The vice-president of the European Central Bank talks to Cliff Taylor, Economics Editor, about the Stability and Growth Pact and discusses his concerns for the euro zone.
High and rising fiscal deficits in some of the euro-zone countries, if not addressed, threaten to undermine budgetary stability in the medium term, the vice president of the European Central Bank (ECB) has warned.
As deficits rise in France and Germany, Mr Lucas Papademos has pointed out that the average deficit across the euro zone is approaching 3 per cent and that, on the basis of current information, prospects for reductions next year in high deficit countries "are not reassuring".
As the debate intensifies on the future of the EU Stability and Growth Pact, which sets the budgetary rules for euro-zone countries, the ECB is becoming more vocal. EU finance ministers discussed the French deficit this week and the European Commission is shortly to bring forward proposals on how to deal with the issue, before it goes back to the finance ministers in November.
In an interview with The Irish Times in Frankfurt this week, Mr Papademos gave the most detailed explanation yet of the ECB view.
He saw two immediate signals for concern. The first was that the average budget deficit in the euro zone is "close to 3 per cent", the upper limit set in the stability pact for a country's deficit levels. The second concern was that, "in a number of countries, budget deficits have been above 3 per cent for two years and, on the basis of available information, the prospects for a significant reduction in 2004 are not reassuring".
"These facts imply that there is a risk that fiscal discipline in the euro area may be undermined on a medium- and longer-term basis and this is a serious concern."
A key point, he added, was that increasing deficits were not only due to the economic cycle but also reflected structural factors and "discretionary measures" in some countries.
Central to the debate under way across the EU is whether cutbacks aimed at reducing deficits in countries such as France would seriously hamper growth prospects by cutting demand. However, Mr Papademos emphasised the longer-term risks to growth and stability that persistently high deficits can bring and the potential impact on confidence.
Mr Papademos, a former governor of the Bank of Greece during its fiscal stabilisation of the late 1990s, is critical of much of the debate on the future of the pact, a lot of which, he believes, has centred on the implementation of specific provisions rather than "on the substance".
The view that more flexibility in interpreting the pact and correcting high deficits could help speed recovery "is not, in general, correct", he said.
In countries where deficits are already rising and the overall budgetary position is unsatisfactory "further short-term fiscal stimulus may not actually increase confidence and aggregate demand".
"On the contrary, one could argue that, in such countries, faster progress towards fiscal consolidation could boost confidence and help economic recovery.
"These substantive issues have not been addressed sufficiently in the recent debate," he said.
The experience in Greece in the late 1990s, as well as in other countries - where sharp cuts in the deficit coincided with falling interest rates and inflation and rising growth - demonstrated this, he said.
Many economists here have also argued that the fiscal consolidation of the late 1980s boosted confidence and helped create the conditions for the Irish boom period.
It was also important, he added, in assessing budgetary positions, that account be taken not only of the outstanding public debt but also the longer-term impact of unfunded pension liabilities and rising healthcare costs associated with ageing populations.
What of calls for increased flexibility in implementing the provisions of the pact?
The pact already allows for considerable flexibility, he said, including consideration of the impact of the economic cycle and special country circumstances.
"It is, in my view, important to strike the right balance between pragmatism and flexibility and the need to retain the effectiveness and credibility of the pact as a framework that can ensure sound public finances over the medium and long term. Flexibility should not be abused so that the effectiveness and credibility of the pact is undermined."
Asked whether he saw this as a real risk, he said it was necessary to wait and see what steps were taken to address the deficit positions.
"In principal there is a risk. The developments of the last two years have not been encouraging but whether there is a serious risk depends on the actions both of the Commission and the Ecofin [EU finance ministers\] and of the responsible political authorities in the countries that face budgetary imbalances."
Questioned on whether excessive deficits could have an impact on monetary policy in the medium term, Mr Papademos said: "Yes, over the medium and longer run, an imprudent budgetary policy will complicate the task of the ECB to maintain price stability and can be expected to have adverse effects on long-term economic growth."
This was the fundamental argument behind having budgetary rules in a monetary union, he added.
What of the argument that the pact terms should be loosened to allow countries with low debt levels - such as the Republic - to borrow more to invest in infrastructure?
Mr Papademos said: "In theory you can make a case for it, but in practice there are very serious risks."
Borrowing to finance investment could lead to a sizeable increase in indebtedness, relative to output growth, he said, which could then constrain fiscal policy over time as debt servicing costs rose. "The experience of a number of countries underlines the risks associated with such policies," he said.
