Economic stagnation in Europe has intensified the controversial nature of a number of EU issues, including Euro zone economic policy management and the new Constitutional Treaty, while the Spanish position on these issues has become increasingly problematic.
A sense of impending gridlock has spread within the EU during recent months against the backdrop of continental slowdown. EU members are now set to square off, amid heightened tensions, in debates over the future European constitution. Fierce rows over the legitimacy and convenience of individual member states’ budget priorities and fiscal policies have brought into question the sustainability of the current configuration of the EU’s Stability and Growth Pact, while the opening salvos in what promises to be an intense struggle over the next EU budget have knotted together a number of complex economic policy issues. On most of these issues, Spain finds itself pitted against Germany, the single strongest EU member state and the one that will end up gaining the most in terms of political influence, regardless of the outcome of the IGC negotiations over the new Constitutional Treaty.
The biggest problem in Europe today –and no doubt a significant factor in the recent Swedish referendum– is economic stagnation, with a new recession poised just over the horizon. This year, the Euro zone economy is expected to grow between 0.5% (IMF forecast) and 0.7% (EC forecast), while most projections for 2004 put Euro zone growth barely above 1%. Nearly everyone’s European growth forecasts for 2003 have been repeatedly revised downwards as the year has progressed, as has the consensus outlook for the coming years
Germany’s economy –which constitutes approximately 30% of the Euro zone– has experienced negative growth for two consecutive quarters (-0.2% in the twelve months to July 2003). While business sentiment (as revealed by the important IFO and ZEW surveys) has recently registered steady improvements, German evaluations of the current situation (as opposed to future prospects) have remained depressed. More importantly, with the German economy threatening to slide into a tough deflationary spiral, and the banking system beginning to shows signs of fragility similar to that in Japan when its bubble economy began to burst over ten years ago, the sheer weight of the German economy is bound to drag down even the EU’s more dynamic economies (like Spain, where growth remains over 2%) which, nevertheless, maintain intensive trade links with the Euro zone (nearly 70% of Spain’s total exports).
There are a number of reasons why the European economy is malfunctioning. First, Europe tends to follow the US’s lead through the economic cycle: during the recent 2001 recession in the US, Europe continued to register significantly higher growth, while now that the US has begun to grow tentatively again, Europe is slipping down. The fact that the US economy continues to show only mixed signals as to a possible sustained recovery has kept sentiment in Europe lacklustre at best. Contributing to this has been the significant appreciation of the euro against the dollar (some 25% during the last two years) and the Asian currencies (particularly the Japanese yen and the Chinese yuan) which limits the Euro zone’s potential to export its way into recovery. However, another significant contributing factor is the seeming chaos currently reigning over economic policy in Europe, and fiscal policy in particular.
Many critics argue that the ECB has been too slow in lowering interest rates because it has concentrated too much on hawkish policy designed to pressure key EU countries like Germany, France and Italy to keep public deficits within the limits of the Stability Pact and to move faster and deeper on important structural reforms (particularly labour market, health care and pension reform). But the ECB’s mandate has always been clear: price stability, with inflation below 2%. The recent change in the nuance of the ECB’s inflation target (from below 2% to below, but close to, 2%) has given the central bank at least some additional flexibility to set interest rates with German growth in mind, but it still does not fundamentally change their priorities from low and stable inflation to growth and lower unemployment. Jean Claude Trichet (set to become the new president of the ECB in November) will more than likely follow the policy stance developed by Wim Duisenberg, even if he is likely to be more soothing to the markets. Therefore, we should expect no significant change in the management of the ECB and the execution of monetary policy.
Then there is the fiscal policy issue, where lack of consensus over whether loosening or tightening is currently more appropriate, and on how to interpret and execute the Stability and Growth Pact, has only contributed to increasingly damaging economic uncertainty. Last year, German and France followed Portugal’s 2001 breach of the pact, registering public deficits well over the allowed limit of 3% of GDP. Both –along with Portugal and Italy– are set to breach the 3% threshold again this year and, in all likelihood, in 2004 as well. France, after having initially announced that it planned to reduce its deficit to below the allowed limit only in 2006, did bring forward this expressed intention to 2005, but only after receiving heavy criticism from the European Commission, the ECB and the smaller EU member states. Even now, France officially projects a budget deficit of 3.6% of GDP in 2004. In contrast, Spain has just submitted its budget for 2004 to the Spanish parliament for debate. Should the projections be achieved, this would constitute the fourth consecutive year of budget balance for Spain, as opposed to three consecutive years of deficits above the Stability Pact limit in the Franco-German axis.
