Improving the Stability and Growth Pact through a proper accounting of public investment

Olivier Blanchard (Massachusetts Institute of Technology) and Francesco Giavazzi (University of Bocconi, Bank of England and CEPR)

Reforming the Pact: the Solbes proposals

In November 2002 the European Commission adopted a new set of ideas for reforming the the Stability and Growth Pact (SGP) put forward by Commissioner Pedro Solbes. The proposals, that will be considered by ECOFIN this Spring, make important progress. In particular:

1. The deficit that is relevant for the Pact will no longer be the ‘structual’ budget deficit but the ‘structural’ deficit. . Increases in the deficit that result from a slowdown in economic activity will not be considered.

2. In assessing a country's compliance with the rules of the SGP the Commission will instead take into account the inter-temporal budgetary impact of structural reforms, such as a tax reform or government investment in public infrastructure. By raising a country's growth potential, such reforms may improve public finances in the long run but are often costly in the medium run. Allowing for such medium run budgetary costs should eliminate an obstacle to structural reform. However, this will only be available to countries where:

• government debt is below the 60% of GDP

• public finances are on a sustainable footing, taking into consideration the outstanding public debt, contingent liabilities (such as implicit pension obligations) and other costs associated with ageing populations

3. Countries that run structural budget deficits are expected to improve their structural deficit at the rate of at least 0.5% of GDP per year, presumably after allowing for the effects of 'costly' structural reforms.

According to the Commission, these proposals can be achieved within the framework of existing Treaty provisions and SGP Regulations. While making important progress, these proposals have two shortcomings:

1. They give the Commission a newly acquired and very large degree of discretion. The old rules worked almost automatically. This was their major drawback but also their advantage. It is unlikely that national governments will accept delegating so much discretion to the Commission, particularly in order to evaluate the long run benefits of reforms.
   

2. Although the proposals recognise that public investment is different from current government spending they do not go far enough. In particular the Solbes proposals fail to remove a serious error in current SGP rules: the way governments are expected to account for public investment. By failing to address this point, the proposals are silent on the lack of transparency that surrounds ‘investment agencies’, the institutions some EU members use to bypass SGP accounting rules.

The first point hits at the heart of the debate on economic governance in the EU; an issue that is unlikely to be solved soon. Instead, the Solbes proposals are likely to prompt ECOFIN to give national finance ministers discretion to evaluate the long-run budgetary implications of structural reforms in their own countries.

A correct accounting of public investment would instead be generally accepted. A private company does not attribute the entire cost of an investment project to a single year's accounts. Investment implies future returns - its cost should thus be distributed over time as those returns accrue. Amortization of investment expenditures by governments is not allowed by the SGP though the treaty does not prevent it.

The advantages of a correct accounting of public investment

A private company does not attribute the entire cost of a long-term investment project to a single year's accounts. Investment implies future returns: its cost should thus be distributed over time as those returns accrue. Amortization of investment expenditures by Governments is not allowed by the Pact, although the treaty does not prevent it. Correct accounting of public investment would have three advantages:

The advantages of a correct accounting of public investment.

Correct accounting of public investment would have four advantages:

1. Remove financial constraints on public investment.

   This is important in the euro area, for two reasons:

1. Gross public investment in the 12 EMU countries has been falling as a share of GDP since the mid 1970s. Today net investment is probably close to zero in Germany, Italy, Belgium and Austria.

2. Enlargement of the EU opens up opportunities for valuable public investment projects both in the EU and in the accession countries - if only because the geographic size of EU markets will increase.

2. Introduce a mechanism whereby, over time, the stock of public debt will equal the stock of public capital.

   This is the 'optimal' level of the stock of public debt in the long run.

3. Introduce more transparency in the budget.

   The inability to treat investment separately has created an incentive to shift investment expenditure off budget through the instrument of government-owned investment agencies in some EU countries.

4. Sustain aggregate demand in the euro area.

   Consider the case of Germany, a country in the midst of a recession and with a deficit problem. According to the existing rules, Germany would need to cut the deficit, and thus domestic demand, by close to one per cent of GDP. Now consider the effect of a rule that excluded net public investment for the definition of the deficit relevant for the SGP. Since net public investment in Germany today is essentially zero, excluding it would not affect the budget numbers relevant for the SGP. However, the modified rule requires a very different fiscal action: rather than a tax increase or a cut in spending, Germany would have to replace one per cent of GDP of current expenditure with an equivalent amount of public investment. The modified rule would thereby stimulate aggregate demand instead of cutting it.

Rules that allow proper accounting of government investment, separating it from current expenditure, appear to be consistent with article 104.3 of the EU Treaty. This article is too lax, as it makes no distinction between gross and net investment. Therefore the current Treaty allows for gross investment to be accounted for differently than other expenditure. When in fact, only net investment should viewed differently.

Investment agencies

The special agencies used by some countries to run public investment projects could be turned from instruments for opaque accounting into transparent tools for running capital budgets. The agencies should receive a transfer from the central government that reflects the fact that public projects have a financial return, net of capital depreciation, which may be less than the market return. Such agencies should be allowed to borrow on the market amounts equal to their net investment in new public projects. Running an agency properly raises an incentive problem: whatever financial return the agency extracts from its projects, the central budget will make up for the difference. This problem necessitates that the contract between the agency's manager and the central government should be carefully designed. Our paper addresses this problem by laying out a set of principles for the institutional design of such investment agencies.

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