The Stability Pact: Safeguarding the Credibility of the European Central Bank

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I. Introduction

Based on a proposal by the German finance minister, Theo Waigel, first launched in November 1995, the Stability and Growth Pact agreed at the Dublin Summit of 13-14 December 1996 and finalized in Amsterdam on 16 June 1997 seeks to enforce fiscal discipline. inside EMU by strengthening, clarifying and speeding-up the 'excessive deficit procedure' of the Maastricht Treaty; and by building in quasi-automatic sanctions to penalize countries found in excessive deficit.

The central features of the Stability Pact provisions regarding the decision procedures, the timing and the size of sanctions are examined in the next section (Section II) of this paper. In order to form a balanced judgement on the usefulness (or otherwise) of the Stability Pact it is necessary to understand the rationale behind it. Reactions to the Maastricht fiscal criteria, both as an entry condition for EMU and as a permanent constraint to be enforced by the Stability Pact inside Stage Three of EMU, can be classified into three main groups. The first group welcomes the discipline the criteria impose on policymakers and is concerned about limiting negative spillovers from irresponsible fiscal policies inside EMU; we review these arguments in Section III of the paper. The second group - on the contrary - worries about the costs of restricting the flexibility of fiscal policy. Both arguments together give rise to a (familiar) debate over the relative virtues of rules versus discretion (or credibility versus flexibility), here applied to fiscal policy. Section IV of the paper presents a stylized model of the Stability Pact to show that it need not necessarily compromise macroeconomic stabilization. While most of the debate has been dominated by the first two groups, the main inspiration for the fiscal criteria really has been to aid the European Central Bank in its pursuit of price stability, as we argue in Section V.

The three different views on the Stability Pact can easily be traced to the respective theoretical frameworks used to assess the role of the fiscal criteria. From the perspective of traditional (Keynesian) macroeconomics and optimum currency area (OCA) theory the suggestion that fiscal policy should be restricted appears to be the opposite of what is required, since fiscal policy is the only remaining national policy instrument. This line of argument has led to the prevalently critical attitude towards the Maastricht fiscal provisions in the economics profession. Arguments in favour of deficit and debt ceilings are usually drawn from political economy or public choice approaches that identify a deficit bias in political decision making processes. In this perspective the Maastricht provisions are useful to help achieve a reduction in deficits and debt desirable in its own right and independently of EMU. Besides drawing on the debate over rules versus discretion the discussion of the Maastricht fiscal provisions can also be approached from the perspective of the literature on international policy coordination. If there are fiscal policy spillovers across countries and in a common capital market, deficit ceilings might be seen as a rule-based partial substitute for fiscal policy coordination inside EMU.

None of the above purely fiscal arguments adequately reflects the primary purpose of the Maastricht criteria and the Stability Pact. In the words of the president of the European Monetary Institute Alexandre Lamfalussy (1997) the Maastricht provisions help countries to "exercise concerted discipline in the conduct of their fiscal management ... to minimize the risk of an adverse policy mix and an excessive burden on monetary policy". Any attempt to capture the motivation for the Stability Pact and the Maastricht fiscal criteria must therefore focus on the interaction of fiscal and monetary policy. The premise here is that central bank independence alone is not sufficient for the credibility of monetary policy but requires the support of a generalized "stability culture" (Winkler 1996) and of fiscal discipline in particular. …