Even if we never join the single currency, the pact still raises important issues for us, since the financial markets may well in effect "require" countries which stay outside EMU to follow a fiscal discipline at least as tight as the pact itself.
Under the pact, the final details of which are due to be agreed at the Dublin summit in December, countries will need to submit their budgets to continuous assessments by the European Council of Ministers, and will be subject to fines of up to 0.5 per cent of GDP, paid into the EU budget, if they persistently run a budget deficit greater than a limit of 3 per cent of GDP.
In order to be sure of respecting this limit during a recession, countries will probably on average need to aim for a budget deficit of 1 per cent of GDP or less, and they may also be fined if the ratio of public debt to GDP exceeds 60 per cent.
These targets will be continuously monitored and policed by peer group pressures at Ecofin, the European Council of Finance Ministers. The opinions of Ecofin are already an important constraint on budgetary policy for member states, but they are set to become far more potent after EMU, since the decision to levy fines will not be wholly automatic, but will be subject to qualified majority voting at the Council. Many important details of the pact have still to be settled, especially the degree to which the fines will be automatic.
The Germans are pressing for them to be almost wholly so, subject to only a few very specific exceptions (such as the onset of a deep recession, defined very strictly as a drop of 2 per cent in GDP within a calendar year), but most other members want much more discretion to be exercised by Ecofin. Some point out that it is dangerous to worsen a budget deficit still further by levying fines just when the deficit is rising anyway, and want Ecofin to have the power to waive this punishment where appropriate. But the Germans fear jumping into a toothless arrangement, and have recently been muttering that if there is too much fudging, then there may be no monetary union.
This row looks set to worsen in the next few weeks, with a lot of the usual public posturing by all sides before a compromise is reached. But it is hard to see the single currency failing now on this particular rock, so a compromise will be reached eventually, and the Stability Pact will be a cornerstone of EMU if the latter goes ahead.
Would this be a good thing? Obviously, there will be many in Britain who will not find such interference in our national rights politically acceptable, but they should not be in favour of the single currency in the first place. A more interesting question is whether the pact makes economic sense for us. Clearly, in the first few years the pact will involve a further large dose of fiscal deflation for Europe, as countries reduce their budget deficits from around 4 per cent of GDP to under 1 per cent.
This will be a recessionary force, but its impact can in principle be offset by the adoption of an expansionary monetary policy by the European Central Bank. Provided that the ECB acts more wisely than the national central banks on the Continent have done in the recent past - which means that its members must avoid catching a dose of "Bundesbank machismo" in setting monetary policy - then the pact could succeed in giving the EU lower budget deficits and lower interest rates, which is what has been needed for a long while. But admittedly it is difficult to be confident about how the ECB will act in its early years, and it is certainly possible that its board members, who will be wholly immune from any political influence, will err on the side of extra toughness to build "credibility" at the outset.
Given this risk - which would lead to prolonged European recession - there is certainly a case for the UK choosing to observe any learning difficulties from the outside for a while. There is also another problem for the UK worth mentioning. The case for the pact is that, inside a monetary union, there may be an incentive for individual countries to run large budget deficits on the grounds that they would suffer no interest rate penalty from doing this. In particular, if the market believed that the debt of a country such as Italy was in effect underwritten inside a monetary union by the rest of the EU, then the Italians might be able to borrow for a long while on the creditworthiness of other countries, and not of themselves. Thus the most creditworthy economies in the EU have a strong incentive to ensure that the Stability Pact is meaningful.
Surprising as it may seem, Britain is among the most creditworthy of all EU members at present, though this is no thanks to the present administration. Despite the fact that John Major's premiership has seen a virtual doubling in the national debt in nominal terms, our debt ratio remains at around 55 per cent, compared with 60 per cent in France and Germany, and 120 per cent in Italy. Much more important, these official figures for the debt ratio fail to include "off-balance sheet" items, where Britain has an even larger advantage over other countries. As the graph shows, the present value of future pension rights amounts to only 5 per cent of GDP in the UK, compared with 80-100 per cent elsewhere in Europe.
It has been argued that if we join EMU then we will somehow assume a responsibility for these unfunded pension liabilities in our neighbouring countries. This is not really the case. In theory, each country will remain liable for its own pension liabilities, just as it will remain responsible for servicing its own national debt. But in practice, these pension liabilities will increase the incentive for countries to add to their budget deficits, or to reduce the real burden of their debt by applying pressure to the ECB to permit a rise in inflation.
These risks will add to the level of interest rates paid by all members of the union, unless the Stability Pact has real power to control budget deficits going forward. Only then can countries be forced to take direct action to restrict their unfunded pension liabilities, which is what is needed.
Many people might argue that these pension differences are sufficiently important to imply that the UK should stay out of EMU. But if we go in, they certainly mean that it is in our interest to have a Stability Pact with genuine muscle. So we should be supporting the Germans on this issue in the run-up to the Dublin summit.Reuse content