The Stability and Growth Pact will lead member countries to aim for
cyclically balanced budgets. Until this steady state is reached, Europe will
continue its efforts at deficit cutting. While so doing, politicians are less likely
to undertake the difficult labour market reforms that are really needed. Is
further fiscal retrenchment wise? The paper reviews the reasons that have
been advanced in favour of a Stability Pact and finds them wanting. The
most serious justifications, such as the systemic risk of bank crisis following
a government’s failure to service its debt, can be better dealt with in other
ways: for example, by prudential limits on banks’ exposure to public debts.
Moreover, our analysis reveals that the macroeconomic costs of the Stability
Pact, while sizeable, are not as dangerous as often believed. The costs will
be barely visible once the steady state is reached. The true macroeconomic
costs are front loaded; they concern the next few years, after a decade already
dominated by convergence efforts.
— Barry Eichengreen and Charles Wyplosz
Stability Pact
More than a minor nuisance?
SUMMARY
Economic Policy April 1998 Printed in Great Britain
© CEPR, CES, MSH, 1998.
1. INTRODUCTION
The Maastricht Treaty provides the institutional framework for Europe’s monetary
union. Its essential features have been the subject of extensive discussion: these
include the three-step transition, the creation of a European Central Bank,
procedures for shaping the conduct of fiscal policy (the Excessive Deficit and
Mutual Surveillance Procedures of Art. 103, 104 and 109) and the no-bailout rule
prohibiting the ECB from acquiring public debt directly from the issuer (Art. 104 of
the treaty and Art. 21 of the Protocol on the European System of Central Banks).
The one post-Maastricht element, finalized at the June 1997 meeting of the
European Council in Amsterdam, is the Pact for Stability and Growth.
1
The pact
clarifies the provisions of the Excessive Deficit Procedure. It calls for fiscal
The Stability Pact:
more than a minor nuisance?
Barry Eichengreen and Charles Wyplosz
IMF, University of California, Berkeley, CEPR and NBER; Graduate Institute of International
Studies, Geneva, and CEPR
STABILITY PACT 67
For help with data we thank Tamim Bayoumi, Herve Daudin, Paul De Grauwe, Tom Fernley, Morris Goldstein,
Patrick Honohan, Alessandro Missale, Th. Papaspyrou, Ole Marius Tideman, Giuseppe Tullio, Bill White and
Geoffrey Woglom. Xavier Debrun, Arjan Kadareja, Darren Lubotsky and Matthew Olson provided efficient research
assistance. Financial support was provided by FNRS in Switzerland and the Center for German and European Studies
of the University of California as well as the National Science Foundation in the United States. The opinions
expressed are not necessarily those of the International Monetary Fund. Without implicating them in our conclusions,
for helpful comments and guidance we would like to thank Donogh McDonald, the members of the Economic Policy
Panel, our discussants, the journal’s referees and David Begg.
1
The ‘growth’ part was added at the request of the French authorities as a face-saving device after they were forced to
soften their previous opposition.
positions to be balanced or in surplus in normal times so that automatic stabilizers
can operate. It urges stronger surveillance of medium-term fiscal positions with the
goal of providing an early warning signal that the 3% reference value for budget
deficits is at risk. It clarifies the conditions under which participants in the
monetary union will be allowed to exceed the 3% deficit ceiling without being
determined to have an excessive deficit. Countries will be automatically exempt
only if their GDPs have declined by 2% and the excess deficit is temporary and
small. Those in which GDP declines by between 0.75% and 2% could also be
exempt, but only with the concurrence of the Council of Ministers. Countries with
even milder recessions will be found to have an excessive deficit and forced to
make mandatory deposits that are transformed into fines if the fiscal excess is not
eliminated within two years.
Although this new transparency is welcome, it also reveals a more restrictive set of
provisions than those laid down by the Maastricht Treaty. The treaty says only that
the general government deficit may not exceed its reference value (3% of GDP)
unless the deficit has declined significantly and continuously to where it is close to
that reference value, or the excess of the reference value is only exceptional and
temporary and the deficit remains close to the reference value. It says nothing, in
other words, about the size of the output decline producing that exceptional and
temporary excess deficit, or the period over which it must occur. In this sense the
Stability Pact implies less flexibility than the Maastricht Treaty.
The Stability Pact has not received the same systematic analysis as other aspects
of the Maastricht Treaty.
2
Providing that analysis is our purpose in this paper.
Our conclusion is that the Stability Pact will have some effect. Governments will
adjust their fiscal policies just enough to avoid incurring fines. EU authorities for
their part will give countries just enough leeway to avoid having to fine them.
Actually imposing fines would worsen conditions in the adversely affected member
state, lead to recrimination and deal a blow to EU solidarity. Actually incurring fines
would subject a government to serious embarrassment and loss of political face.
Hence, the pact is likely to alter fiscal behaviour just enough to avoid these
outcomes.
This will reduce the extent of automatic stabilization. Estimates based on
historical data suggest that automatic stabilization may increase in the output gap,
but by only a fraction of a percentage point. Hence the ‘minor nuisance’ of the title.
But even a fraction of a percentage point on the growth rate can become important
when allowed to accumulate over time. Our simulations suggest that, after
accumulation over the last two decades, levels of real output would have ended 5%
lower in France and the UK, and 9% lower in Italy.
