The stability pact: safeguarding the credibility of the European Central Bank.

Artis, Michael ; Winkler, Bernhard

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. Furthermore, the crucial problem of policy coordination arises between (national and aggregate European) fiscal policies and the common monetary policy, rather than across national fiscal authorities alone.

II. The Provisions of the Stability Pact

The legal background

The declared purpose of the Stability and Growth Pact is to provide "both for prevention and deterrence" in securing budgetary discipline (European Council 1997, Annex I, II and III). In order to understand the motivation and the legal construction of the Stability Pact it is important to recall that the Maastricht Treaty not only makes accession to EMU conditional on convergence as measured by the well-known convergence criteria but also commits countries joining EMU to avoid "excessive deficits" thereafter. At the root of the Stability Pact lies the perception that the procedures and the possibility of sanctions already incorporated in the Maastricht Treaty would prove insufficient and impractical for securing budgetary discipline once the threat of exclusion from EMU was removed after 1999. The original German proposal of concluding a separate treaty among EMU participants was quickly discarded, since it was argued to require a risky and lengthy ratification process and also would have introduced an undesirable additional legal divide between the "Ins" and the "Outs". Therefore the Stability Pact had to build on the existing Treaty provisions, which it could not supersede but only complement.

This explains the peculiar legal construction of the Stability Pact which consists of three separate components, a European Council Resolution and two Council Regulations. The European Council Resolution on the Stability and Growth Pact (Council Resolution 97/C 236/01, see Appendix A) "solemnly invites all parties, namely the Member States, the Council and the Commission, to implement the Treaty and the Stability and Growth Pact in a strict and timely manner" and "provides firm political guidance" (para. IV.), but - unlike the Council Regulations - without being legally binding. Essentially, the Resolution is a self-commitment device to take certain decisions and vote in a certain way within the procedures envisaged by the original Maastricht Treaty. In particular, the commitment to keep medium-term budgetary positions close to balance or in surplus and the "automaticity" of sanctions for violations of the 3 per cent deficit ceiling rest solely on a political declaration with no immediate legal force and without abrogating the elements of qualitative judgement contained in the Treaty.

The Council Regulation on the strengthening of the surveillance of budgetary positions and the surveillance and coordination of economic policies (Council Regulation (EC) No. 1466/97) builds on Article 103 of the Maastricht Treaty and represents the prevention element of the Stability Pact. It requires euro members to annually and publicly present "stability programmes", while non-euro members submit annual "convergence programmes" specifying medium-term budgetary objectives. The Council, on recommendation of the Commission, gives an opinion on the programmes, monitors their implementation and can pass recommendations that may be made public.

The Council Regulation on speeding up and clarifying the implementation of the excessive deficit procedure (Council Regulation (EC) No. 1467/97, see Appendix B) - together with the Resolution - mainly represents the deterrence elements of the Pact. It seeks to render more precise the definition of an excessive deficit given in Article 104c(2a) 2nd indent, which allows for breaches of the 3 per cent criterion if they are "exceptional", "temporary" and if the deficit remains "close" to the reference value, thereby reducing the flexibility and degree of discretion of the original Treaty. It also specifies the nature of sanctions and the procedures and timing of their imposition in order to deter excessive deficits.

The mechanics

We now turn to a consideration of the mechanics of the procedures involved, with a view to establishing how effective - and how flexible - they are likely to be. The important elements are the timing and size of the sanctions envisaged, the circumstances under which exceptions are granted and the degree of discretion in the application of sanctions. The size of sanctions must be of an order that serves as an effective ex ante deterrent but without being so severe as to render the control of public finances too difficult ex post. The Pact envisages that these sanctions (see Appendix B) would comprise a fixed element equal to 0.2 per cent of GDP plus a variable element equal to one tenth of the difference between the deficit ratio and the 3 per cent reference value. To begin with (see below) the sanctions would take the form of a non-interest-bearing deposit, only later that of an outright 'fine'. In this context it is important to note the potentially destabilizing effects that could arise from the interaction of the sanctions and the reactions of financial markets to the imposition of fines. In fact the financial penalties that could be exacted by the bond market in the form of higher interest payments may easily be much larger than those arising from the Pact itself (Thumann, 1997): perhaps for this reason the size of the latter is limited to a ceiling value of 0.5 per cent of GDP.

