The 2001 Irish Reprimand

Effects on EMU Credibility and Enforcement Power

By
Cliffs of Moher, Liscannor, Ireland
The 2001 Irish Reprimand : Effects on EMU Credibility and Enforcement Power - Barbara Barath

Abstract

This article uses the case of the Irish Reprimand to showcase the importance of European Monetary Union (EMU) credibility. Although the reprimand was justified in light of Ireland's inflationary spillover effects and pro-cyclical fiscal policies, the measures taken by the European Union (EU) against Ireland have resulted-and may continue to result in a loss of credibility with respect to EU citizens who see contradictions in EU behavior, especially considering the fact that clear violators of the Stability and Growth Pact (SGP), for example, Germany and France go unpunished. Considering the reprimand in the context of the current debate surrounding the SGP, it is important that the EMU focus on maintaining credibility with EU citizens (not financial markets) by consistently and transparently applying its measures to gain public opinion and confidence.

Introduction

In 2001, the EU issued a reprimand to the EMU member state with the fastest growth rate and largest fiscal surplus, as a share of Gross Domestic Product (GDP) in Europe.1 While Ireland's growth was due in large part to its ED membership, it received a reprimand because the EU perceived its fiscal policies to be aggravating the overheating of its economy.

Although the EU was right to worry about spillover effects from Irish inflation, its reprimand did not serve to stabilize the EMU. Instead it served to decrease the credibility of the EU-the overall perception of EU citizens regarding its ability and desire to produce a beneficial tradeoff for each nation (i.e. EU-led stability and growth in the long-term in exchange for national sacrifices in the short-term)-because (a) the justification for the reprimand itself was questioned, and (b) the reprimand was a part of a trend of inconsistent behavior towards member states on the part of the EU.

The justification was questioned not only because Irish inflation was caused partly by external shocks (rather than Ireland's budget), but because Ireland had been taking measures to limit its inflation, which was (and projected to continue) diminishing. Ireland claimed that its tax cuts were necessary in anticipation of economic downturn. While the government did not suffer any material sanctions, its public did respond negatively-with the rejection of the Treaty of Nice.

The EU has since come under criticism because of its inconsistent actions as other members whose violations were more clear-cut than that of Ireland escaped reprimand. An analysis of the EU's actions reveals that it has generally used its discretion to the advantage of national interests and has benefited EMU performance. It has, however, ironically worked against the common interest: bringing EMU credibility into question-due to the combination of the questionable justification of the Irish reprimand and inconsistency in other cases-has potentially made future enforcement of EU rules difficult.

History: Irish Growth and Reprimand

When Ireland joined the then European Economic Community in 1973, the country's income-per-head was about sixty percent of the community's average; it is now around 120 percent. Ireland's biggest export for most of its history has been its people; now high-tech goods stream out of Ireland, and immigrants stream in.2

There is no doubt that Ireland's membership in the EU played a significant role in the economy's expansion. In the past thirty years, Ireland has received a net total of 32 billion euros in agricultural and regional development subsidies.3 The link between these transfers and Irish growth may, however, not be as close as some imagine.4 The true sources of Ireland's growth-its ability to assert its independence from the United Kingdom (UK) and attract foreign direct investment (FDI)-were nevertheless in large part made possible by its EU membership.

Ireland used participation in the exchange rate mechanism of the European monetary system (EMS) to sever the link between the Irish punt and the British pound in the late 1970s and early 1980s. EMS participation also encouraged a redirection of Irish trade from Britain to the Continent, not only enhancing the country's economic independence from its former colonial master but also strengthening the technological base for Irish manufacturing.5

