The stability and growth pact: its role and future.

• Author: Tanzi, Vito

When, some years ago, a group of European countries decided to establish a European Monetary Union that would have a common currency and a European Central Bank, it faced the reality of significant differences in economic conditions among the member countries. These differences involved inflation rates, interest rates, levels and structures of public spending and revenue, and levels of fiscal deficits and public debts. Furthermore, the reputations of the policymakers of the countries were not similar, having been shaped by different past performances.

Some of these differences could be ignored, being of limited importance to the functioning of a monetary union. Some could be assumed to disappear automatically once the EMU came into existence. Some could be expected to be reduced by market forces. Some, however, were seen as central to the functioning of the EMU and requiring special attention. Among these were the countries' fiscal situations.

Monetary Unions and Fiscal Policy

These situations were widely different in terms of size of fiscal deficits and public debts. For example, in 1995, the year when new statistical definitions of the basic variables were introduced, to make them more comparable across countries, the net lending of the general government--the agreed-upon definition of fiscal outcomes--ranged from a positive value (a surplus) of 2.1 percent of GDP in Luxembourg to a negative value (a deficit) of 12.2 percent of GDP in Greece. The range in the shares of gross public debts as a percentage of GDP was even wider: from 6 percent in Luxemburg to 134 percent in Belgium and 123 percent in Italy.

The Need for Fiscal Coordination

There are various reasons to believe that in a monetary union fiscal policies need to be coordinated and improved. Some of these reasons are as follows.

First, an effective monetary policy, and especially one that has, as its main or only explicit objective, price stability, cannot tolerate major fiscal disequilibria. Good fiscal results are needed if long-run interest rates, which are fundamental for investment and economic growth, are to be low.

Second, as the experience of many countries indicates, the existence of large fiscal deficits and public debts inevitably creates strong pressures--on the part of finance ministers, and directed toward the monetary authorities--to keep discount rates low or, in extreme cases, to directly finance the fiscal deficits. When these pressures are not resisted, they end up compromising the objective of monetary stability.

Third, a monetary union creates a single market for financial capital. This implies that a country with a large fiscal deficit and public debt can access more easily the financial savings of other member countries to finance its own deficit and to service its own debt. This will raise the real rates of interest not only for the country but for all the members of the union--the deficit country can create negative externalities for other countries. Some member countries might be tempted to pursue more expansionary fiscal policies if part of the cost of servicing their public debt is borne by other countries.

Finally, in the long run, the performance of the euro, as an international currency capable of competing with the U.S. dollar, would be affected by the perception, on the part of those who operate in the international financial market, that the fiscal policies of some of the countries of the union are not sustainable. This would reduce the seigniorage of the EMU and, perhaps, contribute to maintaining higher real interest rates.

How to Achieve Coordination

The conclusion that in a monetary union the fiscal policies of the member countries need some control and coordination must be accompanied by a decision on how to achieve those objectives. There are two basic options.

First, and most optimistically, the coordination could be left to market forces. Some economists believe that market discipline, as enforced by the decisions of rating agencies, would be sufficient to promote a behavior consistent with a necessary degree of fiscal coordination (see Goldstein and Woglom 1992, King 1992, and Tanzi 1992). In other words, they believe that policymakers are sensitive to changes, or to threatened changes, in credit ratings so that they adjust their behavior as needed. This conclusion assumes a highly responsible behavior on the part of policymakers and a capacity on their part to make needed policy changes. In reality, however, market discipline seems to become effective mainly when the fiscal situation of a country is so serious as to lead to drastic changes in ratings that effectively cut access to credit. For most situations, changes in fiscal conditions bring about only small changes in ratings and in interest rates as recent experiences in EU countries and in Japan indicate. The effects of these changes on interest rates are marginal and are not likely to change the fiscal behavior of governments.

The second option would be that of following some fiscal rule aimed at constraining fiscal policies. Fiscal rules have become more popular in the world in recent years (Kopits 2001). For thousands of years, and until recent decades, the fiscal rule considered most appropriate was that of budget balance. In 63 B.C., Cicero argued that "the budget should be balanced, the treasury should be refilled, public debt should be reduced" (quoted in Kopits 2001). Seventeen centuries later David Hume wrote: "The practice ... of contracting debt will almost infallibly be abused in every government" (in Rotuein 1955). Therefore, "the consequences ... must indeed, be one of ... two events; either the nation must destroy public credit, or public credit will destroy the nation." Many other historical figures, including George Washington, held the same view. According to Washington, "there is no practice more dangerous than that of borrowing money" (quoted in The Economist, August 23, 2003, p. 11).

One could comment that most of these historical figures were not economists. However, their position on proper fiscal policy did not come from economic theorizing but from their real life observations of what often happened to countries that followed irresponsible fiscal policies. For us, today, it is not necessary to go back to historical examples to find countries that got into trouble when, in the words of Hume, they abused "the practice of contracting debt." There is no...