With respect to the time frame, five components can be distinguished counting from the date (March 1) when national deficit data are transmitted to the Commission. First, the decision time for the Council upon recommendation from the Commission amounts to three months. Then the Member State has four months to react to Council recommendations by announcing corrective action, which, second, leads to the excessive deficit procedure being held "in abeyance". Third, if and when the procedure is resumed, a further three months can elapse before sanctions are imposed. In the case of defiance of Council recommendations from the start (ie without intermittent abeyance) sanctions must be imposed within 10 months (ie within the same calendar year, counting from March 1). Fourth, "unless there are special circumstances" the Member State is expected to have corrected the excessive deficit in the year following its identification. Therefore, in cases where countries pay "lip-service" to Council recommendations but the measures taken turn out to have been ineffective, a full two years will have passed until hard data are available (again March 1), plus up to another three months until sanctions are decided. Fifth, an additional two years pass before a non-interest bearing deposit "should be" transformed into a fine.

The second set of issues regards the exceptions granted and the degree of discretion. The first thing to note is that whilst the Stability Pact gives tighter definitions of the "exceptional" and "temporary" escape clauses of Article 104c(2a) of the Maastricht Treaty it is not any more clear on what is to be meant by "close to the reference value". In case of exceptionally severe recessions exceeding a 2 per cent annual output loss, sanctions will be waived. According to Eichengreen (1997), who considers output declines over four quarters, such deep recessions have only occurred thirteen times over the last 30 years in the 15 EU countries. However, the Stability Pact has opened a window of discretion for output declines falling in between 0.75 per cent and 2 per cent, which are much more frequent, and for which special circumstances can be pleaded. Considering annual changes Buti et al (1997) have counted 7 cases (5 distinct episodes) of real GDP declines exceeding 2 per cent in the 1961-1996 period for all 15 EU countries, and 30 cases (25 separate episodes) in the case of the 0.75 per cent limit.

Note that the 2 per cent reference value is included in the Council regulation and has therefore stronger legal status, whereas the 0.75 per cent rule is based on self-commitment by the Member States. Both values are applied "as a rule", ie are not strictly automatic, and they do not supersede the possibility under Article 104c (3) and (6) that other factors will be taken into account in the decision on whether a deficit is excessive. Inside the corridor of discretion, for output losses between 0.75 per cent and 2 per cent, two additional decision criteria are mentioned explicitly, "the abruptness of the downturn" and "the cumulated output loss relative to past trends".

Qualified majority voting

Where there is room for interpretation, the voting dynamics of the Ecofin Council become decisive. The imposition of sanctions requires a qualified majority where the country in question is excluded together with euro-outsiders. However, the prior decision on whether an excessive deficit exists, according to Article 104c (6) of the Maastricht Treaty, is voted by qualified majority of all Member States under Article 148 (2), ie including the country under examination and even including euro-outsiders. This means that a blocking minority of 26 votes (for example Italy, Spain, Portugal and Greece have 28 votes) could prevent the excessive deficit procedure getting off the ground in the first place, even if there should be a qualified majority of insiders in favour of the imposition of sanctions.

For the decision on sanctions (voted only by euro-insiders, excluding the country under examination) the size of the monetary union matters. Eichengreen (1997) suspects that the application of the Stability Pact will be more rigid in a large EMU as a counterweight to the perceived greater (inflation) pressures on the ECB. On the other hand, the presence of fiscally less disciplined countries should affect the voting behaviour of Ecofin in the opposite direction.

Since a vote on the imposition of sanctions is always required, even outside the "corridor of discretion" concerning exceptional recessions, the practical question for the operation of the Stability Pact depends on how seriously the declaration of intent on future voting behaviour, the "solemn invitation" to the strict and timely application of the Stability Pact, is to be taken. Moreover, the wording of the Pact itself suggests additional room for discretion, since the numerical values and sanctions are only to be applied "as a rule". Both the question of legal enforcement - according to Article 104c(10) of the Maastricht Treaty violations of the fiscal provisions in Article 104c(1-9) cannot be brought before the European Court of Justice - and political realism would lead one to predict a much more pragmatic application of the Stability Pact than the focus on rules and numbers suggests. Finance ministers may well be reluctant to impose sanctions on colleagues, possibly knowing that they themselves may well soon end up in the same situation. In particular, voting behaviour is likely to reflect not only the absolute 3 per cent reference value but the relative budgetary positions of partner countries (and their probabilities of also breaching the deficit ceiling). A relative performance application of the Stability Pact could in fact be desirable if the fact that many countries are in difficulties is due to a common adverse shock and not a sign of a generalized lack of discipline. The drawback is the opportunity for countries to collude in order to escape the discipline of the 3 per cent ceiling (Winkler, 1997b).

