Original Article
Reforming EU economic governance: A view
from (and on) the principal-agent approach
Dermot Hodson
School of Politics and Sociology, Birkbeck College, University of London, Malet Street, London
WC1E 7HX, UK.
E-mail: [email protected]
Abstract This paper asks what European Union (EU) economic governance can
learn from the principal-agent approach and vice versa. The answer to the first part
of this question is that a stylized relationship between the Council of Ministers for
Economic and Financial Affairs (ECOFIN) acting as a collective principal and the
Member States acting as multiple agents can shed light on factors that may have
influenced the design, breakdown and subsequent reform of the Stability and
Growth Pact and the Lisbon Strategy. The answer to the second part is that
applying principal-agent analysis to EU economic governance illustrates many of
the advantages and limitations of this heuristic device. On the plus side, it shows
that principal-agent analysis can be used to understand new modes of EU
governance as well as traditional forms of supranational policy making. On the
minus side, the sheer applicability of this approach raises methodological concerns
with regard to the specification and over-determination of principal-agent
relationships.
Comparative European Politics (2009) 7, 455–475. doi:10.1057/cep.2008.46
Keywords: principal-agent; EU economic governance; Stability and Growth Pact;
Lisbon Strategy
Introduction
Principal-agent analysis has, thanks to its ‘greater institutional sensitivity over
traditional theories of integration’, become a popular tool for understanding
supranational policy making in the EU (Kassim and Menon, 2003, p. 121). In a
seminal contribution to this field, Pollack (2003) employed the principal-agent
approach to understand the reasons why Member States delegate authority
to supranational agents such as the European Commission, European Court
of Justice and European Parliament. More recently, Hix et al (2007) have
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analyzed the ‘dual agency’ of Members of the European Parliament vis-à-vis
national political parties and European political groupings.
The principal-agent approach has also been applied to the study of
European Economic and Monetary Union (EMU). Elgie (2002), for example,
uses principal-agent analysis to understand arguments in favour of, and
against, making the European Central Bank (ECB) more democratically
accountable. For supporters of the status quo, Elgie argues, the ECB has
faithfully fulfilled the functions that were delegated to it under the Treaty. For
those in favour of reform, he suggests, the ECB has shirked its responsibilities
by attaching greater weight to price stability than EMU’s architects had
originally intended.
Schuknecht (2004) extends principal-agent analysis for the study of
EMU’s budgetary rules, arguing that the Stability and Growth Pact can be
understood as a contract between the ECOFIN, acting as principal, and
national governments, acting as multiple agents. The fact that ECOFIN cannot
always distinguish between the ‘fiscal effort’ of Member States and exogenous
shocks affecting public finances, the author argues, creates a serious, and
perhaps insurmountable, problem of moral hazard, as governments have an
incentive to flout the pact by blaming fiscal profligacy on extraneous
circumstances.
Schelkle (2005) goes a step further by combining multi-level governance and
principal-agent analyses of EU fiscal policy coordination, treating national
governments as the agent of ECOFIN in the EU arena and wage bargaining
parties and other interest groups act as agents of national governments in the
domestic arena. Under such circumstances, Schelkle (2005, p. 380) argues, the
challenge for the EU policy-makers is to design a fair and effective system of
fiscal coordination, which can compensate Member States experiencing
relatively hard economic times without incentivizing careless economic policies
or reckless behaviour by domestic price and wage setters. To this end, she
considers the merits of a system of collective insurance that would both require
Member States to reveal their preferences for sound macroeconomic policy
ex-ante and impose ex-post sanctions on fiscally profligate countries in a
constructive manner (Schelkle, 2005, p. 388).
Building on and adding to this earlier work, this paper describes EU
economic governance as a principal-agent relationship in which ECOFIN has
delegated responsibility to Member States to implement that policy mix of
budgetary discipline and structural reform. Its central finding is the principalagent analysis, though it is typically used by the EU scholars to understand
supranational modes of policy making, can also be used to gain an insight
into new modes of EU governance. Specifically, the lack of fiscal discipline
shown by some Member States in the first half of the decade and the slow
pace of structural reform can be attributed to shirking by agents, problems of
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asymmetric information and incomplete contracting, tensions within the
principal and the failure of ex-post sanctions to bite. From this perspective, the
March 2005 reforms of the Stability and Growth Pact and the Lisbon Strategy
can be understood as an attempt to correct some of these deficiencies by
refocusing on the framing agreement between ECOFIN and the Member
States, trying to align the interests of both parties and encouraging fire-alarm
oversight at the Member State level. Though the case of EU economic
governance illustrates the appeal of principal-agent analysis it also points
towards its limitations. In the first place, agency theory offers no real criteria
for selecting one formulation of the principal-agent relationship over the many
conceivable alternatives that typically exist in any given policy domain. This
problem of specification is compounded by a problem of over-determination
in so far as the multiple factors that can influence a principal’s contractual
relationship with an agent make it difficult to gauge the relative importance of
any one factor.
The remainder of this paper is divided into four sections. Section I presents a
principal-agent perspective on EU economic governance and highlights some
of the simplifying assumptions upon which this approach rests. Section II uses
this set up to examine the limitations of EU economic governance before the
2005 reforms. Section III analyses some of key features of the revised Stability
and Growth Pact and the Lisbon Strategy. The final section draws general
conclusions for our understanding of both EU economic governance and
principal-agent analysis.
