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Skip Navigation LinksHome :: Back Issues :: Germany shows up pact’s shortfalls

September 2002

Germany shows up pact’s shortfalls


European integration




Predicting the future requires more luck than skill - this applies as much to economists as it does to tabloid astrologers. But when the strength and reputation of an entire political union rest on the consequences of getting it wrong, there is cause for concern.
During the past year there has been a frenzied look at budget deficits across the eurozone, and an assessment of countries in danger of breaching the 3%-of-GDP limit stipulated by the Stability and Growth Pact. In an eager attempt to disguise the true size of budget deficits, governments have been wildly overestimating GDP growth.
Germany is a good example. Its budget deficit is expected to breach the pact's target - estimates by Barclays Capital range between 3% and 4% of GDP - and public spending is high and set to rise further in the wake of recent flood damage. To compensate, the German government has decided to postpone tax reforms, a measure expected to yield ¤3.5 billion for the federal government, and ¤3.6 billion for the regional governments.
There are other options in financing flood repairs too. If the opposition CDU/CSU coalition wins the September election, it proposes to scrap the delays to tax reforms and dip instead into the coffers of the Bundesbank, whose annual profit amounted to ¤11.2 billion in 2001. This would decrease funds for repaying government debt.
"There is no more room for further build-up of government debt," says Frankfurt-based Thorsten Polleit, economist at Barclays Capital. "German public finances are in a terrible state, and to increase them further suggests serious danger for the future of political and economic stability [in Germany]. Spending more today will only transfer the bill to future generations."
Polleit suggests instead a restructuring of current federal and regional budgets - ¤417 billion in tax revenues last year could provide room for manoeuvre. But this option does not seem to be under consideration.
When large economies such as Germany face higher deficits because of new spending demands on top of already high existing ones, there is a danger that the reputation of every eurozone country will be tarnished by just one of them. The Stability and Growth Pact is designed to prevent this. "The pact has brought a longer-term framework and a stability of policy, which is very good news," says Ed Teather, European economist at UBS Warburg. "It helps companies to work within the European economies, and gives a better idea of where things are going in relation to the governments' base-line scenarios."
But these base-line projections offer a misleading picture. In July, Germany predicted second-quarter GDP growth of 0.5%. In August, the final figure came in at 0.3%. This may seem at first sight a small discrepancy, but it's almost a 100% overestimate. Yet investors are failing to show much concern about European budget deficits, so perhaps the pact has retained some confidence.
"The perception that the pact is being undermined is probably a negative factor for the euro but it's not enough to turn the dollar around," says James Shugg, senior economist at Westpac. "But it does help to highlight that there are problems with the euro, and it may be one of the reasons why the euro is well below its recent highs."
The main problem with the Stability and Growth Pact, however, is that it is as political as it is economic. Economists say it was drafted with the main purpose of securing Germany's entry to the euro, which meant assurance that the Deutschmark would not be dragged down by a weaker currency, dogged by large budget deficits of other eurozone countries. "It wasn't properly thought through, and it's good it's being tested now," says Shugg.
Mockery
But the European Central Bank (ECB) should be careful that politicians do not make a mockery of its economic policies. Today, in Europe's larger economies, they are picking and choosing their own ways of approaching the pact's guidelines. While Germany remains committed to falling back below the 3% target in the not-too-distant future, France, for example, has admitted that it cannot do this; an honest approach, if nothing else. At least investors have a better idea of where they stand.
Portugal and Italy are also struggling with the pact. Portugal's situation is particularly shocking - as recently as May the new government revised forecasts that put the 2001 budget deficit at about 2.8% of GDP. Final figures have since been confirmed at 4.1%. And in July, Italy found itself facing scrutiny from European Commission statistical office Eurostat for suspected accounting tricks designed to boost its budget.
Accounting tricks
"The threat of accounting tricks is real," says Teather at UBS Warburg. "When you have rules and targets to meet, the first thing that is going to happen is that all the clever people in government will try to find ways round them. But the beauty of the Stability and Growth Pact is that it is relatively vague." Giovanni Zanni, European economist at CSFB, agrees. "There's a lot of blurred accounting in place - it's just one of those things governments are trying to use to have more freedom," he says. "But there's always the risk of a retrospective impact. If Eurostat says the accounting is wrong, and that shows a higher deficit, that can lead to natural sanctions through [damage to a country's] reputation."
Revised 2002 German budget deficit estimates
Federal Finance Ministry (Dec 01) 2%
Federal Finance Ministry (next expected) 2.5%-2.8%
European Commission (Apr 02) 2.80%
Barclays Capital 3.40%
UBS Warburg 3.40%
Westpac >3%
CSFB 3%

Since the Stability and Growth Pact was drawn up, the EC has threatened sanctions against countries that fail to meet its requirements in time. Earlier this year, Portugal evaded a warning from the Council of Economics and Finance Ministers of the European Union (Ecofin). But to warn Portugal would have meant warning Germany and others too. Judging by France's already independent approach to the pact, this may have caused some dissent among the larger eurozone economies. Now, given the surprise proportions of Portugal's final deficit, the council will consider administering a fine instead, worth 0.5% of GDP.
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