This technological base was a foundation for the main source of Ireland's growth: FDI in the form of high-technology investments from the United States and Japan. The most spectacular growth spurt began in 1995 as investors recognized that Ireland was certain to be a founder member of EMU.6 FDI was further attracted not only by Ireland's cultural appeal (there may have been "a shift in worldwide technology favoring Irish aptitudes and workplace attitudes"7) but also through Irish government initiatives in taxes, education and wage policy. After the failure of expansionary fiscal policies to stimulate growth in the late 1970s and early 1980s, the government instituted attractive corporate tax rates (as low as 10 percent) and invested heavily in education, resulting in rapidly improving skills levels, in order to attract direct investment by export-oriented multinationals.8 The availability of a skilled labor force at competitive wage rates (made possible by price-incomes policies) and of technologically-advanced capital (from whom developers could profit at low tax rates) attracted further investment and spurred GDP growth, which averaged near ten percent during the 1996-2000 period (compared to only 2.6 percent for the eurozone as a whole).9

Its growth was so significant that, by 2000, that the EU instructed Ireland through the Broad Economic Policy Guidelines (BEPGs) to increase its fiscal surplus in order to reduce the threat of overheating in its economy and prevent the transmission of inflation to the rest of the eurozone. The Irish finance minister, Charlie McCreevy, planned on December 6, 2000 for a record fiscal surplus in his budget for 2001, and on January 24, 2001, the Commission "welcomed" these budget surpluses, which "would clearly be sufficient to provide a safety margin against breaching the deficit threshold."10 The Commission, however, criticized what it considered to be major pro-cyclical elements of the budget (cuts in direct and indirect taxes and increases in current and capital expenditures)11 which it concluded would further increase domestic demand and thereby aggravate inflationary pressures. It therefore proposed that the Council adopt a recommendation addressed to the Irish government to end the inconsistency of the expansionary aspects of its budgetary plans with the BEPG. The Council of Economics and Finance Ministers (ECOF IN) accordingly issued an "early warning" recommendation to Ireland on February 12, 2001,12 the public nature of which made it a formal reprimand.13

While Ireland's finance minister Charlie McCreevy responded to the 2001 reprimand saying that it was "very difficult" for him to see why it was warranted,14 the Irish government did make some changes in its budget, including a special savings incentive scheme-which would take demand out of the economy-as well as a tax recovery scheme that clamped-down on offshore accounts and unpaid Deposit Interest Retention Taxes-which would increase the budget surplus. On October 24, 2001 the Commission ruled that, due to the changing economic climate (resulting from agricultural crises, especially foot-and-mouth-disease, as well as the slowdown of the United States and world economy in the aftermath of September 1115) and the implementation the abovementioned counter-cyclical tax measures in the budget, the previous overheating in the economy had been reduced.16 Although some Irish called the statement "a humiliating u-tum on its economic reprimand,"17 the credibility of the EU came into question. According to a report from the European Voice in March 2001, "Selling euro-zone membership to Swedish and British Social Democrats just got even harder and Irish Members of the European Parliament (MEPs) have warned that their countrymen may punish the EU by refusing to ratify the Nice Treaty in a referendum."18 Ireland did indeed reject the treaty in June 2001 probably more because the reprimand resulted in fears of losing political autonomy (along with questions of neutrality and abortion rights19) than because of opposition to enlargement per se.20

Although the Irish remain strong supporters of EMU, member states must continue to convince their publics (and the EMU the member states) that the benefits of EMU membership outweigh the costs. In order to do so, the EMU must maintain credibility in the application of its rules and procedures.

EU Rules and Procedures

The Maastricht Treaty on European Union (TEU) and the Treaty Establishing the European Community (TEC) set economic objectives for the EU to include "a high level of employment," "non-inflationary growth," and "convergence of economic performance."21 In order to achieve such goals and avoid conflict under the EMU, the member states agreed to monetary and fiscal harmonization measures.

For monetary harmonization, the European Central Bank (ECB) uses a two-pillar strategy to maintain price stability: maintaining an annual rate of change of less than but near two percent in the Monetary Union Index for Consumer Prices (MUICP), which measures aggregate price developments across members states, and less than 4.5 percent liquidity growth, with M3 as the aggregate measure.