I. EU Economic Governance: A Principal-Agent Perspective
Principal and agents
A principal-agent model is, according to Moe’s classic definition, ‘an analytic
expression of the agency relationship, in which one party, the principal,
considers entering into a contractual agreement with another, the agent, in
the expectation that the agent will subsequently choose actions that
produce outcomes desired by the principal’ (Moe, 1984, p. 756). The lucidity
of the principal-agent approach is such that, for a given policy domain, a large
number of principal-agent relationships may be conceivable. EU economic
governance is no exception; one could, for example, conceive of a principalagent relationship between ECOFIN and the Member States, between the
Eurogroup and national governments, between the European Council and
the Member States and between the 320 million people who live in the euro
area and the EU institutions and so on. By itself, the principal-agent approach
offers no real criteria for choosing between alternative formulations of the
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principal-agent relationship. Where this choice is justified a priori rather than
on empirical grounds, this raises methodological concerns that the relationship
at the heart of principal-agent analysis is arbitrarily specified. While this caveat
in mind this paper focuses on the relationship between ECOFIN acting as a
collective principal and the individual Member States acting as multiple agents.
Although ECOFIN is not the only candidate for principal, its role in relation
to EU economic governance is pivotal. In spite of the growing importance of
the Spring European Council and the Eurogroup, ECOFIN retains formal
decision-making responsibilities under Articles 99 and 104 of the Treaty. The
term ‘collective principal’, which is taken from Lyne et al (2006, p. 44), is
used to reflect the fact that ECOFIN is a body in which 27 Finance Ministers
reach agreement among themselves before negotiating a ‘common contract’
with Member States.1 As Thatcher and Stone Sweet (2002, p. 6) observe, the
principal-agent relationship is complicated when the principal is made up of
multiple actors. For example, the principal’s preferences may prove to be
unstable over time if its actors engage in competition with one another or if its
composition changes. It follows that the internal politics of ECOFIN in general
and the convergence of preferences among EU Finance Ministers in particular
will have a significant bearing on the credibility of the Council’s contract with
the Member States (see Section II).
The choice of Member States as multiple agents raises the question of
whether it makes sense to distinguish between ECOFIN and the individual
Member States when, under Article 203 of the Treaty, the former includes
representatives of the latter. From a political-economy perspective, this
distinction is tenable as neither budgets nor structural reforms are implemented
by the members of ECOFIN as a matter of decree. Rather, the achievement of
these goals will depend on the preferences of, and interaction between, a wide
range of actors, including Heads of State or Government, other cabinet
members, national parliamentarians, social partners and voters. This distinction is also consistent with the legal basis of the Stability and Growth Pact,
which states that ECOFIN should ‘take the necessary decisions’ under Article
104 of the Treaty, while leaving Member States to ‘take corrective budgetary
action’ when it is warranted.2
The decision to delegate
In the principal-agent approach, the decision to delegate is, as Pollack (1997,
p. 102) puts it, generally explained in terms of the ‘functions a given institution
is expected to perform and the effects on policy outcomes it is expected to
produce’. There are strong, if sometimes neglected, functionalist reasons for
choosing a decentralized approach for EU economic governance. The loss of
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national interest and exchange rates under EMU, for example, underlines the
importance of retaining a degree of flexibility in national economic policies to
offset the impact of asymmetric shocks. Similarly, differences in national
wage-bargaining institutions, regulatory environments and other economic
structures mean that a one-size-fits-all structural reform is unlikely to suit all
Member States (Deroose and Langedijk, 2003). These functionalist reasons
notwithstanding, concerns over legitimacy are likely to have played some
role in Member States’ reluctance to cede control over economic policies to the
EU level (Verdun and Christiansen, 2000, p. 168). This fact points to a
weakness in the principal-agent approach, which, as Pollack (1997, p. 107)
acknowledges, pays insufficient heed to the ‘the ideological concern for
democratic legitimacy’.
The principal’s problem
The essence of the principal’s problem, as Ross (1973) labels it, is that the
principal cannot assume that its welfare will be maximized at all times by the
agent, making it necessary to monitor and enforce compliance. There are three
reasons to suppose why the principal’s problem may arise in relation to EU
economic governance.
Firstly, the interests of the Member States and ECOFIN may be
heterogeneous. As discussed above, the Finance Minister is among a host of
actors whose actions and preferences may affect budgetary policies
and structural reforms. For example, a Finance Minister’s preference for
deficit reduction may be overridden by calls from his or her cabinet colleagues
for tax cuts or expenditure increases. Likewise, the commitment of the
government to labour-market reform may be opposed by those who want to
protect current employment conditions at the expense of taking measures to
curb unemployment.
Secondly, budget deficits and structural reforms may be affected by
economic shocks that are outside the control of the Member States (See
Schuknecht, 2004 and Schelkle, 2005). For example, an unexpected economic
downturn may generate lower than expected government receipts, leading to an
increase in budget deficits in spite of the expenditure constraint shown by
Member States. Likewise, an oil shock that leads to persistent inflationary
pressures may mask the benefits of lower prices resulting from greater productmarket competition.
