EUROLAND’S STABILITY AND GROWTH PACT: ESSENTIAL INGREDIENT FOR A SUCCESSFUL MONETARY UNION
Many commentators argue that Euroland’s Stability and Growth Pact imposes too harsh a restriction on countries’ fiscal policy at a time when they can no longer control their own monetary policy. But writing in the latest issue of the Economic Journal, Professors Roel Beetsma and Harald Uhlig demonstrate that the pact is vital for the effective operation of the monetary union. What is more, countries would be better off not joining EMU at all than joining EMU without a pact. But their results also suggest that the actual pact suffers from two weaknesses that undermine its credibility: first, its sanctions are ‘one-size-fits-all’; and second, they are not automatic but negotiable.

The researchers note that EMU highlights the precarious relationships of individual countries with a common monetary policy. One might take the view that there should be no problems at all: a conservative and independent European Central Bank (ECB) will simply ensure low and stable inflation, while the individual countries select the fiscal policies they prefer.

But the relationship is more complicated than that. In particular, there is the possibility that a high-debt country or a country in recession may successfully pressure the ECB into loosening monetary policy. This will generate inflation and may have real effects across the entire union. Indeed, the (failed) French attempts to set up a counterweight to the ECB and the problems that surrounded the appointment of the ECB President raise fears that the institution may not be fully insulated from political pressure.

Beetsma and Uhlig argue that implementation of the Stability and Growth Pact can avoid this inflationary scenario. While EMU may exacerbate public debt accumulation if the ECB is less than fully independent, by imposing sanctions for running excessive deficits, the pact can correct the additional debt accumulation associated with EMU.

The argument runs as follows: given their terminable stay in office, policy-makers are often compelled to take a rather short-term view. In particular, it often looks attractive to raise additional debt in order to pay for expenditure; the benefits of this fall to the party in power, while the cost of repaying the debt will fall to their successors. These successors will try to solve part of the debt problem by increasing inflation, but this inflation channel now operates through the ECB, imposing a large part of the inflationary burden on the other countries in EMU.

Hence, it is because of the asymmetric allocation of costs and benefits and the political distortion of short-sighted governments, who act independently and (rationally) choose to ignore the impact of their actions on euro inflation, that excessive debt accumulation may arise. The Stability and Growth Pact acts as a disincentive to this process by punishing those countries whose debts are deemed to be excessive. This punishment takes the form of a fine in the order of some non-negligible fraction of GDP.

Beetsma and Uhlig conclude that the actual Stability and Growth Pact adopted at the Amsterdam summit in June 1997 suffers from two major weaknesses. The first is its ‘one-size-fits-all’ character. Not all countries will be equally well off under the pact. In particular, those that start off in a relatively unfavourable economic or budgetary situation are more likely to have sanctions imposed on them. The research suggests that it would have been better to adopt a pact with sanctions that take into account the initial conditions under which countries have entered EMU.

Second, the sanctions are not automatic, but can only materialise after a long process of negotiations among EMU members. This, say the researchers, undermines the pact’s credibility.

Note for Editors: ‘An Analysis of the Stability and Growth Pact’ by Roel Beetsma and Harald Uhlig is published in the October 1999 issue of the Economic Journal. Beetsma is Professor of Economics at the University of Amsterdam; Uhlig is Professor of Economics at Tilburg University.

For Further information: contact RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or 0468-661095 (email: romesh@compuserve.com ); RES Media Assistant Niall Flynn on 0171-878-2919 (email: nflynn@cepr.org); or Roel Beetsma on 00-31-20-525-4203 (email: beetsma@fee.uva.nl).