Although fiscal policies are set by member states, they are limited by European guidelines -- to avoid excessive fiscal deficits and to respect the medium­term budgetary objective of "close to balance or in surplus" - and procedures.

The excessive deficit procedure represents a commitment to avoid excessive fiscal deficits (defined as a debt to GDP ratio at, below or declining towards sixty percent and a deficit to GDP ratio at, below or declining towards three percent). The procedure includes a critical break-set out in Article 104 of the TEC-beyond which parties to the excessive deficit procedure become legally responsible for their actions22 and can be fined up to 0.5 percent of GDP.

The multilateral surveillance procedure requires all member states to participate in the elaboration of BEPGs, which contain both an assessment of the general economic performance of the EU and specific recommendations for each member state to follow in order to coordinate its policies with the common European interest. Because it is impossible for the EMU to punish inflationary policies in individual member states, the TEU granted to the Council responsibility for ensuring that member states "regard their economic policies as a matter of common concern."23 Its main method of enforcement against member states who do not abide by the BEPGs is the issuance of reprimands (such as that against Ireland), which can be damaging as long as a peer pressure mechanism is in place through which states who fail to work within the EU's framework for economic policy coordination are considered sinners: "Any member state that fails to operate within the framework is self-interested (pride), excessive (gluttony), and indolent (sloth)."24 If the credibility of EU rules is lost, however, the force behind the Council's enforcement mechanism-a general commitment to common interest25-would be lost.

At the 1997 Amsterdam summit, the Council of Ministers introduced the SGP in order to provide clearer guidelines on the usage of the previous two procedures. The Council of Ministers could then issue an early warning in the event that it has sufficient evidence to believe that a member state might not meet the requirements for either the multilateral surveillance or the excessive deficit procedures. This "early warning procedure" is intended to encourage member states to meet EU fiscal guidelines before approaching the Article 104 break after which legal sanctions for noncompliance apply.26 Since most procedures, therefore, rely mostly on public opinion for enforcement, it is important that the public feels that reprimands are justified and consistent.

Justification for Reprimand and Inflation

"In light of the comparative performance of the Irish economy," it is not surprising that the Irish finance minister questioned the justification of the 2001 reprimand.27 While it is likely that McCreevy instituted the tax cuts that motivated the reprimand for political reasons (as implied by the Economist caption, "McCravesyour vote"28), it is important to analyze the validity of the assumptions that the EU made as the basis for its reprimand: a) the overheating of Ireland's economy (i.e. high levels of inflation in Ireland) would have spillover effects and destabilize the EU as a whole and b) the inflation itself was caused by the government's loose fiscal policy (or at least could be diminished by a reversal of that policy).

Effects of Inflation

According to The Economist, "Ireland's inflation harms nobody but the Irish. It will not affect the euro's credibility on world markets, nor have the slightest measurable effect on eurozone inflation as a whole."29 EU Monetary Affairs Commissioner Pedro Solbes seemed to agree as he said that the Irish economy (contributing a share of just one percent to the EU's aggregate GDP) is too small to pose a threat to the stability of the eurozone as a whole.30

Even if inflation itself is not directly transmitted to other countries, the fact that the ECB must set interest rates based on average EMU inflation rates means that Irish inflation did have spillover effects. Even in 2002 when Irish inflation had decreased to just under five percent, the combination of its inflation with that of Greece, Spain, Portugal, and the Netherlands (where inflation was just under 4 percent) pushed the eurozone average to 2.3 percent despite the fact that German's inflation averaged only 1.3 percent.31 The ECB therefore set the nominal interest rate in such as way that real interest rates in high inflation countries became negative while they were too high for countries like Germany (for whom the tight monetary policy resulted in falling prices as well as slow-and even negative in 2003-growth).32 Despite its otherwise impressive economic performance, inflation in Ireland did negatively affect other EMU members.

