One channel through which EMU policy-makers have sought to diminish uncertainty and increase the credibility of the fledgling ECB is the Stability Pact. This fleshes out the ‘excessive deficit procedure’ of the Maastricht treaty, setting a limit of 3% of GDP for budget deficits, defining the exceptional conditions when breaching the limit is acceptable, and establishing how fines can be levied against countries with excessive deficits.

A clear benefit of the Pact is that it enhances monetary credibility by limiting the circumstances in which the ECB chooses to, or is forced to, print money. But this benefit has a price since the Pact reduces fiscal flexibility. And in our view, most of its other benefits could probably have been achieved at lower cost by other means.

For example, within EMU, governments can no longer inflate away the burden of excessive debt: under certain circumstances this may leave them no alternative but to default on their debt. This could precipitate a banking crisis not only in the indebted country but also in the banks of other EMU countries holding its bonds. Concern about a systemic banking crisis might then force the ECB to print money. The appropriate remedy is to change prudential regulation of banks’ exposure to such positions, not to put a cap on the deficits themselves.

Other justifications for the Pact are also misguided. For example, if the Pact’s objective is to foster fiscal policy coordination, then there is no reason for its asymmetry, banning deficits more than surpluses. And the objective of preventing one country from imposing high interest rates on the others is invalid – both theoretically, since this is a market-based cost that can be tackled with market-based measures; and empirically, since European countries borrow in a market fully integrated into world financial markets and are too small to affect world interest rates.

The Pact also includes a number of features that will make its operation less automatic than is commonly believed. For example, fines are unlikely to be levied because the political fallout could be cataclysmic. And since, according to our calculations, the output costs of the Pact are not too large, the EMU countries will almost certainly choose to manage their fiscal policies to avoid incurring explicit penalties.

In countries that stay close to the 3% deficit limit, the Pact may lead to the loss of ‘automatic stabilizers’ whereby deficits widen during recessions and thus cushion the decline in demand. The loss turns out to be more limited than is often feared but is not negligible: similar to optimistic assessments of the welfare gains from EMU. The best response would be to re-establish the ability to use ‘automatic multipliers’, in effect managing demand countercyclically. This can be achieved by running cyclically balanced budgets: in surplus at the peak of the cycle and at a 3% deficit at the bottom of a non-exceptional recession.

If the current period of expansion proves to be long-lived, bringing the budgets to this cyclical balance may prove relatively painless. But if the expansion is weak and short-lived, much greater discretionary effort will be needed. In the end, the main risk is that, after a decade of painful convergence to pass the entry criteria, public opinion might display ‘Maastricht fatigue’. Policy-makers forced to abide by the Stability Pact will then be unable to undertake the other urgent structural reforms facing the European economy – to tackle unemployment and the effects of an ageing population on the welfare system.

Barry Eichengreen and Charles Wyplosz
Respectively, University of California, Berkeley, and CEPR; and Graduate Institute of International Studies, Geneva and CEPR

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