Pact and fiction

The EMU stability accord will hurt rather than help, argues Gilles Saint-Paul
The recent Amsterdam summit has validated the stability pact, which states that participants in monetary union should be tied together by such a pact, preventing them from running excess deficits. The French government has not been willing to put EMU at risk by reneging on or renegotiating this pact.

The French government's motivation for renegotiating the stability pact might have been questionable anyway, since structural reforms, rather than fiscal stimulus, are needed for a long-lasting reduction of unemployment. In addition, the fiscal margin of manoeuvre is small in a country where public debt has doubled from 25 per cent of GDP to more than 50 per cent in less than four years.

However, it is amazing how little criticism this stability pact, which has very little economic basis, has attracted from mainstream analysts.

There are two potential arguments in favour of the restrictions suggested by the stability pact. One says that fiscal deficits would jeopardise the European Monetary Institute's price-stability objective, as there would be mounting pressure to print money to finance deficits. The answer to that argument is simple. Either the EMI is independent, or it is not. If it is independent, there is no reason to expect it to inflate in response to deficits.

The evidence suggests that large deficits eventually increase inflation in countries where the central bank is not independent (such as many Latin American countries), but that there is no connection between deficits and inflation when the central bank is independent. For example, the Reagan deficits were not accommodated by the Federal Reserve Bank, nor have the German deficits following reunification led to increased inflation there. In both cases, an independent central bank stuck to its objective of price stability. Therefore, if the EMI has appropriate status, a stability pact is unnecessary.

The second argument has it that, in a monetary union, a country running a deficit will push interest rates upwards, with adverse consequences for the other countries. This is true, but except in the short run, this has nothing to do with being a member of the monetary union. When a government (or, for that matter, a consumer or a firm) increases borrowing, the demand for savings rises and real interest rates are pushed up. This increase in rates allows savings to be allocated where they are needed most. Capital moves where its real return is highest, regardless of whether one is in a monetary union or not. Only in the short run can this be alleviated by an appreciation of the currency of the country where borrowing has increased.

But, it can be argued, such an increase in interest rates harms other countries not responsible for the deficit. This is true, but no more than an equivalent increase in borrowing by firms or households. Yet nobody advocates rationing credit to these agents - quite the contrary. In an integrated economy any supply or demand decision by an agent, on any market, will affect equilibrium prices worldwide. There is no reason why such interaction, which contributes to an efficient allocation of resources, should be harmful when one is dealing with one type of agent, governments, and one market, the credit market. Furthermore, this is unlikely to be a big deal. World capital markets are integrated, and it is unlikely that borrowing by a middle-sized country will generate much pressure on world interest rates.

The only reason why it might be necessary to limit individual countries' ability to borrow is if there were a weak federal European government, with a sufficiently large budget to potentially bail out highly indebted countries. These countries would then be tempted to spend too much, knowing that others would ultimately pay for it. We are far from such a situation. Until we reach it, it is perfectly justified (indeed, economically optimal) for governments to run a deficit when expenses are temporarily high, or receipts temporarily low.

Indeed, because EMU precludes the use of monetary policy to stabilise the economy when it faces asymmetric shocks, fiscal policy will be needed more under EMU. The stability pact aims at preventing this tool from being used, which will make economic fluctuations far more painful.

The Germans, who imposed their stability pact on other countries, ran deficits in excess of 3 per cent after reunification to smooth the tax burden of the temporary increase in expenditure needed for financial reunification. It would have been invidious to ask them to transfer 0.3 per cent or so abroad, on top of the burden of reunification, as a penalty.

Economics tells us nothing about the desirable level of a deficit. There is nothing special about 3 per cent. The criterion should obviously be adjusted for cyclical fluctuations, but how? Thousands of academic papers have been written to try to disentangle true cyclical downturns from permanent slowdowns in productivity growth.

The current pact specifies that no penalty would be paid should GDP fall by more than 2 per cent. If we are talking about nominal GDP, this is such a severe restriction that it is unlikely such conditions would ever be met. If we are, more sensibly, talking about real GDP then the threshold depends on the measurement of the GDP deflator, a non-trivial issue, and the criterion creates an incentive to over-estimate it.

Even so, one should note that in a country like France, real GDP never fell by more than 1.4 per cent in any single year between 1960 and now. This is also true of Germany. In the UK, a fall by more than 2 per cent was only observed once, in 1980. The criterion should also be stated in terms of primary deficits - that is, exclude interest payments on debt. Countries that have built up a large stock of debt, like Italy, may violate the pact for years, despite a very tight fiscal policy, just because of large interest payments. Adding penalties to their debt burden will only make their problems worse.

Finally, the stability pact is probably unenforceable. A government has only limited control over its deficit. Therefore, what is the legal principle behind holding governments liable for outcomes they do not control? The criterion is set in terms of national GDP, which is subject to substantial error.

Countries will feel their partners are stealing money from them, precisely when they experience hard times. Governments have already invoked the Maastricht convergence criteria to justify austerity packages that were much needed anyway. The result has only been to increase resentment against EMU, and Europe in general.

Gilles Saint-Paul is a professor of economics at DELTA in Paris and a research fellow in CEPR's lnternational Macroeconomics programme. For further information about CEPR, call 0171 878 2917.