Causes of Inflation

Because of limited convergence between EMU members, Ireland's asymmetric response to external shocks may have been the source of its inflation rather than the government's fiscal policies. Due to the country's small size and openness, higher import prices resulting from rising oil prices and a sustained period of euro weakness against sterling and the US dollar (Ireland is uniquely exposed among euro area countries to the euro's external value, as the UK and the US account for almost half of Ireland's total merchandise imports) caused inflation to pick up in 2000.33 If Ireland's economic deviance was, in fact, a result of external factors, attacking the government's fiscal policies would not have solved the underlying problem. The effects of the second-best solution to inflation (i.e. decreasing demand) would be, at best, short-term.

Although domestic factors clearly also contributed to the rise in inflation, the Commission itself noted that the budget for 2001 "included measures aimed at containing inflation." Although it felt that those measures would "likely... be counterproductive,"34 the government's budgets were intended to limit inflation. By January 2001, Ireland's inflation rate had actually fallen from six percent in November 2000 to 3.9 percent and was falling further as the main factors pushing it up had stopped or gone into reverse.35

In fact, some fiscal stimulus may have been necessary as Irish officials repeatedly emphasized that a general economic slowdown was already predictable in February 2000 since the US economy, to which the Irish economy was far more exposed than most EU countries, was then warning of a possible recession.36 Furthermore, the International Monetary Fund (IMF) noted that the deterioration in the global outlook for high-technology companies posed "considerable downside risks" given the importance of FDI to Ireland's economy.37 Given the potential of an economic recession, Ireland's overheating economy was bound to cool down and may have needed fiscal stimulus rather than a reprimand.

Although the Irish government's claim that it was fully aware of this need in early 2001 can be questioned (since it could not have foreseen the global economic downturn resulting from September 11), rational actors questioned whether the reprimand was necessary or justified. This is not surprising given the fact that, a week after he spearheaded the unprecedented reprimand of Ireland, Solbes, paid tribute to the positive aspects of Irish economy.38

Nevertheless, McCreevy did make some budget revisions (the abovementioned savings and tax-recovery schemes mentioned) of which the Commission approved and which prompted the Council to say that its recommendations had to some extent been adhered to39 because they decreased demand. As many claim that Ireland actually ignored the reprimand,40 it is unclear whether the revisions were actually an admission of the inflationary nature of the previous budget or simply a continuation of what the government intended to be anti-inflationary measures.

Given Ireland's special circumstances, a one-size-fits all policy may not be appropriate since member states whose economic structures and macroeconomic performance will not and were not even intended to converge either as part of the process leading up to the monetary union or the Lisbon strategy.41 Solbes suggested that Ireland, which had reduced its debt to low levels, should have been allowed greater freedom in order to make public investments and create jobs.42 Instead, it appears that the Council decided to "make an example" of Ireland and create a precedent for a "valuable coordination effort"43 since it believed that, if Ireland's sins were ignored in 2001, then it would be impossible to chase bigger countries' sins when they really mattered.44 Ironically, the reprimand may have negatively affected the credibility of the EMU and therefore its ability to enforce future recommendations.

EU Credibility and Enforcement

Member states have implicitly accepted that the trade-offs of EMU membership (e.g. exchange rate stability at the cost of national monetary policy control and fiscal policy coordination at the cost of limitations on national fiscal policy) are favorable.45 The stability of the EMU are, however, weakened as the policy framework and institutions come into question either because the targets themselves are too strict or because they are applied inconsistently.

Although the rules and procedures that guide member-state performance are relatively dogmatic, the EU has a great deal of discretion. For example, the Council can issue a recommendation when a state's economic policies "risk jeopardizing the proper functioning of economic and monetary union"46 and the Commission can make a qualitative assessment of a country's budgetary situation with even the "hardest" enforcement mechanisms (i.e. Article 104 of the excessive deficit procedure).47 The use of discretion has inevitably led to inconsistency.