Thirdly, the capacity of Member States to exercise budgetary discipline may
vary. For example, a coalition government may find it easier to keep
government borrowing within the reference value of the excessive deficit
procedure by incorporating this goal into a fiscal contract between coalition
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partners (Hallerberg, 2004). Similarly, a Member State with a well-developed
tradition of social partnership may find it easier to reach a workable consensus
on the structural reforms that are promoted under the Lisbon Strategy. Under
such circumstances, as Schelkle (2005, p. 380) argues, an effective system of
economic policy coordination must deal with ‘opportunistic behaviour’ within
bureaucracies and among domestic agents.
The difficulty of distinguishing between the effects of, inter alia,
heterogeneous preferences, exogenous shocks and domestic systems of
governance makes it difficult for ECOFIN to ensure that Member States are
promoting fiscal discipline and structural reform. The fact that Member States
may be better placed to make this distinction – because of superior knowledge
of domestic economic, political and institutional conditions – adds to this
problem by creating the risk of moral hazard, that is, Member States will have
an incentive to pursue lax budgetary policies and oppose structural reforms
while blaming the resulting outcomes on extraneous circumstances.
Framing agreements
Schuknecht (2004, p. 21) describes the Stability and Growth Pact as a ‘fiscal
contract’ that attempts to overcome the principal’s problem by tying Member
States to the mast of budgetary discipline. It is more accurate, however, to
describe the Pact as a ‘framing agreement’ which defines, inter alia, the
circumstances under which budget deficits may temporarily exceed the 3 per
cent of GDP reference value, medium-term goals for budgetary policy and
prescribes budgetary adjustment paths and economic and budgetary policies
that are consistent with these goals. As Kassim and Menon (2003, p. 123)
recognize, ‘[w]here the interaction envisaged by an agreement is long-term, the
bargain complex, [and] the negotiating process difficult’ it may not be possible
to draw up a contract to decide how the agent should act under all states
of the world. In circumstances such as these, the authors note, it may be
more practicable for the principal and agent to adopt a framing agreement that
sets out general goals and criteria for decision making (Kassim and Menon,
2003, p. 123).
The Lisbon Strategy provides an even looser framing agreement with respect
to the EU’s structural reform agenda. On a general level, the strategy commits
Member States to the goal of making the EU ‘the most competitive and
dynamic knowledge-based economy in the world, capable of sustainable
economic growth with more and better jobs and greater social cohesion’ by
2010 (European Council, 2000 para. 5). On a more specific note, it sets a
number of non-binding targets for Member States to reach according to a predetermined schedule. These quantitative goals range from the completion of
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the Financial Services Action Plan by 2005 to raise the average employment
rate to 70 per cent by 2010. Beyond this, the Lisbon European Council in
March 2000 broadly gives Member States the freedom to tailor their reform
packages according to their specific needs by means of the Open Method of
Coordination (see Hodson and Maher, 2001).
Police-patrol oversight
To ensure that agents comply with the framing agreement, the principal may
set up an oversight mechanism. McCubbins and Schwartz (1984, p. 1666)
distinguish between two classic forms of oversight: police-patrol and firealarms. Police patrol is a comparatively centralized approach which allows the
principal to conduct a thorough and ongoing assessment of the agent’s
activities through, inter alia, scientific studies and field observation. Fire-alarm
oversight is a more decentralized arrangement which establishes rules and
procedures to enable the public, organized interest groups and other
stakeholders to hold agents to account for their actions. EU economic
governance corresponds more closely to a variation of police-patrol oversight
in so far as Articles 99 and 104 of the Treaty have delegated responsibility to
the European Commission for the centralized monitoring of Member States’
economic policies and for assessing compliance with the Stability and Growth
Pact and the Broad Economic Policy Guidelines (BEPGs).
Under this set up, a secondary principal-agent relationship evidently exists
between ECOFIN and the Commission with the latter carrying out a
supervisory role on behalf of former. Following Tallberg (2002), we can think
of this relationship as one in which the Commission primarily acts as a
delegated monitor but enjoys few if any powers of representation, initiation
and execution in relation to EU economic governance. For the sake of
parsimony, this paper leaves questions about Commission discretion to one
side, assuming that this institution monitors compliance with the BEPGs and
the Stability and Growth Pact in an unbiased fashion in accordance with
Articles 99 and 104 of the Treaty. Should evidence contradict this assumption,
it would be necessary to explore the principal-agent relationship between
ECOFIN and the Commission in greater detail.
Ex-post sanctions
What happens when oversight reveals that an agent has breached the framing
agreement? Although Member States are under no legal obligation to
implement the BEPGs and cannot be threatened with financial penalties,
ECOFIN can issue a non-binding recommendation under Article 99(4) that
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calls on errant Member States to take corrective action. In the absence of legal
obligation and financial penalties, these recommendations constitute a form of
peer pressure that is designed to name, shame and blame errant Member States
into modifying their economic policies (Hodson and Maher, 2001).
Article 104 of the Treaty enforces budgetary discipline through peer pressure
and, in extremis, the threat of financial penalties. The initial stages of the
excessive deficit procedure follow much the same route as the BEPGs, with an
infringement of the budgetary ceiling triggering a recommendation under
Article 104(7) to call on Member States to take corrective action within a given
time period. As with the BEPGs, the aim of this recommendation is to name,
shame and blame the errant Member State into reducing its budget deficit. If
corrective action is not forthcoming and the excessive deficit persists, then, in
contrast to the BEPGs, the Council can vote to impose harder sanctions.
