Survey article

SURVEY EMU

Maastricht follies

			Fiscal policy should not be constrained under a single currency

MADDENINGLY, the Maastricht treaty did not even attempt to do anything that would help to turn Europe into an optimum currency area. It ignored the copious literature on the subject, and instead came up with three proposals that have nothing to do with optimum currency areas, at least one of which is likely to turn out a positive hindrance. It is partly thanks to this bungled design that so many doubts remain about whether the euro will work.

The first proposal was to set up five “convergence criteria” that a country would have to comply with before joining the single currency (see table 4 for the commission’s assessment of their performance). Nothing wrong with that, you might think. The trouble is that, with the possible exception of inflation, none of the criteria has much bearing on a country’s fitness for EMU. Low interest rates flow automatically from low inflation. Exchange-rate stability may, it is true, make it easier to choose the right rate for conversion into the euro. But since the introduction of wider 15% bands in 1993, this has been the subject of fierce arguments, with Britain and Sweden (both outside the ERM) arguing that the criterion no longer means anything, whereas the rest still want to enforce it.


			The biggest controversy, however, has surrounded the other two criteria, on public finances. They were introduced largely at the insistence of the Germans, who feared that the euro might be contaminated by profligate public borrowing. A secondary motive was to restrict EMU, at least initially, to a hard core of members, perhaps made up of Germany, the Benelux three, Denmark and France. It was already clear that the single currency would be unpopular with German public opinion; all the more so if it embraced fiscally unruly Mediterranean folk, especially Italians. This plan seems to have backfired. For a start, the figures had to be fudged even for the hard-core countries. The debt criterion had to be qualified—to let in countries approaching the 60% ceiling “at a satisfactory pace”—to give Belgium any chance at all. France and Italy both resorted to huge one-off manoeuvres (a payment by France Télécom and a repayable euro tax respectively). Even Germany redefined its hospital debt, although it had to give up trying to revalue its gold reserves in the face of fierce hostility from the Bundesbank. And, as the Germans found, once one country is allowed to fudge, others are hard to stop. Moreover, the Maastricht criteria failed to keep out most of the Mediterraneans. Instead, they belatedly encouraged Italy, Spain and the rest to make genuine improvements in their public finances. Those who dismiss the whole Maastricht process as fudge may scoff, but the Mediterranean countries have imposed real spending cuts and tax increases, more so indeed than Germany or France. The overall EU budget deficit fell from 6.1% of GDP in 1993 to 2.7% in 1997. The only country that will be excluded by the Maastricht criteria is Greece—and even it may join by 2001. The second Maastricht proposal was to set a definite date for the start of monetary union that could not be changed. The date chosen was 1999 (with a provision to start in 1997 if enough countries were ready, but this was never a runner). There was a contradiction between setting a firm date and at the same time laying down strict criteria for would-be joiners. What would happen if no country (or, more realistically, only two or three countries) met the criteria? The treaty made no provision for delay—which did not stop plenty of speculation about it. Instability pact Happily, this is no longer an issue. Nor, for much longer, will the Maastricht criteria be. Moreover, even though those criteria have little to do with making EMU a success, the effort of meeting them has been good for a continent that urgently needed a period of fiscal consolidation. Maastricht has helped to produce what Mr de Silguy calls a “culture of stability”. In this sense, barmy as the treaty provisions were, they may have helped to lay the ground for a successful launch of the euro. The same cannot be said of the third Maastricht proposal: to set firm limits, once EMU has started, on participants’ budget deficits through an “excessive deficits procedure”. Subsequently these provisions of the treaty have been worked up, once again at German insistence, into a “stability and growth pact” that limits budget deficits to 3% of GDP, and threatens any country that exceeds them with heavy fines. This pact, unless either amended or ignored, has the potential to wreak serious damage.

The thinking behind the stability and growth pact is simple: first, excessive public borrowing always weakens a currency; and second, once a country is in the euro, it may be tempted to borrow and spend at everyone else’s expense, raising interest rates for all. This could create a severe moral hazard. Yet this thinking is plain wrong. There is little evidence that budget deficits or high debts, per se, undermine currencies. Indeed, there are plenty of counter-examples: remember how huge budget deficits helped to fuel both the strong dollar in the 1980s and the strong D-mark in the 1990s. As for big debts, Belgium, which for years had the largest debt as a proportion of GDP in the OECD, has been able to maintain a strong currency in union with Luxembourg, which has the smallest.

Those concerned about moral hazard also overlook two points. In future, euro area countries will be borrowing in euros, not in national currencies they can directly control. The European Central Bank is specifically barred by the treaty from bailing out national governments. It is likely, therefore, that the markets will watch national borrowing more carefully than before—and if it gets too high, start to impose an interest-rate premium. Secondly, in a world of global capital markets it seems unlikely that one country’s borrowing, however large, will have an appreciable effect on euro interest rates. Mexico’s huge dollar borrowing in 1995-96 did not raise American interest rates.

Proponents of the stability pact might say, so what? It is surely better to keep down budget deficits in any case, with the aim of balancing the budget over the cycle. At the European Monetary Institute, the stability and growth pact is welcomed. As Wim Duisenberg, its president, puts it, “It should produce a balanced policy mix that does not overburden monetary policy.” The fines envisaged in the stability pact are not automatic: they require majority approval among euro members. Even if they are approved, they do not become payable for at least two years. Any country that moves into recession will escape payment, allowing automatic fiscal stabilisers to come into play. Barry Eichengreen, an American economist and critic of the stability pact*, reckons it has enough loopholes not to be a big concern.

Yet there remains a serious risk that the stability pact will interfere with automatic stabilisers. After all, EMU will have removed the scope for independent monetary or exchange-rate policies, leaving fiscal policy as one of only a few ways for a country to respond to a sharp economic downturn. If that country is already running a deficit close to 3%, as most euro members are today, it might not be able to let its automatic stabilisers work. According to OECD estimates, a 1% shortfall in GDP growth normally pushes up the budget deficit by half a percentage point. The stability pact’s let-out for a recession is far too tightly drawn for this. Had the pact been in force over the past ten years, Germany and France would have had to pay fines (of 0.5% of GDP) respectively in three and four of those years.

Worse still, central constraints on national fiscal policy send two unhelpful messages to financial markets. One is that the centre is deeply concerned by excessive national debts—and, by implication, fears it may have to bail out an excessive debtor. That could undermine the no-bail-out clause in the treaty. Such a mechanism can be seen at work in America, where most states and cities are constrained by balanced-budget rules; the markets assume that the federal government will, in a crunch, bail them out. In Canada, by contrast, there are no such constraints. As a result, credit ratings vary enormously between provinces.

The second unhelpful message is that, with national fiscal policy constrained, the only viable alternative must be an EU-wide fiscal policy, complete with fiscal transfers. Indeed, prospective members of the euro are already talking of co-ordinating their fiscal policies. The commission, ever eager to promote fiscal harmonisation, is egging them on. Yet the public and political appetite for a federal system of fiscal transfers in Europe is limited. Germany and the Netherlands have already threatened to cause trouble in the enlargement negotiations unless their net EU budget contributions are reduced.

In short, the stability pact, even with loopholes, may make it harder for the euro to weather the EU’s first economic downturn, and could increase the pressure for bail-outs or fiscal transfers. Luckily, with Europe’s economies recovering and budget deficits declining, a downturn looks some years away. In the meantime, the European Central Bank will have plenty of other problems on its mind.

*“The Stability Pact: More than a Minor Nuisance”, by Barry Eichengreen and Charles Wyplosz. In Economic Policy 26, CEPR/Blackwell, forthcoming