Government Investment and the European Stability and Growth Pact

Abstract

Introduction and summary Since 1999, 13 countries have abandoned their national currency and joined the European Monetary Union, adopting the euro. This new currency regime posed unprecedented challenges in designing institutions that would ensure its success and stability. Particularly important to this endeavor was defining the interaction between fiscal policy and monetary policy. In the case of national currencies, large and persistent fiscal deficits frequently lead to higher levels of inflation (Sargent and Wallace, 1981: and Sargent, 1986). This possibility became an even greater concern when many countries decided to share a single currency. Under the new regime, each country would fully reap any benefits of deficit spending but could potentially force others to face the undesirable consequences of undermining the independence of the newly created European Central Bank or generating instability in the Eurobond market (Chari and Kehoe, 2004). This concern was addressed in the Maastricht Treaty of 1992, which paved the way for the monetary union, and especially in the European Stability and Growth Pact (SGP), which was adopted in 1997. The pact made permanent some of the conditions that the Maastricht Treaty required of entrants at the creation of the single currency. The cornerstone of the SGP is a cap of 3 percent on the ratio of general government deficit to gross domestic product (GDP) that each country is allowed to run in any given year. In its original form, the pact set the cap to be independent of the mix of government spending (whether transfers, recurrent expenses, investment, or interest payments), and allowed for exceptions only in case of an unusual event outside of the state's control or a severe recession. (1) From the outset, many criticized the SGP as imposing a straightjacket on fiscal authorities. In this article, we address one specific criticism: the argument in favor of special treatment for public investment (Buiter, 2003; Blanchard and Giavazzi, 2004; and Monti, 2005). The argument starts from the premise that the fiscal authorities have a bias toward projects that yield immediate gains and postpone the costs. Therefore, applying the 3 percent cap to both investment and other expenses would lead governments to neglect their historical role as providers of major infrastructure (such as roads, airports, and schools) in favor of spending that yields more immediate but less long-lasting benefits (for example, social insurance or crime prevention). According to this view, appropriate incentives could be restored if some of the costs of public investment were postponed as well. This would require more borrowing to pay for public investment than to pay for other expenses. The notion that public investment ought to be treated differently from other government expenses is far from new. In fact, the prescription that the government should only be allowed to borrow to pay for public investment is known in public finance as the golden rule. Many national governments adopted this rule in the eighteenth and nineteenth centuries (see, for example, the quotations in Bassetto with Sargent, 2005), (2) but the rule fell out of favor at the national level in the twentieth century, and very few countries adopt it nowadays (Germany being a notable exception). By contrast, this rule well approximates the behavior of most U.S. states: Almost all of the states' constitutions provide for very strict borrowing limits, but many allow significant borrowing for public investment (National Association of State Budget Officers, 2002). In recent years, many countries have struggled to meet the strict deficit cap imposed by the SGP. When the core countries of France and Germany failed to meet it in 2002, 2003, and 2004, it became clear that the pact was unenforceable, at least in its original form. As a result, the pact was reformed in 2005. (3) This reform explicitly acknowledged the role of public investment as well as policies to foster research and development and innovation (European Council on the Stability and Growth Pact, 2005, article 1). …