Stability and Growth Pact Controversy
The Stability Pact debate pits most of the EU’s smaller states against the offenders (all of which, with the exception of Portugal, are larger EU states). Spain, for example, while not considering itself a small EU country, has thrown its weight in with them, arguing vehemently that the Pact must be honoured and maintained in its current configuration. Germany has led the camp of the supposed offenders, arguing that the current situation in Europe should be considered exceptional (particularly in Germany, where the economy finds itself in recession) and therefore worthy of focusing policy on the ‘growth’ aspect of the Pact by invoking its exception clause. The Stability and Growth Pact originally contained a vaguely worded clause allowing for exceptions to the limit in times of economic downturn, but it is nevertheless up to the Ecofin, with input from the Commission, to determine what should constitute a legitimate exception.
Countries like Spain have argued that, while they undertook the necessary political sacrifices to not only meet the minimum requirements of the Pact but also to successfully achieve the mid-term goal of a balanced budget, countries like Germany and France wasted a critical opportunity. As a result, they should not be allowed to force their European partners into a significant fudge of the Pact, for to do so could severely undermine the credibility of the Euro zone. Along with the rest of the Pact’s defenders, Spain has supported the Commission’s hard-line stance when interpreting the Pact and continues to call for the maintenance of rigour, and even the enforcement of sanctions.
Adding to the problem over defining appropriate fiscal policies is the inherent ambiguity of the Pact’s intentions and content. While intending to leave fiscal policy in the sovereign hands of member states (in contrast with the single currency project which obliges participants to share monetary sovereignty within the ECB), the Stability and Growth Pact was also designed to stimulate a reduction of structurally high public debt levels within the EU (still some 69% of GDP in the Euro zone last year). Excessively high debt levels in some countries, combined with a lack of a Community limit on the creation of new debt, would allow undisciplined countries to free-ride on the relative austerity of others while contributing to higher interest rates which could potentially affect all of Europe (particularly since the ECB’s monetary policy is gauged for the Euro zone as a whole).
This ambiguity of intention is matched by a similar ambiguity in content. The 3% maximum deficit limit and the goal of mid-term budget balance were nuanced by the inclusion of an exception clause which would allow the 3% limit to be breached under exceptional circumstances of economic downturn. However, given that the clause was included as the result of an intense debate over the desirability of such a limit, it was understandably defined in an ambiguous fashion. Germany is now attempting to claim that the current situation fits the original intention of this exception clause. This clash between a common commitment to structural change and cyclical realities of the kind Europe is now experiencing forms much of the backdrop to the current fiscal crisis.
The debate has become more vicious because the Euro project, along with the macroeconomic criteria carried over from the Maastricht treaty, assumed a continued and steady emphasis on structural reforms of increasingly expensive welfare states and rigid labour and product markets. This critical objective was reinforced by the Lisbon Agenda adopted in 2000. Yet, many of those who moved slowly on structural reforms (including Italy and France, which delayed a number of reforms due to public opposition) happen to be the same countries that failed to reduce their structural budget deficits sufficiently during the days of rapid growth in the late 1990s.
Should the Stability Pact be maintained in its current configuration and enforced? Or should it be reformed or even scrapped? On the other hand, is there any potential for a compromise somewhere between strict enforcement and a broad reform that would allow the exception clause to be invoked? Part of the difficulty in answering such questions lies in the fact that other underlying questions must be answered first. For example, what would be worse for the Euro zone: defending the integrity of the pact and the perceived market benefits this would produce –even if the price were a worsening of the downturn in Germany and France, which might easily spread across the rest of the Union and thereby damage the market prospects of the Euro even more? Or risking a perceived lack of rigour in EU economic policy –with its potential damage to the euro’s exchange rate and its image in the middle and long run– even though this might be the price for stimulating the Euro zone economy at a moment when the US is requesting an expansion of the EU’s internal demand, something which might actually improve the general perception of Europe and the euro? The answers to these questions demand the unravelling of some tricky trade-offs between perceived risks and benefits, making the Stability Pact debate easy prey for the promotion of particular national agendas.
The Spanish position ferociously defending the integrity of the Pact has been paradoxically strengthened by the fact that Germany was the prime mover behind the original Maastricht convergence criteria –which, to a large extent, were aimed at countries like Spain, widely perceived to be spendthrift and undisciplined– and the enshrinement of the budget criterion as a permanent feature of EU economic policy. The fact that ever since 1998, when the final decision was taken on which national aspirants would be accepted as founding members of currency, Spain has performed much better in terms of fiscal deficits than Germany, has only served to bolster Spanish confidence enough to take the hard line on Germany and the other offenders now. Spain successfully harnessed the dynamic catalyst of ever-falling interest rates to reduce budget deficits (through lower debt service requirements and more dynamic tax revenues stemming from a rapidly growing economy), while Germany failed to lower the structural (or non-cyclical) element of its deficit sufficiently when the economy was buoyant. Spain, on the other hand, even managed to lower taxes in the process.
