The Maastricht Treaty and the stability pact take the view that fiscal policies in a monetary union should be subjected to rules. Let us evaluate this argument.

After having presented the stability pact, we will show that it contradicts the basic advice of the OCA approach. Then we will try to understand the rational for it. Finally we will assess the design stability pact and show that it could be improved.

I The stability and growth pact

1 - Context

The Maastricht Treaty defines budgetary rules countries have to satisfy in order to enter EMU (The 3 percents deficit and the 60 percents debt norms).

At the insistence of Germany, a 'Stability and Growth Pact' was signed. This stability pact is quite important as it is likely to guide national fiscal policies in the EMU.

The stability pact was agreed upon by the EU countries at the Summit Meeting of December 1996 in Dublin.

2 - Principles

Its main principles are the following :

- countries will have to aim at achieving balanced budgets

- countries with a budget deficit exceeding 3 percents of GDP will be subject to fines. These fines can reach up to 0.5 percent of GDP.

- These fines will not be applied if the country in question experience exceptional circumstances (i.e. natural disaster or a decline of their GDP of more than 2 percents during one year)

- In cases where the drop in GDP is between 0.75 and 2 percents the application of the fine will be subject to the approval of the EU finance ministers.

- Countries that experience a drop in their GDP of less than 0.75 percents have agreed not to invoke exceptional circumstances.

The Maastricht Treaty and the stability pact take the view that fiscal policies in a monetary union should be subjected to rules. Let us evaluate this argument.

II The OCA approach : need for either a centralised budget or flexibility

The stability and growth pact seems to go against a key conclusion of the fundamental theory of OCA. The need for flexibility of national fiscal policies (in a monetary union without any centralised budget) is the central conclusion of the Optimal Currency Area approach.

The theory of OCA leads to two implications for fiscal policies in monetary unions.

A - The need for a centralised European budget

1 - It is desirable to significantly centralise the national budgets to the European level

Let us consider the case of an asymmetric demand shock, affecting negatively France and positively Germany. Let us assume that the social security system is organised at the European level and those income taxes are also levied by the European government. It is clear that the centralised budget will work as shock absorber.

In France output declines and unemployment tend to increase. This has a double effect on the European budget : 1) the income tax collected by the European government in France decline 2) whereas unemployment benefit payments increase.

Exactly the opposite occurs in Germany. Thus the centralised European budget automatically distributes income from Germany to France, thereby softening of the social consequences in France of the demand shift.

2 - The MacDougall Report (1977)

A centralised budget allows countries that are hit by negative shocks to enjoy automatic transfers, thereby reducing the social cost of monetary union. This was a major conclusion of the influential MacDougall Report (1977)..

This report argued that monetary union in Europe would have to be accompanied by a significant centralisation of budgetary powers. The emphasis was especially strong on the unemployment benefit system.

Given the fact that a strongly centralised European budget is unlikely to emerge n the near futures, some observers have argued that it would be advisable to postpone EMU

3 - The optimal degree of budgetary centralisation is function of the labour market ...

It should be stressed that the size of these budgetary effects very much depends on the degree of wage/price flexibility and labour mobility. If these are large, the automatic transfer from Germany to France will be low.

The less we have wage flexibility and labour mobility, the more we would need a centralised budget. In this view, one could argue that the European countries entering the EMU will be fact with the choice of either promoting more political integration or deeply reform their labour markets. Once the EMU is introduce, the price of no extra political integration would be a reform of the labour market.

4 - ... and function of political factors

Too centralised a European Budget would entail large and quasi permanent transfers from on e group of countries to another. The sense of national identification being much less developed at the European level than at the country level, this would certainly lead to great political problems. This could even endanger the unity of the EU.

Þ thus, although Europe needs some further centralisation of the national budgets (including the social security system) to have a workable monetary union, the degree of centralisation should stop far short from the level achieved with the MS.

