2. EMU and the Growth and Stability
Pact (GSP): what’s the link?
Postgraduate Students:
Pazara Maria - Chatzipoulidis Nikolaos
Thessaloniki, December 2012
DEPARTMENT OF BALKAN, SLAVIC AND ORIENTAL STUDIES
MASTER’S DEGREE IN
POLITICS AND ECONOMICS OF CONTEMPORARY EASTERN AND SOUTH
EASTERN EUROPE
Instructor : Paraskevopoulos Christos
3. CONTENTS
1. Introduction
2. Economic and Monetary Union (EMU)
3. Monetary Union and Stability and Growth Pact
4. The Stability and Growth Pact
5. The problem with The Stability and Growth Pact
6. Reforms of the Stability and Growth Pact
7. The need for policy coordination: redistribution and
budget transfers
8. Conclusions
9. References
4. Introduction
Economic and Monetary Union is an advanced stage of multinational
integration involving a common monetary policy and closely coordinated
economic policies of the member states. EMU is based on a common
market in goods and services but is itself necessary for the proper
functioning of the common market, as exchange rate variations between
Member States currencies hinder trade and investments. In other words
one Market one Money .The states are abandoned their sovereignty over
the economy in order to have gains from EMU . The purpose of the pact
was to ensure that fiscal discipline would be maintained and enforced in
the EMU. “EMU fiscal rules reflect the interaction between the
multinational nature of EMU and the lack of political authority of federal
bank”.Marco Buti
Economic and Monetary Union (EMU)
The Economic and Monetary Union (EMU) that began on 1 January
1999 is the framework not only for monetary policy but also for fiscal
policies of the member states that are part off EMU (Hagen, 2002).
The Maastricht Treaty played a significant role in the formation of EMU
first the treaty set out the timetable for the implementation of Delors
Report, the substance of this report was the necessary transfer of powers
to the level of the union and put more emphasis on the institutional
changes that required that was applied under the 3 stages and the key
features of these stages embodied in the treaty. In the first stage should be
achieved : complete freedom for capital transactions increased co-
operation between central banks, free use of the European Currency Unit
and improvement of economic convergence, at the second stage regard
the Establishment of the European Monetary , ban on the granting of
central bank credit the increase co-ordination of monetary institute
policies the process leading to the independence of the national central
banks and strengthen of the economic convergence at last at the third
stage we have the introduction of Euro, the single monetary policy by the
European System of Central Banks, entry into force ERM II and entry
into force of the Stability and Growth Pact (European Central Bank,
2012).
5. Secondly the treaty set out the Convergence criteria for qualifying the
EMU, third the treaty set out the European central Bank (ECB) and
Fourth it was set out the way that the EMU would operate. (Hix, 1999;
Tsoukalis, 1997)
Nevertheless the idea of EMU has its roots as back as in the negotiations
in the treaty of Rome in 1956.
Although the EMU is the outcome of a bargaining, a deal between France
and Germany ,the design of EMU is German, and we can realize that
through the convergence criteria , the independence of European Central
Bank from political control is conducive to maintaining price stability
(technocrats over politicians) for example in Greece the replacement of
Papandreou by the unelected former ECB member Papademus an act
followed Papandreou’s public commitment to a national referendum on
the EU’s bailout proposal, a project vehemently opposed by the European
‘Troika’ (the EU, IMF, and the European Central Bank (Hopkin, 2012).
On the other hand the Maastricht formula represents a compromise
between the monetarists and the economists (Germans) on the issue of
European integration. It pleased the monetarists (French) by establishing
a strict calendar for the transitional stages to the EMU and by using
monetary policy and the desire for a common currency to compel the
European economies acceptance of convergence (mongabay.com, 2012)
At last the main ingredient of EMU is the central goal of price stability
according to this belief in order to have a stable currency we must have
stability of public finances. This belief is interlinked with the German
fear that high and rising public debts would undermine the centrals bank
ability to maintain price stability and will lead to hyperinflation similar to
what happened in 1920s in Germany and in Austria that led to the disaster
of World War II (Hagen,2003; Hix, 1999).
The Germans hoped that the EMU would be an Optimal Currency
Area(OCA) by few members and the euro would be as strong and stable
as the Deutschmark.