III. The Stability Pact and Fiscal Policy

Constraints on fiscal policy, such as the deficit ceiling of the Stability Pact, can be useful if in their absence deficits would tend to be excessive from the national or the international (here: European) point of view. In both cases, the benefits of commitment to rules or deficit ceilings must be weighed against the potential losses from reduced flexibility of fiscal policy in stabilizing economic shocks, as discussed in Section IV.

Countering domestic deficit bias

Many proponents of the Stability Pact regard it as a valuable external commitment technology - desirable in its own right - in the face of unsatisfactory domestic political budget processes. The simplest story, put forward most forcefully by public choice theorists (Buchanan 1977, Olson 1965), draws on the observation that special interests pushing for public expenditure programmes are generally well-organized, unlike taxpayers. Moreover, future taxpayers are not represented at all in the democratic process, which favours the build-up of public debt to be repaid by future generations and may also lead politicians to ignore the negative long-run growth effects of deficits via the crowding out of productive private investment. Government instability and a host of other political and institutional factors can be used to explain why the public finance performance of political systems has differed widely across countries (Alesina and Perotti 1995, Roubini and Sachs 1989, Grilli et al 1991, Corsetti and Roubini 1993) and has produced a debt build-up in most of Europe over the past two decades, which is widely regarded as excessive (Masson 1996). For this argument to provide support for the Stability Pact, though, one would have to find that Monetary Union in some way would increase the domestic deficit bias.

In fact, the effects of monetary union on the incentives of fiscal policymakers can go in both directions. On the one hand, the long-run budget constraint facing governments is hardened to the extent that the Maastricht Treaty's "no-bail-out clause" is credible and monetary financing of government debt by the European Central Bank is ruled out (Glick and Hutchison 1993). On the other hand, access to financing will be easier in the unified European capital market and (presumably) cheaper for high debt and deficit countries no longer suffering national interest rate premia for devaluation and inflation risk. Abolishing national currencies removes the disciplining effect of international currency markets on national fiscal policies (Thygesen 1996), even though bond markets may be expected to remain a powerful deterrent (provided that the "no-bail-out clause" is perceived as credible).

The trust in bond markets exerting sufficient discipline on fiscal policies inside EMU and thus obviating the need for additional fiscal constraints can be challenged on two grounds. First, default probabilities and therefore risk premia are unlikely to be sizeable enough to act as an effective deterrent ex ante, as long as countries retain sufficient taxing powers and control of tax bases to continue servicing their debt (Eichengreen and von Hagen 1996). Second, market reactions and political crises in response to fiscal problems tend to be discontinuous, ie provoke a sudden and abrupt withdrawal of confidence which is difficult and costly to deal with ex post and thus may undermine the credibility of the no-bail-out clause ex ante (thus reducing risk premia) especially if financial market instability threatens to spill over across the euro-area. For these reasons it remains doubtful that market discipline can be effective in offsetting a domestic political deficit bias or in preventing possible adverse effects on partner countries, as discussed below.

Coordinating fiscal policies

The main channels through which national fiscal policies affect partner countries in EMU are via import demand, the common interest rates, the common exchange rate and the stability of the financial system. The case for the Stability Pact as a proxy for fiscal policy coordination first requires that spillovers from fiscal expansions and debt build-up would tend to be negative and that monetary union would aggravate any such spillovers. The short-run effects from fiscal expansions on foreign output should be positive and, in a standard Mundell-Fleming model, should be smaller under fixed exchange rates. The effects on the common real interest rate, and therefore the crowding out of partner countries' investment, should be negligible to the extent that individual borrowers are small relative to the European (and world) capital market. Moreover, the interest rate link represents a pecuniary externality and therefore would not call for a centralized intervention on welfare grounds (Buiter et al 1993). The justification for the 3 per cent ceiling on actual rather than primary or structural deficits as the relevant "expression of the burden on financial markets" (Thygesen 1996) is therefore not convincing by itself.