B - If no budgetary centralisation, national fiscal policies should be flexible

1 - In Europe, no substantial centralised budget will emerge in the mid run.

In the context of the European monetary union, such a centralisation of the national government budgets is not possible. In such a case, the OCA theory says that fiscal policies should be used in a flexible way.

2 - Therefore, national fiscal policies should be flexible to stabilise asymmetric shocks

This means that when countries are hit by a negative shock, they should be allowed to let the budget deficit increase. This budget deficit appears automatically (declining government revenues and increasing social outlays). This deficit acts as an automatic economic stabiliser.

The conclusion is therefore that substantial autonomy should be reserved for these national fiscal policies. In the logic of the OCA theory, countries lose the monetary policy instrument by joining the EMU. The fiscal policy instrument is the only left.

III The case for a European control over national fiscal policies

A- Fiscal policies cannot be used on a regular basis as shock absorbers

1 - Fiscal policies cannot be used without significant side-costs.

The major problem with the previous analysis is the underlying assumption that governments can create budget deficit to absorb negative shocks without any significant costs. We shall now show that the use of fiscal polices as shock absorbers entails grave problem of sustainability (of deficits).

2 - The sustainability problem : the debt dynamics

The sustainability problem can be formulated as follows. A budget deficit leads to an increase in government debt which will have to be serviced in the future. If the interest rate on the government debt exceeds the growth rate if the economy, a debt dynamic is set in motion. It leads to an ever-increasing government debt relative to GDP. This become unsustainable and requires corrective action.

3 - Stopping the debt dynamics : two solutions outside a monetary union

If the interest rate exceeds the growth rate of the economy, dynamics of debt accumulation can only be stopped :

- if the primary budget deficit (G - T) turns into a surplus

- or if a sufficiently large revenue appears from monetary creation

The latte option has been chosen by many Latin American countries during the 1980s, and more recently by some eastern European countries. It has also led to hyperinflation in these countries.

4 - Stopping the debt dynamics : on solution left in a monetary union : creating budget surpluses

In a monetary union, monetary creation is not controlled by the member states. Therefore countries, in order to get out of the debt dynamics, will have to reduce spending and/or increase tax. This will have a deflationary effect on the economy with detrimental effects on aggregate demand.

5 - Conclusion 1 : Fiscal policies cannot be used for very long

Fiscal policies are not the ideal shock absorber the OCA theory made us think. Fiscal policies cannot be used to offset negative economic shocks for very long. Large government budget deficit quickly lead to unsustainable debt dynamics from which countries find it difficult to extricate themselves.

After having used fiscal policies, and before being able to use it again, the price to pay is fiscal rectitude for many years. Conclusion : once used, it will not be possible to use these fiscal policies for many years.

6 - Conclusion 2 : fiscal rectitude creates the conditions for using the budget as a shock absorber

Moreover once fiscal policies have been used it becomes harder to use them again.

Let us consider the examples of Belgium, the Netherlands and Italy. These countries allowed their budget deficit to increase significantly during the early 1980s. This increase of budget deficit came mainly as a response to the negative consequences of major recessions. their use hampers the possibility of their future use.

At the end of the 80s,after many years of budgetary restriction, Belgium and the Netherlands had succeeded in stabilising the debt-to-GDP ratio. They were able to do so by running substantial surpluses in the primary budget. However, this stabilisation of the ration was very high. As a result, when the next recession hit the country in 1993-1994 it was quite difficult for them to use fiscal policies sin a countercyclical way.

Italy did not succeed in stabilising its debt-GDP ratio during the 80s, because it failed to create the required primary budget surpluses. This prevented the Italian government from using budgetary policies in a countercyclical way.

B - The negative externalities of a country's unsustainable fiscal policy

Not only fiscal policies cannot be used on a regular basis as a response to asymmetric shocks, but also they have negative externalities for other members.

The basic insight of this argument is that a country which finds itself on an unsustainable path of increasing government debt, creates negative externalities for the rest of the monetary union.

