Ifo Viewpoint No. 62: Will the Sinners Punish Themselves?

Hans-Werner Sinn
Munich, 28 February 2005

When Germany pushed for the Stability and Growth Pact as a prerequisite for giving up the deutschmark, it did not anticipate that it would be the first country to violate this pact. While the pact says that a government cannot borrow more than 3% of its GDP, Germany’s public deficit was 3.7% and more in the years 2002 to 2004.

There have been more sinners, though. France also violated the criterion in these three years, Portugal did so in the year 2001 and The Netherlands in 2003. Greece even cheated by manipulating its statistics. While the reported deficits were below the limit, the country had to admit that the true deficit was on average 4,3% in the period 2000-2004 and never below 3,7%.

Other countries have been more successful due to lucky circumstances. Italy, for example, not only benefited from the creative accounting skills of its government but also from the fact the euro brought about interest convergence in Europe. The long-term interest rates for Italian government bonds declined from about 12% to about 4% in the ten years from 1994/95 to 2004/05. Given that the Italian debt-GDP ratio is currently about 106%, this in itself reduced the public debt ratio by more than 8 percentage points. Other things equal, Italy would have had a public deficit of 11% of GDP in 2004 rather than the reported 3.0% had the interest rate not declined, not counting that today’s debt/GDP ratio would have been much higher. It was not the Italian government but the euro itself which helped Italy satisfy the Stability and Growth Pact. But now Italy seems to have run into trouble again and also wants to weaken the pact.

The idea of the pact was to impose firm borrowing constraints on European governments so as to forbid them making gifts at the expense of future generations and limit the risk that Europe one day would go the Italian way: borrow without limits and print more money to erase the real debt via inflation. While constraints are a good idea, it is understandable that the EU governments do not like them. Sinners do not like rules.

The reform proposals that are currently being debated are adventurous to say the least, because they all seem to center around the question of which government expenses should be exempt from the calculation of the deficit. The list of exemptions includes a country’s net payments to the EU, education expenses, investment in general or exceptional expenses. The pact would become meaningless under such circumstances.

Future generations already bear an excessive pension burden in all European countries. In Germany, for example, the Council of Economic Advisors calculated the implicit pension debt to be more than 270% of GDP. If the open public debt of 67% of GDP is added, an overall debt-GDP ratio of about 340% results. Other European countries are in a similar situation. This is a problem in particular since the Europeans have fewer children than people from other continents. The future generations that are to pay the bill are simply not there.

Europe is moreover the continent with the slowest rate of growth in the world. Average EU growth in 2004, when the world economy had the strongest growth for more than a quarter of a century, was only 2.2% while inflation was 1.9%. This is about 4% in nominal terms, and more will hardly be possible in the longer run. With such low growth, the 3% criterion is no longer compatible with the 60% debt/GDP limit that the Maastricht Treaty had postulated for the euro countries. Countries that borrow 3% and grow at a rate of 4% will converge towards a debt/GDP ratio of 3/4 or 75%. A country like Germany which only has a growth trend of 1% in real terms and may continue to have only 1% inflation in the medium term would converge to a debt/GDP ratio of 150%.

All of this shows that the Stability and Growth Pact should be made tougher rather than weaker. The easiest way to keep the debt/GDP ratio under control would be to have a staggered deficit criterion that reduces the allowed public deficit to less than 3% for countries whose debt/GDP ratio exceeds 60% and increases the allowed public deficit to more than 3% for countries whose ratio falls short of this level. This would automatically take account of the growth differences and it would give a country the incentive to run surpluses in good times so as to increase the scope of maneuver in bad times. But there is little hope that this will come about since it is the sinners themselves who will determine the conditions under which they are punished.


Hans-Werner Sinn
Professor of Economics and Public Finance
President of the Ifo Institute

Published under the heading "Irrweg zu Lasten der Zukunft", Financial Times Deutschland, No. 41, February 28, 2005, p. 26; printed also in Der Standard (Austria), Taloussanomat (Finland), Diario Economico (Portugal), Expansion (Spain), Berner Zeitung and L'Agefi (Switzerland), Ekonom (Czech Republic), Aripaev (Estonia), Vilaggazdasag (Hungary), Rzeczpospolita (Poland), Danas (Serbia), Finance (Slovenia), Companion (Ukraine), Jordan Times (Jordan), Al Eqtisadiah (Saudi Arabia), Les Echos (Mali), The Oriental Morning Post (China), The Financial Express (India), Daily Times (Pakistan).