How to deal with the Stability and Growth Pact - A critical disquisition on the stability tool of the EMU

Contents

1. Introduction

2. The terms of the SGP
2.1 The aim of the Stability and Growth Pact
2.2 Basic rules of the pact

3. The pacts deployment up to the present

4. Theoretical background
4.1 Arguments for changing the pact
4.2 Arguments for keeping the pacts basic rules

5. Reforming the SGP

6. Conclusion

7. References

1. Introduction

Within the field of International Political Economy the case of monetary unions has become a big issue. Especially the establishment of the EMU has led to numerous academic publications. An intense political but also scientific discussion arose about the Stability and Growth Pact of the European Monetary Union.

In March 2005 the ministers of finance and economics of the European Union decided to form the Stability and Growth Pact in a more flexible way. In the future countries that are above the 3 % limit should be judged as individual cases. In the academic discussion few economists already claim this, to be the pacts death.

The paper starts by providing some basic facts about the terms of the pact and it’s application during the last years. Chapter 4 provides a short overview about the theoretical background to the field, which can be simplified as Monetarism vs. Keynesian Economics.

The main research question is, how we should deal with the pact. Should it be kept like it is today? Or are there good options to change the pact?

In chapter 5 I will point out the most important arguments for keeping the pact and for changing it. Chapter 6 finally goes into the latest academic discussion about a reform of the pact and presents different approaches in doing so.

2. The terms of the SGP

2.1 The aim of the Stability and Growth Pact

A monetary union can only be successful on the long run when the governments submit to a certain budgetary discipline. An institutional framework is therefore necessary. As a matter of principle high rates of public debt can affect the stability of a currency. The higher a country’s level of debt is, the more likely is the possibility that this country will try to minimize its debts by means of inflation.

The rule-based framework should prevent, that the countries of the EMU run into big debts and thereby create inflation and financial insecurity.

Another more implicit aim is to constrict the crowding down effects of high public debt in the member states, e.g. to reduce the danger of excessive indebtedness of one country. This is required because financial markets do not automatically sanction a single member state within a monetary union and the other countries would therefore fear to pay higher interest rates.

(Ohr, 2004)

2.2 Basic rules of the pact

The stability criteria closely resemble the convergence criteria that were put up for countries to join the EMU. Generally budgets of the member states should be kept in surplus or close to balance. When this is not the case at least the limit values should not be broken. The public debt has to be kept fewer than 60% of GDP and the overall government budget deficit-to-GDP ratio should not exceed 3% (except special circumstances like big recessions). The provisions to enforce non-excessive deficits and sound fiscal policy of the member states can be found in the Maastricht treaty. The articles 103 and 104c build up a twin-track strategy. Paragraph 103 can be seen as preventive early warning system. States close to the 3% limit have to adopt guidelines given out by the council of ministers to adjust their fiscal policy. Article 104c (the name has been changed into 104) allegorises what is also called “the excessive deficit procedure”. It consists of rules to avoid excessive deficits or to sanction mistakes in fiscal policy. (Rubin, 1996; Warin, 2004)

The procedure runs over three different stages. After the Commission has put the Council into service, the ECOFIN has to decide whether an excessive deficit exist and if this is the case it has to give its recommendations including a deadline within the fiscal problems have to be solved.

In the next step the ECOFIN speaks out that measurements have to be taken also including a specific time limit.

In the final stage the ECOFIN can demand deposits when the deficit is still acute. The deposits have a range from 0.2% up to 0.5% of GDP, depending on the level of deficits, and can be transformed into a fine if the excessive deficit hasn’t been corrected after two years. The decision to impose sanctions however can only be made with a 2/3 majority of the ECOFIN. (Annett, 2005; Mathieu, 2002)

3. The pacts deployment up to the present

The Maastricht treaty of 1992 listed the criteria of convergence, that EU member states had to fulfil if they wanted to enter the third stage of the EMU. Considering a decision made by the German Constitutional Court that permitted the German participation in the EMU only when the other countries would have sound fiscal policies and would thereby be able to underwrite monetary stability the German minister of finance Theo Waigel proposed a “Stability Pact” at the Dublin council. Waigel was also forced by the Bundesbank and by the citizens of Germany whose fear has ever been monetary instability and inflation. The pact was adopted was adopted into the treaty of Amsterdam although it’s name was changed into “Stability and Growth Pact” after France had insisted on it’s preference for growth. Due to the effort of Waigel the Council finally also adopted the “excessive deficit procedure” in July 1997. (Levitt, 2000)

By the beginning of the EMU all countries except Greece had fulfilled the 3% criteria (the “60% debt rule” was not essential for entering the third stage of the EMU because of special agreements with the failing countries). The average deficit in the euro area was at 1½ % (1999-2003) of GDP and had clearly declined compared to the time between the treaties of Maastricht and Amsterdam. This was mainly by means of a period of economic growth inside the EU and therefore increasing GDPs. (Annett, 2005)

The economic downgrade following 9/11 led to serious fiscal problems in few euro area countries and became apparent in Portugal first. In 2001 Portugals deficit was 4.1% of GDP, clearly above the allowed 3%. In 2002 also France and Germany broke the criteria. After it became clear that the deficits would not be removed in 2003 the ECOFIN started the “excessive deficit procedure” against the three countries. The procedure however was suspended by the council of ministers. Therefore no deposits that could be transformed into fines were taken from the countries failing to adhere to the pacts rules. In March 2005 the European Council agreed on keeping the rules of the SGP. The flexibilization of the rules appliance and the way they can be interpreted made them indeed as Feldstein cites “effectively meaningless”. A good deal of special cases can from now on be brought into return to circumvent the “excessive deficit procedure” (e.g. costs of German unification, enhanced French military budgets). (Berger, 2004; Feldstein, 2005)

However the Euro has remained as a stable currency and has furthermore gained 30% to the US-Dollar. After the first six years of the monetary union already five out of twelve countries have higher deficits than permitted. The SGP seems to be unable to guarantee sound fiscal policy of the participating countries. The question that arises out of this is clear: How should we deal with the pact in the future?

In the next chapter I will analyse the main arguments for changing the pact and for keeping it as it is, including challenging the economic logic of the pact.

4. Theoretical background

The discussion about the SGP mirrors the long existing antagonism between Keynesian and the liberal Monetarist perspective.

Keynesian Economics are short-run and demand driven: "In the long run, we're all dead," stated John Maynard Keynes when critics claimed that his theory was not future-oriented. The first aim is to create full employment. To reach this the state has to foster the macroeconomic demand. Its instruments are deficit spending in recessions and surplus savings in good times. A central importance has therefore a countries fiscal policy, whereas monetary policy is just flanking. The general assumption of Keynesian Economics is market failure and not so much errors in the government’s policy.

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