From Initiating to Breaching to Diluting the Stability and Growth Pact

Abstract

In European Monetary Union (EMU) with its decentralized fiscal policies there is a strong bias towards large chronic budget deficits. Having a common currency implies that a member country running high fiscal deficits does not have to bear the full cost of doing so. In particular, high deficits in an individual member country are unlikely to cause a rise in that country’s interest rates. If interest rates rise, they rise in the whole currency area. Thus each individual member state can shift part of the cost of its own fiscal profligacy on to other member countries. However, large chronic budget deficits and the ensuing rising debt-to-GDP ratios are harmful. They crowd out private investment and thus lower long-term economic growth. Furthermore, sooner or later they may induce governments to put pressure on the European Central Bank (ECB) to permit higher inflation in order to erode the real value of the debt. These adverse effects of national fiscal policies make it necessary to effectively limit budgetary deficits of EMU member states. They are the fundamental justification for the Stability and Growth Pact (‘Stability Pact’ for short).