Under Article 104(11) these sanctions will begin with an obligation to impose
additional information requirements in the event of new bond issues, followed
by an invitation to the European Investment Bank to reconsider its lending
policy towards the Member State in question. The sanctioning procedure can
end with the imposition of non-interest bearing deposits, which can ultimately
be converted into a fine. Although the financial penalties of Article 104(11) are
perhaps the most well-known feature of the excessive deficit procedure, their
importance should not be exaggerated. As the European Commission (2002a)
implies, the Treaty envisages the use of financial penalties only after a
protracted breach of the excessive deficit ceiling, leaving economic governance
dependent, in other circumstances, on peer pressure and non-coercive methods.
II. The Limitations of EU Economic Governance
An important test of the principal-agent approach concerns its ability not only
to make sense of contract formation but also to identify the conditions under
which contracts breakdown and the ways in which they might be strengthened.
The focus in the remainder of this paper shifts from understanding the design
of EU economic governance to highlighting the factors that may have impeded
the implementation and enforcement of the Stability and Growth Pact and the
Lisbon Strategy in the first half of the decade.
Shirking by agents
Perhaps the most straightforward way for a principal-agent relationship to
breakdown occurs when an agent shirks its responsibilities, that is, deliberately
acts in a way that is contrary to the interests of the principal. In the case of EU
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economic governance, the preferences of some agents would certainly appear
to have diverged from those of the principal at one time or another. The
European Commission has been sharply critical that ‘implementation has not
always been consistent with the ambition and the provisions of the Treaty and
the Stability and Growth Pact (SGP)’ (European Commission, 2004a, p. 60).
In this respect, the failure of some Member States to consolidate their fiscal
positions during the economic upturn of 1999–2000 is widely held to have been
a contributory factor in the excessive deficits that followed the 2001–2002 slow
down (European Commission, 2004b). Member States have also been criticized
for the lack of progress in improving the functioning of product, labour and
capital markets. In its report to the Spring European Council in March 2004,
the European Commission concluded that although ‘undeniable progress’ had
been made towards implementing the Lisbon Strategy, ‘the overall implementation levels and the progress made in Member States are still insufficient’
(European Commission, 2004c, p. 5). Kok (2004, p. 28) put this more sharply
by suggesting that ‘[t]here is little benefit in governments agreeing to measures
in Brussels if they do not then show the same commitment when it comes to
implementing those measures at national level’.
Asymmetric information
Even if the preferences of some Member States may have diverged, in some
instances, from those of ECOFIN, it is doubtful whether the strains on the
Stability and Growth Pact and the Lisbon Strategy before their reform can
be attributed to shirking alone. There is, for example, a growing body of
literature that suggests that domestic budgetary institutions matter when it
comes to complying with the Stability and Growth Pact. The European
Commission (2006), for example, finds that well-developed expenditure rules
have a significant impact on efforts to maintain sound budgetary policies in
EU Member States. Extraneous circumstances may also have impeded the
implementation of the Lisbon Strategy during its first 5 years. The Kok Group
(2004, p. 6) cites the economic slowdown of 2001–2002, an overloaded
agenda, poor coordination and conflicting priorities, in addition to a lack of
commitment by Member States, as being among the factors that may have
impeded the EU’s structural reform agenda.
The difficulties of disentangling shirking from extraneous impediments to
fiscal discipline and structural reform illustrate the informational asymmetries
faced by ECOFIN in monitoring Member States’ compliance with EU
economic governance. This problem was further compounded by deficiencies
in statistical governance. The European Commission (2002b, p. 4) notes that in
spite of ‘continuous progress over almost a decade’ deficiencies remain in the
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‘compilation and reporting of government accounts’ across Member States.
Problems highlighted by the European Commission include the frequency of
revisions to national accounts, difficulties in reconciling government borrowing
statistics with other national accounts, delays in the transmission of budgetary
statistics and political interference. The extent to which non-reliable statistics
can hinder budgetary surveillance was underlined in 2002 when the newly
elected Social Democrat government in Portugal revised its predecessor’s
budgetary estimates for 2001 from 2.8 to 4.8 per cent, revealing the existence of
an excessive deficit.
Informational asymmetries have also occurred in relation to the Lisbon
Strategy because of the problems of identifying structural reforms and their
effects. As Deroose et al (2008) argue, the implementation lag associated with
reform measures and pressures on policy makers to come forward with, and
recycle, reform proposals has made it difficult for observers to disentangle
proposed from enacted reforms and to distinguish between reforms that are
commensurate with their objectives and those which are likely to fall short. In
its report, An Agenda for a Growing Europe, the Sapir Group make a similar
point, calling for ‘a more sustained investment in developing effective
methodologies’ so as to allow policy makers to get a better grip on what is
required to make EU economic governance work (Sapir et al, 2004, p. 86).