According to Mundell an Optimal currency Area (OCA) exists if the
economic benefits of joining or forming a monetary union are bigger than
the costs. One of main costs of the monetary Union is the loss of a policy
tool which are the independent exchange rates. This macroeconomic tool
is used to protect the economies from diversified economic conditions for
example one state has economic growth and the other is facing a
6. recession these varying economic conditions are called as asymmetric
shocks. (Hix, 1999; Mundell, 1961)
In order to understand what is the role of the Stability Pact and the
linkage between SP and EMU its obligatory to examine the asymmetric
shocks and how these can be addressed .Asymmetric shocks can be
addressed by many mechanisms as 1)Labour mobility 2) Wage Flexibility
& Capital mobility 3) Fiscal transfers and 4)Budget deficits (Hix, 1999).
Asymmetric shocks also can be addressed through devaluation or
revaluation of the currency through low or high interest rates. But in a
monetary union this is impossible as the exchange rates are fixed. Fiscal
transfers are solutions to asymmetric shocks. Asymmetric shocks can be
appeared both at national and regional level can be attributed to a variety
of structural differences.
The stability and Growth Pact is one of the pillars of Economic and
Monetary Union (EMU) a disciplinary device with a goal to ensure sound
budgetary balances and low public debts. (Buti, 1998)
The fiscal discipline is ensured by the SGP by requiring each Member
State, to implement a fiscal policy aiming for the country to stay within
the limits on government deficit (3% of GDP) and debt (60% of GDP),
and in case of having a debt level above 60% it should each year decline
with a satisfactory pace towards a level below (Wikipedia, 2012).
7. MONETARY UNION AND STABILITY AND GROWTH PACT
Given the permanent nature of monetary union, there was a need
for a set of rules to govern public finances of member states once they
entered the Eurozone. To ensure that Eurozone members continued
maintain sound public finances necessary for the stability of the euro, the
Stability and Growth Pact (SGP) was later established to provide
continuity after the economic criteria in the Maastricht Treaty were
fulfilled.
While the euro is a supranational currency, the EU has few rules
beyond the Maastricht convergence criteria regarding policies in taxation
and government expenditure in member states once they joined the euro.
The Maastricht Treaty partly addressed this issue with the Excessive
Deficit Procedure, but the latter was criticized as vague and
unsatisfactory. Article 104c requires governments of member states to
avoid excessive deficits and the European Commission, the executive
body of the EU, was to monitor deficit levels of each country and report
to the Council of the European Union, a body of national ministers from
all member states, if there are gross deviations from the reference values.
The Council has the power to issue warnings to member states and
impose fines as recourse.1
The idea of a more detailed set of procedures to handle excessive
debts, or a “Stability Pact” was proposed by German finance minister
Theo Waigel in the mid-1990s. Germany had long maintained policy that
emphasized low inflation, which had been an important part of the
German economy's strong performance since the 1950s and subsequently.
The German government hoped to ensure the continuation of that policy,
which would limit the ability of governments to exert inflationary
pressures on the European economy. Justification for such a pact was
twofold: first, excessive debt cannot be financed in public markets and
can lead to monetary financings by central banks. Second, a free-rider
externality problem exists where debt-ridden countries could overspend
to a point where they could demand support from other countries. Given
that countries needed to forego control of monetary and exchange rate
policies, countries were presumed to gravitate towards the use of fiscal
policy and excessive fiscal deficits to manage macroeconomic shocks.2
THE STABILITY AND GROWTH PACT
1
Nagai, Victor, Stability and Growth Pact and Fiscal Discipline in the Eurozone, Honor Thesis
submitted for the Huntsman Program in International Studies and Business at the University of
Pennsylvania, 12 May 2012, pp.13-14
2
ibid,p.14
8. Two Council Resolutions in July 1997 specified how the excessive
deficits procedure under the Stability and Growth Pact would operate.
First of all, on the basis of a report from the Commission and the
Economic and Finance Committee of the Council, the EcoFin Council
judges that a member state has an excessive deficit if its annual
government deficit exceeds 3 per cent of GDP, unless there has been a
severe economic downturn or an unusual event has occurred outside the
control of a member state. The Ecofin Council then makes
recommendations to the member state concerned and establishes a
deadline of four months for effective corrective action to be taken, which
normally means that the deficit is corrected in the year after its
identification. If after a progressive notice procedure the member state
fails to comply, the Council can decide by a qualified majority to impose
sanctions, at the latest ten months after the reporting of an excessive
deficit. Sanctions take the form of a non-interest-bearing deposit with the
Commission. The deposit comprises a fixed component equal to 0.2 per
cent of GDP and a variable component linked to the size of the deficit.