Article 237(d) TEC, which grants the ECB the authority to sue directly before the European Court of Justice (ECJ) a national central bank that has failed to fulfill its obligations under Community law, reflects the only instance in Community law where a national authority can be sued directly before the ECJ.48 Since member states sacrifice their sovereignty to some extent by giving responsibility for monetary policy to the EU, the credibility of the ECB is extremely important. However, the ECB refuses to give any precise formula for predicting monetary policy on the basis of economic data.49 Furthermore, it has violated its own targets. In 2001, it overshot on both MUICP and M3 indicators but did little to improve its image as it confirmed the reference values (which it had violated) at the end of the year only changing the timing of interest rate decisions.50 In December 2002 the Governing Council decided to lower interest rates even though both indicators suggested that there was inflation. The ECB president explained the decision, saying that output growth was low and expected to remain low so the increased growth from reduced rates would not result in increased inflation or the undermining of price stability.51 Although the ECB's reduction of interest rates can be interpreted as an effort to aid member states in structural reforms by allowing for growth, its willingness to deviate from its own rules reduces the institution's credibility.

In order to ensure that national fiscal policymakers take into account the preferences of those people who live outside their fiscal borders but within the monetary borders of the EU,52 the EU also has special powers to control members' fiscal policy (e.g. EDP excludes the member state concerned from the final voting, thereby suspending membership rights to ensure EMU stability53). Some rules of conduct for fiscal policies are clearly necessary because a country that allows its debt to GDP ratio to increase continuously would have increasing recourse to the capital markets of the union, driving up the union interest rates and thereby increasing the burden of the government debts on other countries.54 However, the EU's fiscal targets, which imply that governments should wipe out all of their debts,55 may be too strict (even though the target date for balanced budgets has been postponed). De Grauwe, who claims that there is no valid economic reason why governments should have no debt at all, writes: "Forcing governments to run their affairs with the constraint that they cannot issue new debt creates incentives to reduce investments that have a return extending far into the future. This is a recipe for low growth, even stagnation."56

Furthermore, when countries are hit by economic hardship, fining them through the excessive deficit procedure could prevent the alleviation of the hardship.57 As The Economist writes, "fining a country for spending too much is as counterproductive as punishing indigent drunks by making them buy another round."58 Because national governments may not accept low growth in the face of elections, they are likely to defect, thereby decreasing the ability of the EU to force cooperation.

In fact, countries have defected but have escaped reprimand despite much worse economic performance than Ireland. Germany, for example, started running fiscal deficits after the 2001 worldwide economic slowdown. In contrast to the Irish situation, however, ECOFIN was slow to respond. When the Commission recommended that the German government be given an early warning in February 2002, the Council instead chose to accept reassurances that the German government would act.59 The Council finally initiated the excessive deficit procedure against Germany in early 200360 and also against France in June 2003.

Both French and German leaders protested, however, emphasizing the importance of the word "growth" in the Stability and Growth Pact. Although the countries' protracted deficits mainly reflected the governments' readiness to yield to pressure from organized interest groups,61 ECOF IN voted on November 25, 2003 not to move beyond the break in the excessive deficit procedure-instead holding the excessive deficit procedure "in abeyance" - so that neither country would be subject to sanctions for their failure to comply with fiscal policy recommendations. The Council's decision to ignore the Commission recommendation brought criticism from both the ECB and Commission,62 the latter of which sued the Council in the ECB in the European Court of Justice (ECJ), which ruled on July 13, 2004 that the Council could not reinterpret the implementation of a disciplinary procedure.63 In the end, France and Germany were let off the hook.

Even Portugal avoided reprimand. While it claimed to "share the European Commission's concerns" when it was ordered to rein in its deficit in 2001,64 the Council accepted assurances that the government would fix the problem even after it became obvious that the Portuguese government had grossly understated its fiscal deficits.