Deficiencies in the framing agreement
A principal-agent relationship can also come under strain if tensions arise over
the framing agreement between the two parties. In the first half of the decade,
tensions of this kind occurred in relation to the Stability and Growth Pact,
which was criticized in some quarters for focusing too much on budget deficits
and fiscal discipline and giving insufficient attention to factors such as the
economic cycle and the sustainability of public finances. This matter came to a
head in 2002 when a number of commentators, including the then European
Commission President, Romano Prodi, criticized some defenders of the
Stability and Growth Pact for advocating fiscal tightening during an economic
slowdown. As the European Commission (2002b) recognized, such perceptions, whether justified or not, undermined the credibility of the Stability and
Growth Pact in the eyes of the press, markets and the general public (European
Commission, 2002c, p. 6).
If the fiscal framing agreement between ECOFIN and Member States was
painted as being overly restrictive, the structural reform contract was criticized
for being overly lax. As the Kok Group (Kok, 2004) put it, a key weakness in
the original Lisbon Strategy was that it suffered from having too many
priorities, too few of which were clearly defined. This lack of focus is manifest
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in the number of economic guidelines issued under Article 99 of the Treaty. In
1993, the inaugural BEPGs contained just three general guidelines. By 2003,
driven by the Lisbon Strategy, there were 23 general guidelines, four euro area
specific ones and 94 country-specific recommendations for the period 2003–
2005 (Deroose et al, 2008). The growing number of priorities for structural
reform has made it difficult to establish a set of core priorities for the EU
economy and to understand the trade-offs between different objectives.
Tensions within the collective principal
As discussed in the previous section, ECOFIN can be viewed as a collective
principal with EU Finance Ministers reaching agreement among themselves
before negotiating, and then enforcing, a common contract with Member
States. A divergence of preferences among EU Finance Ministers, it was
warned, could undermine ECOFIN’s credibility as a principal and give more
leeway for the agents. One occasion on which divergent views on EU economic
governance came to a head in ECOFIN was 23 November 2005, when EU
Finance Ministers failed to endorse the European Commission’s recommendation against France and Germany under Article 104(8) and 104(9).
The European Commission’s recommendations on France and Germany
were significant because, if endorsed, they would have taken a significant step
toward the imposition of financial penalties under the excessive deficit
procedure for the first time. After lengthy negotiations in ECOFIN, the
European Commission’s recommendations failed to gain the support of a
qualified majority of Member States in spite of the support of Austria,
Belgium, Denmark, Greece, the Netherlands, Spain and Sweden. In addition,
the Council took the unprecedented step of declaring the excessive deficit
procedures against France and Germany ‘in abeyance for the time being’
(Council of Ministers, 2003, pp. 17–21).
Following a legal challenge of this decision by the European Commission, the
European Court of Justice (ECJ, 2004) ruled that although ECOFIN was under
no legal obligation to adopt the Article 104(8) and 104(9) recommendations
against France and Germany, but that it had acted unlawfully when it suspended
disciplinary actions against these Member States. In spite of this ruling, the
divergence of preferences within ECOFIN severely undermined the credibility of
the Stability and Growth Pact and made it impossible to return to ‘business as
usual’. The European Commission recognized this point in its January 2004
strategy for economic policy coordination and surveillance, which simultaneously
announced its intention to challenge ECOFIN’s decision of 25 November 2003 at
the European Court of Justice while accepting that some reform of the Stability
and Growth Pact was inevitable (European Commission, 2004a).
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Limitations of sanctions
A final factor that weighed on the principal-agent relationship between
ECOFIN and the Member States was the limitations of peer pressure as a
sanction mechanism. As Deroose et al (2008) note, the willingness of officials at
the EU and Member State level to engage in public criticism of Member States’
economic policies appears to have diminished over time. One explanation for
this phenomenon is that sanctions can impose a cost on the sender as well as
the target. This was clearly demonstrated in February 2001, when ECOFIN’s
Article 99(4) reprimand against Ireland fuelled widespread criticism for both
ECOFIN and the Commission for ‘interfering’ in Irish economic policymaking. Given the strength of this backlash against Brussels, it is not entirely
surprising that ECOFIN has yet to issue an Article 99(4) recommendation
against another Member State.
In summary, this section has shown that, from a principal-agent perspective,
a range of factors may have undermined the Stability and Growth Pact and the
Lisbon Strategy during the first half of the decade, including shirking by
Member States, asymmetric information, deficiencies in the framing agreement, tensions within the collective principal, and the ineffectiveness of ex-post
sanctions. On a methodological level, this shows that principal-agent analysis
can be used not only to understand contract formation but also to identify the
factors under which contracts breakdown. What it does not do, however, is
rank the relative importance of these various factors or explain the possible
linkages between them. The resulting problem of over-determination suggests
that the principal-agent approach falls someway short of offering a fullyfledged theory of policy making (See Pollack, 2007).
III. The Reform of EU Economic Governance
This section extends this analysis to the reforms to EU economic governance in
March 2005. Its purpose is to offer neither a complete description nor a
justification of the revised Stability and Growth Pact and re-launched Lisbon
Strategy but rather an account of how key elements of the reforms can be
understood in principal-agent terms.
Refocusing the framing agreement
From a principal-agent perspective, the reform of the Stability and Growth
Pact in March 2005 constitutes an attempt to refocus the fiscal framing
agreement between Member States so as to strike a better balance between
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factors that are within the control of agents and those that may not be. The
reforms attempt to do this in three key ways.