Each subsequent year the Council may decide to intensify the sanction by
requiring an additional deposit, although the annual amount must not
exceed the upper limit of 0.5 per cent of GDP. A deposit may be
converted into a fine if the excessive deficit has not been corrected after
two years. Also, the Ecofin Council may decide to abrogate some or all of
a sanction, depending on the progress made by the member state
concerned in correcting the excessive deficit, but any fines already
imposed are not reimbursable. 3
THE PROBLEM WITH THE STABILITY AND GROWTH PACT
Subsequently, the Stability and Growth Pact places a severe
constraint on a member state running a large enough deficit to threaten
the stability of the euro. However, a political decision is needed to
impose sanctions. The main problem with the Stability and Growth Pact
is that if an asymmetric shock occurs, because of the rules imposed by the
Pact, the government instead of running a budget deficit has to find
another way to gain money. It has to cut other expenditure programmes
or to raise taxes. Raising taxes however will be a major problem for a
state at the bottom of an economic cycle. Raising taxes will reduce the
competitiveness of an economy because it will increase production and
wage costs. Also, raising taxes takes money out of circulation at a time
that it is mostly needed, when a state faces an economic crisis. Also the
ECB pursues a restrictive monetary policy as defined by the price
3
p.335
9. stability goal in the treaty and national governments are forced to pursue
restrictive fiscal policies because government funds must be close to
balance or in surplus. Thus, the Stability and Growth Pact leads to a
particular mix of monetary and fiscal policies. This mix is certainly anti-
inflationary but if there are asymmetric economic cycles it is likely to be
very unpopular in member states with the lowest levels of growth. With
divergent cycles, the interest rates set by the ECB will be higher than
those needed for a state at the bottom of an economic cycle. In this
occasion the state will not be able to borrow money to overcome its
economic crisis. Additionally, because of tight monetary policies at the
EU level and constraints on national government budget deficits, states
are unlikely to introduce structural reforms. EMU would work more
efficiently if states reformed their labour markets and welfare states. But
structural reforms would produce high unemployment in the short term.
Consequently the public would be unlikely to support such structural
reforms, unless they were balanced with monetary and fiscal policies to
stimulate economic growth.
The contradictions of this policy mix within EMU came in surface
in 2002 and 2003. The French and German governments wanted to
borrow money in order to tackle the problem of rising unemployment and
sluggish economy, knowing that raising taxes or introducing labour
market reforms at the bottom of an economic cycle were politically
unfeasible. By increasing their borrowing, these governments exceeded
the 3 per cent annual deficit criterion in the Stability and Growth Pact. In
November 2003 France and Germany were able to secure the support of
enough other member states to suspend the excessive deficits procedure.
The Commission was astonished with the decision of the member states
to practically abandon the Stability and Growth Pact and it decided to
take the case to the European Court of Justice. This incident comes in
contrast with the description of the Stability and Growth Pact as
“Stupidity Pact” by Romano Prodi, the then president of the
Commission.4
REFORMS OF THE STABILITY AND GROWTH PACT
In 2005 the EU Council under the pressure of France and Germany
relaxed the rules. The EC said it was to respond to criticisms of
insufficient flexibility and to make the pact more enforceable. The Ecofin
agreed on a reform of the Stability and Growth Pact. The ceilings of 3%
for budget deficit and 60% for public dept were maintained, but the
decision to declare a country in excessive deficit can now rely on certain
parameters: the behaviour of the cyclically adjusted budget, the level of
4
10. dept, the duration of the slow growth period and the possibility that the
deficit is related to productivity-enhancing procedures.