1 - Externality 1 : An unsustainable increase in the debt of one country forces the other to follow more deflationary policies.

Indeed, a country that allows its debt-GDP ratio to increase continuously will have increasing recourse to the capital markets of the union.

Þ this increase in the union interest rate in turn increases the burden of the government debts of the other countries.

Þ if the governments of these countries choose to stabilise their debt-ratio GDP, they will be forced to follow more restrictive fiscal policies

Þ thus the unsustainable increase in the debt of one country force the other countries to follow more deflationary policies.

2 - Externality 2 : political pressure on the ECB

There is a second externality that may appear. The upward movement of the union interest rate, following the unsustainable fiscal policies of one country, is likely to put pressure on the ECB.

Countries that are hurt by the higher union interest rate may pressure the ECB to relax its monetary policy stance. Thus the unsustainable fiscal policies will interfere with the conduct of the European monetary policy.

IV Do we really need rules ? Yes some, but not that much

A -Critique and defence of the negative externality 1 Þ we need less rules

1 - Implicit assumption of the argument : inefficiency of capital markets

The argument over the first negative externality is based upon the implicit assumption that capital markets do not work properly. Let us now suppose that capital markets work efficiently.

What will happen when one country, say Italy, is no an unsustainable debt path ? Does it mean that the union interest rate will increase, i.e. that the interest rate to be paid in France, Germany, etc.. will increase ?

2 - If they work efficiently, there will be different no unique union interest rate

If the markets work efficiently, they will recognise that the debt problem is an Italian problem. Investors will let Germany borrow money at a lower interest rate than Italy.

Thus, if markets work efficiently, they will be no externality. Other government will not suffer from the existence of a high Italian government debt.

It does not make sense to talk about the union interest rate. If capital markets work efficiently, they will be different interest rates in the union.

3 - Therefore rules are less needed

B - Defence of negative externality 1 Þ we need some rules

1 - Capital market efficiency seems difficult to achieve

The previous argument (no unique interest rate if capital markets are efficient) is certainly a powerful argument. However, there is a possibility that lenders will find it difficult to attach the correct risk premium to the Italian government.

2 - The risk of 'bail out' may

Suppose the lenders believe that in case of a serious debt crisis (i.e. inability of the Italian government to service its debt) the other countries will step in to 'bail out' the Italian government. These countries may have an interest in doing so because the Italian debt crisis may spill over to the rest of the financial system.

On way to solve the problem would be a 'solemn declaration o the MS that they will never bailout other MS'. Such a 'no-bail-out' clause was in fact introduce in the Maastricht Treaty. The problem is that it is not fully credible since MS may have an interest in doing an 'exception'.

3 - Conclusion : their will be spill over effects between national interest rates

B - Does monetary union increases fiscal indiscipline ? We don't know (two contradicting effects)

Proponents of rules have argued that a monetary union is likely to reduce the fiscal discipline of national governments. Adversaries of rules have argued the opposite. How a monetary union may change the incentive of fiscal policy-makers. Two factors are important. The first one lead to less discipline, the second one to more discipline.

1 - Diminution of the risk premium and possibility of a bail out Þ softer budget constraint

The risk premium attached to a country, and influencing the interest rate, consists of two component :

- the risk of default (i.e. the risk that the country will not service its debt).

This include the risk of 1) outright default (stopping payments) 2) the risk of implicit default (monetisation of the debt, i.e. money creation to reduce the real value of the debt)

- the risk of devaluation

The risk of devaluation and of implicit default (money creation) is eliminated in a monetary union (since national governments do not have control of monetary policy). Moreover the risk of outright default is limited by the implicit possibility of 'bail-out' in case of a debt crisis.

Þ therefore, the interest rate is much lower

Þ softer budget constraint

Þ incentive to create budget deficit.