Firstly, the revised Stability and Growth Pact allows ECOFIN to take into
account a greater range of economic variables when assessing medium-term
budgetary positions. To this end, Member States are assigned differentiated
medium-term budgetary objectives that take into account ‘the diversity of
economic and budgetary positions and developments as well as of fiscal risk to
the sustainability of public finances, also in the face of prospective demographic changes’, while at the same time ensuring room for manoeuvre vis-à-vis
the 3 per cent of gross domestic product (GDP) reference value.3 For euro area
members and participants in the Exchange Rate Mechanism (ERM) II, these
medium-term budgetary objectives can range from 1.0 per cent of GDP to a
position of close to balance or in surplus (European Council, 2005, p. 28).
Secondly, ECOFIN can now pay greater attention to the ‘effort’ that
Member States make to comply with the Stability and Growth Pact. Euro area
members and participants in ERM II that have not yet achieved their mediumterm objectives will use 0.5 per cent of GDP as the benchmark for their annual
budgetary effort (European Council, 2005, p. 30). The agreement also makes
reference to the need for a ‘more symmetrical approach to fiscal policy over the
cycle through enhanced budgetary discipline in economic good times’.4
Thirdly, ECOFIN has altered the exceptionality clauses that determine the
conditions under which budget deficits are allowed to exceed 3 per cent of GDP
temporarily and by an amount that is close to the reference value. Under the
new Pact, a severe economic downturn is defined as ‘a negative annual GDP
volume growth rate or from an accumulated loss of output during a protracted
period of very low annual GDP volume growth relative to its potential’.5 The
agreement also spells out the range of ‘other relevant factors’ that the
European Commission should take into account when preparing its report on a
breach of the 3 per cent reference value under Article 104(3).
Although these changes may, as Schuknecht (2004) argues, help to ‘insure’
Member States against the risk of breaches of the Stability and Growth Pact
that are due to exogenous circumstances, they also complicate the principal’s
task of monitoring compliance. This underlines the importance of ensuring
that budgetary coordination in the EU is monitored in a transparent
and publicly verifiable manner so as to minimize the risk of moral hazard.
The European Commission (2005, p. 6) tacitly acknowledges that greater
‘room for economic judgement in the fiscal surveillance procedure’ puts ‘a
greater responsibility on both the Commission as it assesses budgetary
developments and the Council as it decides on what steps to take in the
surveillance procedure’.
Whereas the revised Stability and Growth Pact allows for a more complex
framing agreement between ECOFIN and the Member States, the re-launched
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Lisbon Strategy attempts to simplify matters. Firstly, achieving higher growth
and more jobs has been placed at the centre of the EU’s structural reform
agenda with a view to setting clearer priorities and increasing support for the
EU’s structural reform agenda (European Council, 2005). Secondly, the Spring
European Council has adopted ten reform priorities, ranging from the creation
of a European Research Area and the promotion of better regulation to the
reform of social protection systems. Thirdly, the BEPGs and the Employment
Guidelines have been brought together in a single document for the first time,
with the combined number of guidelines being cut to 24 for the period 2005–
2008. These guidelines were carried over into the period 2008–2011, signalling
the determination of EU policy-makers to focus on existing reform objectives
rather than accumulating new ones.
Although the new-look Lisbon Strategy has greater focus than its
predecessor, the sheer scale of the reform agenda that remains, coupled with
the perennial problem of identifying reform measures and their effects, means
that the problem of asymmetric information has not gone away. As in the case
of budgetary reform, a transparent approach to monitoring will be critically
important for the success of the EU’s reformed system of economic
governance. To this end, the Commission is involved in the development of
reform databases and other methodologies to improve the tracking of
structural reforms in EU Member States and to measure the impact of specific
policy measures on growth and employment (See Deroose et al, 2008).
Aligning the interests of principal and agent
The concept of ownership features prominently in both the reform of the
Stability and Growth Pact and the Lisbon Strategy. The European Council
(2005, p. 22) for example, identifies ‘increasing national ownership of the EU
fiscal framework’ as one of the core motivations for reforming the Pact,
alongside fostering transparency and clarifying implementation. The European
Commission (2004c, p. 5) also attaches importance to increasing national
ownership, arguing in its Communication to the Spring European Council in
2004 that ‘[e]stablishing broad and effective ownership of the Lisbon goals is
the best way to ensure words are turned into results’. To this end, it contends
that ‘[e]veryone with a stake in Lisbon’s success and at every level must be
involved in delivering these reforms y [and] must become part of national
political debate’ (European Commission, 2004c, p. 5).
For Collignon (2008, p. 79) references to ownership in the reform of EU
economic governance amount to little more than ‘cheap talk’. He examines the
concept of ownership from a Coasian standpoint, linking it to ideas like
property rights, the limitations of access and the exclusion of non-performers.
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From this perspective, the fact that the revised Stability and Growth Pact and
re-launched Lisbon Strategy do not fundamentally alter the assignment of
economic policies under EMU implies that their impact on ownership is likely
to be negligible.