Why was Ireland reprimanded while these other countries were not? The crucial difference between Ireland and the other cases is that Ireland's policy was pro-cyclical. With the use of the BEPG, the Council pursues an anti-inflation program, preempting a virulent ECB reaction to inflationary policies in individual member states, thereby safeguarding the collective good and avoiding a situation in which governments that maintain low inflation are punished when one or a few defect. Conversely, fiscal policies that do not endanger the ECB's low inflation target are left untouched, even if they break the formal provisions of the SGP - a stance that appeared to receive the tacit approval of the ECB.65 Apparently the EU is aware of the fact that fiscal consolidation within a country could mean a slowdown in economic performance that would not only strengthen popular political opposition against governments (and the EU itself) but also make it even more difficult for governments to meet deficit criteria.

Although the EU appears to have been looking out for national interests in most examples of its inconsistency, the inconsistency remains and still calls into question the credibility of targets and procedures. Because much enforcement is based on peer pressure (which is naturally weak since other countries may not back up EU reprimands if they are in the same situation66), a loss of credibility may mean that the EU will not be able to enforce measures (justified or not).

Conclusion

Those in Brussels who believe that EU-financed programs are among their most effective propaganda instruments in promoting the union67 can rest assured that the Irish are aware of the funding they have received-because billboards must be erected on the sites of all infrastructural investments that receive a certain minimum of EU funding.68 EU citizens-especially those who live in member states who have not enjoyed the profound success of Ireland-may not, however, be as aware of the benefits of EU membership-especially the indirect ones. Since public support is so important in the enforcement of consensus-based mechanisms, launching an attack on the eurozone's most successful member was no way to boost the credibility of future attempts by the EU to direct member states' economic policies.69

Although a thorough analysis of the situation indicates that the EU's inconsistency was understandable given that Ireland's inflation had potential spillover effects and that Ireland's policies seemed to be pro-cyclical (i.e. worsening the situation), the European public does not make such a thorough analysis. Brussels may be perceived as a dangerously erratic and unreliable ally in any campaign to persuade skeptical voters to support the euro70 as they see that the EU prioritizes national interests in certain situations (i.e. perhaps in favor or large countries, or simply in the case of fiscal deficits) but issues reprimands in the case of arguably less egregious violations (e.g. Ireland's inflation). It does not help matters that the cause and projection of Ireland's inflation were questionable (i.e. it may have been caused in part a by Ireland's asymmetrical response to external shocks and been diminishing).

Furthermore, the reprimand was based on the application of "softer provisions" (i.e. BEPG not SGP), the very softness of which give them a "catch all" power71 that allows for great discretion (and therefore inconsistency) on the part of the EU. Since enforcement is based on public opinion, the EU should be careful to consistently and transparently apply measures (especially "soft" ones) by more stringently adhering to its own rules and targets. If it recognizes that they are unreasonable for countries experiencing a slowdown, it should reform them instead of making exceptions.

Given the strength of the euro, financial markets may not see EMU credibility as an issue because they are less concerned about inconsistency since they understand the need for exceptions in certain cases. For EU citizens whose governments are reprimanded or must cut back spending to meet criteria, on the other hand, transparent rules and consistent application are necessary to maintain credibility. Italy would not have been to achieve its economic miracle in the 1990s if its public did not consider the EMU credible. National policymakers can only impose policies for the "common good" without fearing public backlash if their citizens see the EU as credible.

Reform of the SGP is indeed one oft he Luxembourg presidency's priorities. Some proposals are in line with the above recommendations: the imposition of heavy penalties in cases where member states are found to have cheated; and changing the definition of" exceptional circumstances" under which countries are allowed to breach provisions of the pact (i.e. relaxing the limit on government deficits at times of slow growth). Further steps should be taken to increase credibility: for example, the analysis of countries' budgetary situations should be based on cyclically-adjusted budget deficits so that only the structural budget deficit is considered72 and economic policy decisions should be defended before national parliaments in the public arena in order to increase transparency. Most importantly, the EU' s own institutions must agree on the implementation of economic policy in order to be more credible and stable.

Notes

Barbara Barath is completing a master's degree in European Studies and International Economics at SAIS at The Johns Hopkins University, Bologna Center. She graduated from Stanford University IR Program with honors and has worked in the European Parliament.