Spain’s EU Funds
Contributing to this standoff are a number of other contentious issues which have pitted Germany against Spain. Apart from the rift over appropriate policies towards Iraq, Germany has recently suggested that Spain’s superior economic performance has been due, at least in part, to its net recipient status within the EU. In response to tough criticism from President Aznar on Germany’s call to invoke the Stability Pact’s exception clause, Chancellor Gerhard Schroeder remarked in the German Bundestag that Spain’s relatively buoyant economic situation was much less of an impressive achievement if Spain’s receipt of EU funds –much of which (some 25%) is paid for by Germany, out of the German public budget– were taken into account.
The Spanish response was immediate and uncompromising. Finance Minister Rodrigo Rato and a number of his colleagues in the Ministry rebutted the German argument by insisting that Spanish growth remained largely independent of the flow of EU funds. Despite the fact that Spain remains the largest net recipient of EU funds (a flow which has continued to rise in recent years, growing from €7.74 billion in 2001, or 1.23% of Spanish GDP, to €8.87 billion last year, or 1.29% of GDP), a study by Spain’s Institute for Economic Studies, directed by Juan Iranzo, has claimed that EU funds contribute approximately 0.2 percentage points to Spanish economic growth (or less than 10% of the whole). Nevertheless, no reference was made by Spanish officials to the much more significant support to the national budget position that is at least indirectly provided by such funds. Spain has been capable of engaging in extra public spending to the tune of more than 1% of GDP a year as a result of EU funds. Had Spain been forced to contemplate the possibility of having to undertake such spending on its own in recent years, the budget deficit, while remaining in a much healthier position than that of the Stability Pact offenders, would nonetheless be far above the psychologically powerful level of absolute balance.
What Europe Needs for Both Growth and Credibility: Co-ordinated Fiscal Policies
On the other hand, Germany’s rhetorical bargaining position –together with that of France– has been strengthened by recent moves towards structural reform (Agenda 2010, including pension, labour market and health care reforms) and the recent Franco-German proposals to significantly increase expenditure on R&D, information technology and transport and energy infrastructure. Although these proposals have remained vague and, in general, fit within the framework of already established EU programmes (like the 1994 Delors Plan and the 2000 Lisbon Agenda), they could potentially shift the terms of the Stability Pact debate, however slightly. Given that the Commission has recently decided to begin to consider public spending dedicated to such productivity-raising Lisbon Agenda objectives in a special light, such an announcement at least marginally improves the Franco-German position in the Stability Pact debate, particularly since Spain continues to lag behind the bulk of Europe on many of the Lisbon issues, including R&D spending and information technology. Nor is it clear that Spain has moved faster on other structural reforms (labour market, pensions, etc) than the Euro zone’s core of Stability Pact offenders, as illustrated by the government’s retreat last year on labour market reform and the real threat that the pension reform talks of the so-called Toledo Pact could break down before the upcoming elections.
Furthermore, considering the needs of the Euro zone as a whole, from the point of view of continental fiscal policy coordination, countries with stronger growth should be tightening fiscal policy now to allow for the countries in (or near) recession to relax their fiscal positions –even if they have breached the Stability Pact’s limits. The exception clause mentioned above is potentially very valuable in such a situation of asymmetric slowdown, but it should be strengthened with tighter co-ordination on fiscal policy which would encourage loosening in depressed countries and tightening in more buoyant economies. Only then would the Euro zone aggregate budget deficit (currently around 2.2% of GDP) remain acceptably small, particularly relative to that of the US and Japan.
Even independent of such Euro zone concerns, however, Spanish fiscal policy should probably be tighter than it currently is for purely domestic reasons. First, there is Spain’s higher inflation rate (3.1% compared with the Euro zone average of 2.1% and Germany’s 1.1%), a situation which is weakening the economy’s competitive position in Europe with each passing year. Then there is the demographic situation which, for Spain, is even more threatening over the medium term than for most of Europe (see Rickard Sandell, The Ageing of the Population (Part I): The Scope and Future Outlook in Spain, 22-4-03, and (Part II): The Spanish Situation Compared to Other Countries in the European Union, 21-05-03, Analysis of the Elcano Royal Institute). The increased fiscal demands required by this imminent demographic shift should be prepared for now through ever tighter fiscal policy, particularly given that the Toledo Pact negotiations could easily break down during the run-up to the March 2004 elections.