When viewed through the lens of the principal-agent approach, however, the
concept of ownership offers up an altogether different meaning. As Khan and
Sharma (2001, p. 13) observe, ownership can be understood in principal-agent
terms as referring to the extent to which the interests of the principal and agent
are well-aligned. When ownership is high, the agent will naturally prefer to act
in a way that maximizes the welfare of the principal. When ownership is low,
the principal must resort to ex-ante controls and ex-post measures to prevent
the agent from shirking its responsibilities. From this perspective, calls for
increased national ownership over EU economic governance are simply
another way of saying that the coordination of budgetary policies and
structural reforms would function more smoothly if the objectives set by
ECOFIN were embedded in, rather than opposed by, Member States. Thus, in
principal-agent terms, the relevant question is not whether enhanced ownership
is a meaningful goal but rather whether it is a viable one. The Spring European
Council in March 2005 put forward four proposals for enhancing ownership.
K
K
K
K
Firstly, it underlined the need to bolster national ownership of EU economic
governance by increasing the economic rationale underpinning the EU’s
budgetary rules and by focusing structural policies on the core priorities of
growth and jobs. The reform, in other words, provide an opportunity to
renew support for budgetary stability and structural reform among both
principal and agent.
Secondly, it invited Member States to draw up their National Reform Programmes ‘on their own responsibility’ and ‘geared to their own needs and
specific situation’ (European Council, 2005, p. 13). Khan and Sharma (2001,
p. 17) refer to this kind of strategy as a ‘home grown’ approach to foster
ownership. The idea is to allow Member States to (be seen to) choose their
own reform packages so as to avoid the impression of outside interference.
Thirdly, the reforms try to incorporate the views of a wider range of
stakeholders with a view to legitimating EU economic governance. In the
budgetary domain, Member States have been encouraged to draw up stability
and convergence programmes for the legislature and to discuss their contents
and subsequent revisions within National Parliaments. In the structural reform
domain, Member States have been encouraged to discuss their National
Reform Programmes ‘with all stakeholders at regional and national level,
including parliamentary bodies’ (European Council, 2005, p. 13).
Finally, under the reform of the Stability and Growth Pact, the Council
argues that ‘[n]ational institutions could play a more prominent role in
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budgetary surveillance to strengthen national ownership, enhance enforcement through national public opinion and complement the economic and
policy analysis at EU level’ (European Council, 2005, p. 26). To this end, it
agrees that there is scope for discussing the implementation of domestic
budgetary rules in the context of the stability and convergence programmes.
Evidently, these proposals for aligning the interests of ECOFIN and
Member States are couched in rather general terms. As such, a key test of the
revised Stability and Growth Pact and the Lisbon Strategy will be the ability of
ECOFIN to translate these broad aims into a set of concrete policy measures
for promoting a greater understanding among Member States of the
importance of structural reform and fiscal discipline.
Promoting fire-alarm oversight
Following the Spring European Council in March 2005, Feldstein (2005, p. 8)
was quick to rebuff the reform of the Stability and Growth Pact on the grounds
that ‘the Council specified exceptions to the interpretation of these rules that
made them effectively meaningless’. A key premise in Feldstein’s argument is
that the reformed timetable for sanctions under the excessive deficit procedure
means that ‘there is no longer any restraint on individual country deficits’
(Feldstein, 2005, p. 9). In the language of the principal-agent approach, this
implies that the agents can no longer be held to account by the principal for a
failure to implement the contractual agreement. Is this an accurate description?
A closer look at the terms of the agreement shows that ECOFIN still has
recourse to pecuniary sanctions under the new look Stability and Growth Pact.
The default position for the excessive deficit procedure remains that Member
States are expected to correct deficits in excess of 3 per cent of GDP within
1 year of their identification by ECOFIN. The most significant change under
the reform is that ECOFIN can issue a revised recommendation extending the
deadline for correcting an excessive deficit by 1 year based on an assessment of
the ‘other relevant factors’ discussed above and ‘the existence of unexpected
adverse economic events with major unfavourable consequences’.6 This discretion can be exercised only when the Member State in question has complied
with the original recommendation for corrective action, which requires ‘a
minimum annual improvement of at least 0.5% of GDP as a benchmark, in its
cyclically adjusted balance net of one-off and temporary measures’.7
Perhaps the most novel strand of the reforms from the point of view of
accountability concerns the involvement of national actors in the surveillance
of Member States’ economic policies. In particular, Member States have been
invited to discuss their stability and convergence programmes and National
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Reform Programmes with their national parliaments and, in the case of the
Lisbon Strategy, to consult with other regional and national stakeholders. As
already argued, these measures signal an attempt to boost national ownership
over the goals of budgetary stability and structural reform. At the same time,
these measures try to strengthen the enforcement of EU economic governance
by establishing new channels of accountability at the national level.
In principal-agent terms, these measures represent an attempt to introduce
fire-alarm oversight alongside the delegated police-patrol oversight discussed in
Section I. As McCubbins and Schwartz (1984) note, one of the main
advantages of fire-alarm oversight is that it allows the principal to delegate
responsibility for surveillance and enforcement to organized interest groups
and other parties that have a direct stake in ensuring that the agent fulfils the
contractual agreement. When applied to EU economic governance, fire-alarm
oversight represents an attempt to harness the interests of national actors in
fiscal discipline and structural reform by giving National Parliaments and
other regional and stakeholders a role in the surveillance of Member States’
economic policies and their compliance with the Stability and Growth Pact and
the Lisbon Strategy.
