28 October 2010
Vanessa Rossi
(Former Chatham House Expert)


How much are cross-country agreements on economic targets worth? Can they only be enforced by the relatively harsh method of controlling the purse strings?

The dispute reverberating around the Eurozone over what sanctions might be used to police its fiscal rules highlights just how hard it can be to ensure targets are met. Germany has effectively refused to continue underwriting the Eurozone bail out pact beyond 2013 until there is greater accountability and enforcement of the Maastricht rules. Watching the EU grapple with these issues at this week's Brussels summit, perhaps the G20 would be wise to reflect on the wisdom of embarking on yet more efforts to police economies, this time for running extreme trade imbalances and doubtful exchange rate regimes. Indeed, the G20 may be already experiencing a discipline problem with respect to the exit strategies agreed at the last June summit when countries were in the mood to agree to fiscal tightening in the wake of the Eurozone debt crisis. Budget cuts are essential to curb the rise in sovereign debt before it reaches potentially risky proportions - as the G20 agreement recognised.

While there is really no hard and fast rule for what is a dangerous level of public debt, it is prudent to avoid testing the limit. Most governments are wise to keep debt well below 100% of GDP and not to be too reliant on foreign borrowing, in part because they cannot be sure what unexpected events might unfold in the future and impose fresh demands on its resources. However, in spite of both EU targets and the G20 agreement, there are only limited signs of concrete action to reduce budget deficits except from the UK and Germany, which look likely to avoid the risk of debt breaching 100% of GDP. Although Germany's budget deficit was relatively low last year and, arguably, there is some leeway to delay adjustment, its debt to GDP ratio (just over 70%) is very similar to that of the UK, which went into the crisis with much lower ratio than most of its EU neighbours.

It is not clear how many EU member states will be willing and able to implement tough polices aimed at cutting deficits and debt to the Maastricht limits of just 3% and 60% of GDP respectively. Germany has set the pace in the Eurozone with planned budget cuts worth just over 3% of GDP (almost £70 billion) by 2014, however, some countries may simply be unable to achieve adjustment while others could adjust but appear to be unwilling to adopt fiscal austerity.

In practical terms, Greece, Ireland, Portugal, Romania, Hungary and also Spain will find it hard to achieve improvements in state finances given the weak state of their economies and tax revenues - indeed fiscal tightening can become counter productive in the most extreme cases. However, many other countries in less extreme difficulties are dragging their fiscal feet for a variety of reasons. For example, the Netherlands and Belgium have recently struggled to put together coalition governments: they appear unlikely to rapidly agree and impose austerity packages. Italian proposals may be too watered down to prevent an ever bigger debt burden. And France is currently locked in heated disputes due to the lack of public acceptance of the need for austerity measures and union opposition to the proposed raising of the pension age to 62.

In contrast, the UK is proposing a very radical change in spending and targeting substantial budget cuts worth 5-6% of GDP (just over £80 billion over 4-5 years). It deems the risk of a double dip recession to be low, bolstered by the latest better-than-expected results for the UK economy. The recent spending review presented last week won IMF approval and also a vote of confidence from the markets, with the UK securing its valued AAA credit rating.

It is quite plausible that the UK's coalition government will be able to emulate the success achieved by the last Conservative government, which turned around a large budget deficit between 1992 and 1997 while maintaining a fairly robust economic recovery. Nevertheless, it is the question of jobs that underscores why 'success' must be carefully measured - and why comparisons with 1997 may be pertinent. Tony Blair's Labour Party won a landslide victory - and inherited the improved public finances and economic outlook.

Ultimately, the electoral success for the UK government will be determined by unemployment figures as well as GDP growth and a reduced budget deficit. And other European governments will need to heed this message.