2 - Impossibility of monetisation of the debt (money creation) Þ harder budget constraint

There is a second factor, however, which trends to reduce the incentive of MS to run excessive deficits. Countries who join the union reduce their ability to finance budget deficit by money creation Þ harder budget constraint

V The stability pact : an evaluation ( Has it been well designed ? NO )

A - An unbalanced set of rules and the subsequent economic risk

1 - The balance to be found

National fiscal policies in the EMU must find a balance between two conflicting concern :

- flexibility, as stressed by the theory of OCA (in the absence of exchange rate instrument and a centralised European budget, national government budgets are the only available instruments for nation states to handle asymmetric shocks)

- rigidity, in order to limit the spillover effects of unsustainable national debts and deficits. As we saw, unsustainable debts in particular country may harm other member countries and may exert a pressure on the ECB.

2 - The stability pact is unbalanced and mostly guided by the fear of unsustainable deficits

It is clear that the stability pact is quite unbalanced in stressing the need for strict rules at the expense of flexibility. It has been guided more by the fear of unsustainable deficits and debts than by the need for flexibility.

3 - Economic risks

Þ there is a risk that the capacity of national budgets to function as automatic stabilisers during recessions will be hampered.

B - Two Political risks : pressure on ECB and Euro-scepticism

The lack of budgetary flexibility to face recessions will create tensions between national government and European institutions. These tensions will exist at two levels.

1 - Pressure on the ECB to relax monetary policies

As countries will be hindered in their desire to use the automatic stabilisers in their budgets during recessions, they will increase their pressure on the ECB to relax monetary policies. Thus, paradoxically, the stability pact which aim was to protect the ECB from political pressure, may in fact increase the risk of such pressure.

2 - Likely to intensify Euro-scepticism

When countries are hit by economic hardship, EU institutions will be perceived as preventing the alleviation of the hardship of those hit by recession.

Worse, they will be sending fines and penalties when countries struggle with economic problems. This will certainly not promote enthusiasm for European integration. On the contrary, it is likely to intensify Euro-scepticism.

C - Can the stability pact 's strict rules be implemented ?

There is indeed a serious possibility that the implementation of the stability pact will be very difficult. Two problems are to be mentioned :

- as it has been observed in the USA, in countries where rules on budgetary policies are imposed, all kind of creative accounting emerges. Von Hagen (1991) collected empirical evidence in the USA. The conclusion was that the existence of constitutional rules had very little impact on the size of the states' budget deficits. Frequent recourse to the technique of 'off-budgeting'.

- In addition, any imposition of fines will have to be decided by a majority of two-thirds in the Council (Maastricht Treaty art. 104c-13). Since most recession are correlated across countries, it is very unlikely that the majority required to impose fines will easily be found.

Þ the pact may well become a dead letter.

D - Conclusion

The underlying objective of the stability pact is a good one, namely to reduce deficits and debts in many countries on the ground that 1) they have negative externalities for other countries 2) they prevent fiscal policies to be used when they are badly needed to smooth an asymmetric shock..

However, the stability pact is badly designed.

The stability pact has gone too far in imposing rules on national government budgets. The lack of flexibility of national budgetary policies in the EMU will create risks that are larger than the risks of default and bailout stressed by the proponent of rules. As we have already argued, there is very little evidence that a monetary union increases fiscal indiscipline and the risk of default and bailout.

It therefore entails economic as well political risks. On the top of that it is difficult to implement the stability pact.

Conclusion

It is unlikely that a significant centralisation of the national budgets will be achieved in the near future in the Community. Assuming that labour mobility between countries as well wage flexibility will remain small, it is advisable that national fiscal policies should have some flexibility.

However, this OCA view is probably over optimistic about the possibility of national budgetary policies to be used as shock absorber. Indeed, the sustainability of these policies limits their effectiveness. Moreover, the negative externalities they entailed put the case for some European control.

In a nutshell, EMU needs some fiscal control over national fiscal policies, even though the stability pact went to far and entails economic and political risks.

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