The instability pact.

The recent change in the French government brings back the question of whether participants in the monetary union should be tied together by a stability pact which prevents them from running excess deficits. The French government's motivation for renegotiating the stability pact may be questionable, since structural reforms, rather than fiscal stimulus, are needed for a long lasting reduction of unemployment, and since the fiscal margin of manoeuver is small in a country where public debt has doubled from 25 % of GDP to more than 50 % in less than four years. However, one can only be amazed at how little criticism this stability pact has attracted from mainstream analysts. We should be more aggressive in pointing out that it has very little economic basis. There are two potential arguments in favour of such restrictions. One is that fiscal deficits would jeopardize the EMI's price stability objective, as there would be mounting pressure to print money in order 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 the two when the central bank is independent. For example, the Reagan deficits have not been accomodated by the Fed, nor have the German deficits following reunification led to increased inflation. In both cases, an independent central bank stuck to its objective of price stability. So, if the EMI has appropriate status, there is no need for a stability pact. And the incentives to run deficits will be reduced, if governments anticipate that the EMI will not monetize their debt. The second argument is that in a monetary union a country running a deficit will push interest rates upwards, with adverse consequences on other countries. 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) borrows more, the demand for savings increases and real interest rates are pushed up. This increase in interest rates allows savings to be allocated where they are most needed. 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, one can argue, such an increase in interest rates harms other countries, that are not responsible for the deficit. Yes, 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 one would want to limit individual countries' ability to borrow is if there were a weak federal European government, with a budget large enough so that it could potentially bail out highly indebted countries. These would then be tempted to spend too much, knowing that others would in the end 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. The stability pact aims at preventing this tool from being used, which will make economic fluctuations, and all sorts of adjustments far more painful than they would be otherwise. The Germans themselves, who imposed the stability pact on other countries, ran deficits in excess of 3 % after reunification, to smooth the tax burden of the temporary increase in expenditure needed to finance reunification. It would have been foolish to ask them to transfer 0.3% or so abroad, on top of the burden of reunification, as a penalty. Even if one wants to prevent too expansionary policies from taking place, the criterion being proposed makes no sense -- no more than the Maastricht convergence criteria. Economics tells us nothing about the desirable level of the deficit. There is nothing special about 3 %. 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, and there is no obvious way to tell these two things apart from each other at the time they occur. The criterion should also be stated in terms of primary deficits, that is, exclude interest payments on debt. Countries that have accumulated large stock of debt, like Italy, may violate the pact for years, despite a very tight fiscal policy, just because of large interest payments. Finally, the stability pact is probably unenforcible. The government has only limited control on its deficit. The criterion is set in terms of national GDP which is subject to substantial error. The statistics on the basis of which one will determine whether a country has to pay a penalty or not can only be computed by this country's statisticians, with big incentives to cheat and engage into "creative accounting". The notion itself of a deficit is fuzzy and arbitrary. Where is the frontier between central and local government, between government and public firms, between government and pension systems? Since there is no police to force a country to pay, there is no way to have an efficient system of dispute resolution. The misnamed stability pact will further undermine the political support for European institutions in member countries, and fuel antagonism between them as countries will feel that their partners are stealing money from them precisely when they experience hard times. Whatever the reasons of the French government, its unease about the pact can only bring more common sense into the debate.