From a political-economy perspective, there is no guarantee that fire-alarm
oversight can work in relation to EU governance, not least because national
interest groups can be an impediment to as well as a catalyst for reform. Two
factors would appear to be critical here. Firstly, fire-alarm oversight will
function only to the extent that the goals of fiscal discipline and structural
reform are shared by the relevant actors at the Member State level. For
example, if social partners do not share the basic aims of the Lisbon Strategy,
they will have little incentive to hold Member States to account for failing to
implement structural reforms. Again, this underlines the importance of the
ownership agenda for the revised Stability and Growth Pact and re-launched
Lisbon Strategy. Secondly, the effectiveness of fire-alarm oversight will depend
on whether National Parliaments and other national actors have the resources,
information and technical competence to participate effectively in EU
economic surveillance. An instructive example is given by the Economic and
Monetary Affairs Committee (ECON) of the European Parliament which
commissions top international economists to help prepare its quarterly
Monetary Dialogue with the ECB. Without such technical input, it is doubtful
whether the ECON Committee would have been able to engage with the ECB
on complex questions of monetary policy as effectively as it has done
(Campanella and Eijffinger, 2003).
In summary, two key findings emerge from this principal-agent analysis of
recent reforms to EU economic governance. The first is that the broad thrust of
the reforms can be understood as an attempt to correct deficiencies in the
framing agreement between the principal and agents, encourage an alignment
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of interest between the two parties and promote fire-alarm oversight
mechanisms by inviting a wider range of actors to participate in EU economic
surveillance. The second is that the success of these reforms will depend,
inter alia, on the ability of the principal to overcome the problem of asymmetric
information, the extent to which ownership-enhancing objectives can be turned
in concrete policy measures, and on the capacity of national stakeholders to
engage effectively in EU economic surveillance.
Conclusion
This paper has viewed EU economic governance as a principal-agent
relationship in which ECOFIN has delegated responsibility to the individual
Member States for securing budgetary stability and delivering structural
reform. Looking at EU economic governance in this way can, it was argued,
help us to understand not only the design of the Stability and Growth Pact and
the Lisbon Strategy but also the factors that undermined their implementation
in the first half of the decade and the basis thrust of the reforms agreed in
March 2005.
The limited progress of some Member States in achieving fiscal discipline
and structural reform in the early years of EMU was described, in principalagent terms, as the result of shirking from agents, information asymmetries,
deficiencies in the framing agreement, tensions within the collective principal
and the weakness of ex-post sanctions. Against this backdrop, the March 2005
reforms to the Stability and Growth Pact and Lisbon Strategy were interpreted
as an attempt to refocus the framing agreements between the principal
and agents, promote an alignment of interests between the two parties and
encourage fire-alarm oversight at the Member State level. The success of these
reforms, it was argued, will depend on ECOFIN’s ability to overcome
information asymmetries, implement concrete measures to boost ownership
and involve national stakeholders in EU economic surveillance.
This paper has also reflected on the scope and limitations of using the
principal-agent approach to understand EU policy making. On the plus side,
the case study of EU economic governance demonstrated that the principalagent approach can be applied not only to traditional modes of EU policy
making whereby authority is delegated to supranational authorities but also to
new modes of governance whereby the responsibility for policy implementation
primarily rests with the Member States. On the minus side, the paper noted
that focusing on a particular principal-agent relationship or set therefore can
be difficult to specify a priori in a policy area where a large number of such
relationships are conceivable. Moreover, although the principal-agent
approach employed in this paper highlights a range of factors that may have
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contributed to the breakdown of the Stability and Growth Pact and the Lisbon
Strategy, it does not, by itself, allow us to determine the relative importance of
these factors or the linkages between them. These problems of specification and
over-determination suggest that principal-agent analysis should be treated as a
helpful heuristic device for ordering our thoughts about a particular problem
rather than a fully-fledged theory of policy making.
Acknowledgement
Thanks to Joost Kuhlmann, Imelda Maher, Stijn Billiet and an anonymous
referee for constructive comments. An early version of this paper was presented
at a conference on ‘The Political and Economic Consequences of European
Monetary Integration’ at the University of Victoria in August 2005. Thanks to
the conference organizer, Amy Verdun, and my discussant, Patrick Crowley.
The usual disclaimer applies.
Notes
1 In some cases, EU Finance Ministers reach agreement informally, as in the Eurogroup. In other
cases, they are bound by the decision-rules set out in the Treaty. Under Article 99, EU Finance
Ministers formulate and enforce the Broad Economic Policy Guidelines on the basis of a
qualified majority vote. Under Article 104, decisions on the existence of an excessive deficit
(Article 104.6) are based on a qualified majority whereas decisions on the imposition of financial
penalties and fines (Article 104.11) require a two-thirds weighted majority excluding the votes of
the Member States in question (Article 104.13).
2 Resolution of the European Council on the Stability and Growth Pact Amsterdam, 17 June 1997.
Official Journal C 236 , 02/08/1997 P. 0001–0002.
3 Council Regulation EC No 1055/2005 para.5.
4 Council Regulation EC No 1055/2005 para.6.
5 Council Regulation EC No 1056/2005 para.2.
6 Council Regulation EC No 1056/2005 para.5.
7 Council Regulation EC No 1056/2005 paras.4–5.
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