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