13).

The member state governments responded to the EC’s Communication swiftly and decisively to save the lives of their citizens and to keep their public finances on a sustainable path while reaching the stabilization goals. The states used a variety of ways to adjust their fiscal rules, including the activation of escape clauses, temporarily suspending fiscal rules, and modifying the limits of fiscal rules. A study by Davoodi et al. (2022) shows that, as of end 2021, about 105 economies adopted at least one fiscal rule, as opposed to fewer than 10 economies that had them in the early 1990s. At the end of 2021, more than 50 countries had established fiscal councils. Many countries incorporated flexibility provisions into their fiscal rules, most of the time in the form of escape clauses. The rules-based fiscal framework came under pressure during the COVID-19 pandemic, with countries using different ways to adapt their fiscal rules in response to the crisis. The widespread activation of escape clauses showed how fiscal rules can be highly flexible during large shocks. Experience suggests that fiscal rules allowed for a forceful response to the pandemic, disclaiming the concerns that rules are rigid in constraining the governments’ response in bad times. However, fiscal rules did not prevent a large and persistent debt build-up over time. Studies show that deviations from deficit and debt rules were common across countries, but reached unprecedented levels with the pandemic. “On average, countries exceeded the deficit and debt limits by about 50 and 42 percent in the time during 2004–2021, respectively. The COVID-19 economic and health crisis, and the associated fiscal responses, led to a sharp rise in deficits and debt. Almost all countries with deficit rules exceeded the limits – by an average of 4% of GDP in 2020”. (Davoodi et al., 2022, pp. 13, 25).

6 Conclusions

The process of building the Economic and Monetary Union is a long-term and complicated venture that requires a multilevel design. The EMU is formed by countries which fulfilled the Maastricht Treaty’s criteria in various periods and at various levels of economic development. Across countries, the way in which a fiscal policy is conducted depends on a given country’s administrative system, revenue collection system, the foci and objectives of public finance spending, the current economic and social situation, geographical location, and other factors. If implemented in the EU, a common fiscal policy would be confronted with the strong objection by individual governments in response to the excessive constraint on the individual countries affecting their budgetary policies. Worsened budgetary situations and increased sovereign debt across the EU make the stability of public finances a political challenge. Therefore, coordination of the EU’s fiscal policy following the same principles as monetary policy in the eurozone is impossible. What remains to ensure financial system stability and the conditions for economic development of all the EU member states is only to devise a mechanism for coordinating fiscal policy. A mechanism that would be not only acceptable for all the member states, but also respected by them. Reckless fiscal policy may impact the level of interest rates, the rate of inflation, or money value, which, in turn, affects a society’s welfare level. Failure to respect commonly agreed rules and principles for coordinating the EU’s fiscal policy by respective member states is a dangerous precedent, and spawns a number of questions about whether it is advisable for some member states to incur efforts to reduce budget deficit and sovereign debt considering the entire eurozone and the whole international organization, while the remaining states are not held accountable nor bear any consequences for excessively expansionary fiscal policy.

Notes: Research presented in this chapter constitutes a part of the implementation of the “European Financial Security in the Global, Regional and National Dimension” (EUSEC) project funded by the European Education and Culture Executive Agency (EACEA) within the framework of the Erasmus+, Jean Monnet Activities: Jean Monnet Modules, no. 620453-EPP-1-2020-1-PL-EPPJMO-MODULE.

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1

For more on the issue of public goods, see Chapter 1

2

Political integration is of primary importance to create an optimum currency area, as it is necessary to pursue common goals: economic growth, inflation, unemployment, etc.

3

Minz noted that the countries belonging to a single currency area should run an anti-inflationary policy and be similarly inclined to accept inflation.

4

Frankel and Rose developed the concept of the optimum currency area criteria being endogenic. They challenged the earlier exogenic OCA theory and came up with a new approach. They claimed that the countries joining the common currency are not required to meet the exogenic criteria ex ante as defined by OCA, because it is the adoption of a single currency that will bring their economies closer.

5

The Stability and Growth Pact is an agreement of EU member states of June 17, 1997, made during a Council of Europe summit in Amsterdam.

6

In 2003, following a recommendation from the Commission, the Council found that Germany and France were running an excessive deficit, and recommended that the deficit be reduced to an acceptable level by 2004. The Council failed to obtain a majority in the vote. Therefore, the European Commission brought action against the European Council before the European Court of Justice (ECJ). In its judgment of July 13, 2004, in Case C-27/04, the ECJ found that “the Council’s conclusions adopted in respect of the French Republic and the Federal Republic of Germany respectively must consequently be annulled in so far as they contain a decision to hold the excessive deficit procedure in abeyance and a decision modifying the recommendations previously adopted by the Council under Article 104(7) EC.”

7

It is a mechanism dedicated to countries awaiting eurozone admission.

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