68 BARRY EICHENGREEN AND CHARLES WYPLOSZ
2
See, however, Artis and Winkler (1997), Beetsma and Uhlig (1997) and Buti et al. (1997).
The critical question, therefore, is how hamstrung automatic stabilizers will be.
Will the Stability Pact weaken them as much in the future as it would have in the
past, had it been superimposed on actual experience? The answer hinges on how far
below the 3% ceiling budget deficits are when Stage III begins. If budgets move
significantly into surplus relative to past experience, there is no reason why
automatic stabilizers will be much affected. But in the present climate, where
electorates lack the appetite for further spending cuts, significantly smaller deficits
require significantly faster growth. The danger is thus that the Stability Pact
willdivert effort from the fundamental reforms needed to step up the pace.
In particular, without fundamental labour market reform, Europe will fail to
grow by at least 3–3
1
_
2
% a year, and deficits will not decline. The Stability Pact
willgrow more binding, and the operation of Europe’s automatic stabilizers will
remain feeble, increasing the volatility of output, further depressing growth, and
making the provisions of the pact even more binding than before. Through the
operation of this vicious spiral, Europe could be condemned to a low-level
equilibrium trap.
Our view is that leaders have a fixed amount of political capital that they can
allocate to politically costly fiscal reform or politically costly labour market reform.
To the extent that they invest in one, they have fewer resources left to devote to the
other. In practice, they are likely to compromise, doing a little of each. For example,
those European countries that have made the most progress in eliminating budget
deficits and increasing labour market flexibility (Ireland and Finland spring to mind)
have allocated their adjustment effort evenly to fiscal consolidation and labour
market reform.
Our conclusion will be that the Stability Pact may have some slight benefits in
terms of fiscal discipline, but may have significant costs, both in diverting political
effort from more fundamental problems and indeed in making those fundamental
problems worse than before.
2. WHAT THE STABILITY PACT SAYS
The Stability Pact consists of two Council regulations, one on the Excessive Deficit
Procedure and another on surveillance, and a European Council resolution that
provides guidance to the Council and member states on the application of the pact.
The two Council regulations have the force of law. They clarify the meaning of the
Maastricht Treaty’s provisions regarding excessive deficits, in particular in respect of
exceptional and temporary circumstances under which the 3% reference value for
the general government deficit can be exceeded without a determination that the
deficit is excessive. In addition, under the pact’s provisions, participants in the
monetary union commit themselves to a medium-term budgetary stance ‘close to
balance or surplus’.
STABILITY PACT 69
The pact will consider a deficit in excess of 3% to be exceptional if a country’s
GDP declines by at least 2% in the year in question. In addition, a recession in
which real GDP declines by less than 2% but more than 0.75% may qualify with the
concurrence of the Council. The country will have to show that its recession was
exceptional in terms of its abruptness or in relation to past output trends. Countries
with annual output declines smaller than 0.75% will not be able to claim exceptional
circumstances. These provisions thus clarify the Maastricht Treaty’s clauses
regarding the exceptional circumstances under which the 3% reference value can be
exceeded without leading to the determination of an excessive deficit.
The pact also includes provisions concerning further exemptions. While countries
are obliged to correct excessive deficits ‘as quickly as possible after their emergence’
and to ‘launch the corrective budgetary adjustments they deem necessary without
delay’, they will probably be able to run deficits in excess of 3% of GDP for at least
two years in a row without incurring fines. The Commission will receive definitive
data that a country’s deficit in year t exceeded 3% around March of year t+1. By
the end of May it will have issued a recommendation for eliminating that excess in
accordance with Article 103(4). The country will then have to take corrective action
such that the excess is eliminated by year t+2. If no corrective action is taken by the
end of year t+1, financial sanctions will be imposed. But presumably corrective
action that will eliminate the excess in year t+2 will suffice to eliminate this threat.
Thus, two successive years of budget deficits in excess of 3% (and possibly more –
see below) will be permitted.
Moreover, the passage specifying these time limits ends with the qualifying phrase
‘unless there are special circumstances’. The nature of those special circumstances is
not specified. But presumably a country like Finland in the early 1990s, which
suffered budgetary difficulties reflecting special circumstances largely beyond its
control, would be allowed to take even longer to bring its deficit back down to 3%.
Nor does the pact clarify a third provision of the Excessive Deficit Procedure, that
the budget must remain ‘close’ to the reference value to avoid the determination of
an excessive deficit.
Sanctions, when required, will take the form of non-remunerated deposits, which
start at 0.2% of GDP and rise by one-tenth of the excess deficit up to a maximum of
0.5% of GDP. Additional deposits will be required each year until the excessive
deficit is corrected. If the excess is not corrected within two years, the deposit will be
converted into a fine; otherwise it will be returned.
Thus, a careful reading does not imply that fines will be levied as soon as budget
deficits exceed 3% of GDP. The pact is rather more flexible. It allows temporary
exemptions for countries experiencing ‘severe’ recessions. More generally, it allows
time for excessive deficits to be corrected; in the case of undefined ‘special
circumstances’ it allows unspecified amounts of time. Clearly, one needs to think
harder about the political economy of EU policy making to forecast how strictly the
fines and sanctions of the Stability Pact will be applied.
70 BARRY EICHENGREEN AND CHARLES WYPLOSZ