In March 2011, following the European sovereign dept crisis, the
EU member states adopted a new reform under the open method of
coordination, aiming at strengthening the rules, by adopting an automatic
procedure for imposing of penalties in case of breaches of either the
deficit or the dept rules. The new Euro Plus Pact is designed as a more
stringent successor to the Stability and Growth Pact, which has not been
implemented consistently. The measures are controversial not only
because of the closed way in which it was developed but also for the
goals that it postulates. The four broad strategic goals are: fostering
competitiveness, fostering employment, contributing to the sustainability
of public finances and reinforcing financial stability. An additional fifth
goal is tax policy coordination. With respect to public finances member
states commit themselves to enshrining fiscal rules into national
legislation and imposing dept brakes on primary balance and
expenditures at both national and sub-national levels.5
Additionally, the
European Financial Stability Facility (EFSF) was created by the euro area
member states following the decision taken on May 2010 within the
framework of the Ecofin Council. The EFSF’ s mandate is to safeguard
financial stability in Europe by providing financial assistance to euro area
member states within the framework of a macroeconomic adjustment
programme. EFSF was created as temporary rescue mechanism. In
October 2010, it was decided to create a rescue mechanism, the European
Stability Mechanism (ESM). The ESM entered into force on October
2012. 6
The need for policy coordination: redistribution and budget
transfers
The sovereign dept crisis in the euro area is a symptom of policy
failures and deficiencies. The European Monetary Union wasn’t able to
adjust to asymmetric economic cycles, especially after the crisis that
began in 2008. Many scholars have argued that although there is a
monetary union within the eurozone, the problem is the absence of
economic policy coordination. Additionally, the absence of sufficient
redistributive mechanism and budget transfers constitutes a major
problem, which must be resolved in order for EMU to be successful.
Varoufakis argues that the European Union’s pretence that a currency
union can prosper without a surplus recycling mechanism together with
5
European Council conclusions,EUCO 10/1/2011, in
http://www.cosilium.europa.eu/uedocs/cms_data/cocs/pressdata/en/ec/120296.pdf
6
www.efsf.europa.eu
11. the economic inequalities which is growing within Europe constitutes a
major problem. Germany insisted that the Treaty of Maastricht must not
include a surplus recycling mechanism within its legal framework. If a
surplus recycling mechanism existed, according to Varufakis, it would
prohibit the economic collapse of countries with high deficits within the
Eurozone, which leads to the economic crisis of the Eurozone.
Additionally, the absence of such mechanism led the investors to
withdraw their investments from countries in recession within the
Eurozone and further worsened their economy.7
The operation of the EU has an agreed budget of €141 billion for
the year 2011 and €862 billion for the period 2007-2013, this presents
around 1% of the EU’s GDP. With such a small budget the redistributive
capacity of the EU is small. As Hix indicates and as it happened after the
crisis, if asymmetric economic cycles persist, and the EU maintains a
restrictive set of constraints on national fiscal policies, there is likely to
be a growing demand for interstate fiscal transfers linked to the
macroeconomic consequences of the EMU. In the event of a demand
shock in EMU, member states in recession might demand an increase in
expenditure under the EU’s structural funds. However the decision on
this would have to be taken by unanimity and the net contributor member
states might not wish the EU budget to be enlarged.
References
7
Varoufakis Yanis, (2012),The Global Minotaur, Greek edition Athens: Livani pp.404-407
12. Buti, M., Euffinger, S. and Franco, D. (1998). Revisiting EMU’s Stability Pact: a
pragmatic way forward. Oxford Review of Economic Policy, Vol. 19, No. 1.
Available at: http://arno.uvt.nl/show.cgi?fid=61314
European Central Bank: Economic and Monetary Union (EMU) (cited 24 December
2012). Available at: http://www.ecb.int/ecb/history/emu/html/index.en.html
Hagen, J.von (2003). Fiscal Discipline and Growth in Euroland. Experiences with the
Stability and Growth Pact. Center for European Integration Studies, Rheinische
Friedrich-Wilhelms-Universität Bonn, Working paper B06. Available at:
http://www.zei.uni-bonn.de/dateien/working-papaer/B03-06.pdf
Hix, S. (1999). “The Political System of the European Union”. The European Union
Series, pp 278-306
Hopkin, J. (2012). Technocrats have taken over governments in Southern Europe.
This is a challenge to democracy. The London School of Economics. European
Politics and Policy, 24/4/2012. Available at:
http://blogs.lse.ac.uk/europpblog/2012/04/24/technocrats-democracy-southern-
europe/
MONGABAY.COM, Germany and the European Monetary Union (cited 24
December 2012). Available at: http://www.mongabay.com/history/germany/germany-
germany_and_the_european_monetary_union.html )
Mundell, R. (1961). “A Theory of Optimal Currency Areas”. American Economic
Review, vol. 51, pp 657-65
Tsoukalis , L. (1997). The New European Economy Revisited. Oxford University
Press, pp 164-172.
Wikipedia: Stability and Growth Pact (cited 22 December 2012). Available at:
http://en.wikipedia.org/wiki/Stability_and_Growth_Pact