Finally, there is the looming inevitability that Spain’s EU funds will start to dwindle as the accession countries are integrated into the EU budget process. Although Spain successfully bargained at the Nice IGC to retain the national veto over the next EU budget (which would adjudicate EU funds from 2007 to 2013), Spain’s increasing isolation within the EU on other issues makes it far from certain that it will be able to do anything more than mitigate the rate at which its net recipient status is reduced in the near to mid-term future. All of this suggests that Spain might be well advised to begin to plan its fiscal policy more conservatively (rather than resting on the laurels of a balanced budget), to say nothing of the possibility of actively assuming the moral high ground in the EU by ceding to the pressures of Germans on the Stability Pact and engaging in co-ordinated, compensatory fiscal tightening.
Spain, Germany and the IGC: Implications for the Stability Pact
Although its stands with France on agriculture, and recently has stood together with Italy on questions of foreign policy, Spain is now pitted against Germany on nearly every issue, from the Stability Pact, to the EU budget, to European foreign policy (eg, Iraq). Furthermore, Spain finds itself in opposition to all of the current Stability Pact offenders –and, indeed, isolated from the position of most EU member and potential member states, with the occasional exception of Poland and the more frequent exception of the UK– in many of the constitutional debates. This isolation is particularly acute with regard to Spain’s position on the draft treaty’s treatment of the national weights for qualified majority voting within the Council of Ministers. Because the draft treaty’s simplification of the qualified majority criteria (requiring a majority of member states which also constitute 60% of the EU’s population) theoretically reduces Spain’s current capacity (established in the Nice Treaty) to form a blocking minority (although in practical terms, this assumption could be called into question; see Ignacio Torreblanca, ¿Quién teme a la convención? 26-05-03, Análisis del Real Instituto Elcano), Spain has declared its adamant opposition to any change in the voting weights agreed on at Nice.
While the Stability Pact debate is theoretically independent of the tough negotiations that will take place in the IGC, it is hard to imagine that Spain would consider the former more important than the latter. The implication of this is that not only is Spain likely to be willing to trade away that other victory of Nice (the extension of the national veto over the next EU budget agreement in 2006) in order to secure a better deal on council voting weights than that now on offer from Giscard d’Estaing’s Draft Treaty, but it is also ultimately likely to be willing to cut Germany some slack in the Stability Pact controversy. After all, beyond being the single most influential country in the EU today, Germany is the one country that stands to gain the most in terms of future EU political influence from the new Treaty. Even if the Draft Treaty is modified to some degree by the IGC, in all likelihood Germany will remain the big winner and the future strong man within the EU (see Richard Baldwin and Mika Widgren, Decision-Making and the Constitutional Treaty: Will the IGC Discard Giscard? CEPS Policy Brief No. 37, August 2003). Regardless of how much of Spain’s objectives are actually achieved within the IGC, simple realpolitik points in the direction of mending fences with Germany: this implies a natural weakening of Spain’s potential to maintain its radical defence of the Stability Pact budget threshold and at least implicit Spanish support for a consensus solution to accommodate the offenders of the Pact in its current form.
Nevertheless, Spain is unlikely to be able to exert much, if any, influence in the Stability Pact context, particularly since the offending states are likely to be able to form a blocking minority in the Ecofin in the face of any attempt to enforce the Pact’s sanctions. This reality could leave the Stability Pact debate in gridlock, unless Spain were to go in the opposite direction –that is, supporting the German argument to invoke an exception to the Pact. While perhaps improving its chances of keeping much of its Nice gains intact, the logical implications for fiscal policy coordination of such a shift in Spain’s position (ie, a fiscal tightening) would be nearly impossible for it to accept, particularly in an election season in which the governing party will need to trumpet its economic policy successes and not be suddenly seen as the party of excessive austerity after having previously engaged in repeated tax cuts.
In reality, however, because the IGC and Stability Pact debates take place on different institutional levels within the EU, any direct bargaining linkage between objectives within each will be difficult to pull off. This –coupled with the likelihood that the current Spanish government will not have the stomach to contemplate tighter fiscal policy during the run-up to a general election (scheduled for March 2004), even if it were part of a bargain with Germany in the IGC to improve its council voting weights– points to the increasing likelihood of a stalemate within the Ecofin which, eventually, would probably be overwhelmed by the current offenders, finally imposing the German position. The only unknown here is how long this process will ultimately take, and how far down the European economy goes before a fiscal stimulus is legitimised in European terms and used to pull the continent out of recession. The sooner the Ecofin faces up to this reality –one which the G7 has recently accepted– the better. This too, however, may depend somewhat on the Spanish position. Even if Spain were not to take the true European high road by tightening fiscal policy and serving as a catalyst for a new push forward in EU economic governance and policy co-ordination, it could make a positive contribution by simply moderating its current stance on the Stability Pact.