A third externality arises from effects of fiscal expansions on the common external exchange rate, which - in the short run - should appreciate, thus crowding out partner countries' net exports. In the long-run the build-up of debt would tend to lead to a lower real exchange rate. Again, the effects from any individual national fiscal policy path on the common exchange rate should be relatively small compared to the influence of the single monetary policy and the question of the aggregate policy-mix addressed in Section V.

A fourth possible channel of fiscal spillovers arises if an increase in default risk in a member country or a subsequent financial crisis cannot be confined to the country in question but leads to expectations of an explicit or implicit bail-out or a systemic financial crisis across the common capital market. In this perspective the Stability Pact could be helpful in reducing possible systemic risks from sovereign debt default inside EMU. However, it would be more appropriate to limit bank exposure to sovereign debt, to strengthen European banking supervision in general and to clarify the lender-of-last-resort functions at the national and European levels.

On the whole, most of the spillovers of fiscal policies are not strongly related to monetary union per se but rather rest on the degree of trade or financial market integration (Eichengreen and von Hagen 1996). Moreover, strategic interaction with the rest of the world complicates the picture further (Eichengreen and Ghironi 1997) and intra-European fiscal policy coordination may not be desirable given that both monetary and fiscal policies remain uncoordinated with the rest of the world.

IV. The Stability Pact and Fiscal Stabilization

Fiscal stabilization under EMU

Whatever the rationale for the Maastricht criteria and the Stability Pact there is a potential price to be paid for satisfying their rigid numerical limits. This price comes in the form of lost flexibility in the use of active fiscal policy or in the operation of the built-in automatic stabilizers of national budgets and has been the major source of criticism of the fiscal criteria. Two aspects of stabilization can be distinguished conceptually, intra-union stabilization in response to asymmetric shocks and pan-European responses to common shocks.

The debate over fiscal federalism examines the question where stabilization mechanisms should be located, ie whether at the European or at the national level (eg Melitz and Vori 1992, von Hagen and Hammond 1995). It is obvious that a European-wide stabilization scheme is superior in principle since it provides insurance across countries at any point in time, whereas national stabilization has to rely on debt build-up for consumption-smoothing over time. If there are significant Ricardian effects, national fiscal stabilization may be less powerful to the extent that consumption is reduced in the expectation of a higher future tax burden (Bayoumi and Masson 1996). However, empirically Ricardian effects are likely to be small, especially if deficits are perceived to be strictly temporary. The issue then hinges on the question to what extent capital market imperfections impede private agents and national governments from lending and borrowing in order to achieve consumption-smoothing over time (Gros 1996). Again, integrated financial markets and EMU should make access to credit easier for governments (eg the balance of payments constraint is removed) and thus facilitate national stabilization policies.

However, a European-wide scheme could be attractive for another reason since it may be able to stabilize intra-union shocks automatically and in a way that leaves the aggregate fiscal stance unaltered. Unfortunately, there are serious design problems in a centralized insurance scheme which relate to the difficulty of separating out temporary and permanent shocks (and therefore insurance from redistribution issues) and to problems of moral hazard. In any case, the Maastricht construction does not call for an expansion of the central European budget nor the installation of a European-wide fiscal co-insurance mechanism.

Empirical research on fiscal federalism has looked at the experience of federal states such as the US, where the federal budget does perform a sizeable stabilization function in the order of 20 per cent of income shocks in most of the more recent studies (eg Bayoumi and Masson 1995). This does not necessarily imply that the same stabilization function could not be performed equally effectively at the state level. In the US, State budget policies are both less important for stabilization and more severely constrained than in European countries. Moreover, the size of the state sector and the volume of welfare and unemployment benefits is generally much greater in Europe and therefore national automatic stabilizers should be more powerful (Allsopp and Vines 1996). Bayoumi and Eichengreen (1995) have estimated the elasticity of the central government revenue/GDP ratio with respect to output to be in the order of 0.30.5 for a number of European countries, as a measure of the fraction of changes in disposable income that is offset by changes in government revenues. Buti et al (1997) find that the cyclical sensitivity of the budget balance for Europe as a whole is around 0.5 per cent (increase in the deficit in response to a deterioration of the output gap of 1 per cent).

The second issue, therefore, is to examine how well-equipped national fiscal policy would be to perform stabilization within monetary union, ie how necessary and how effective national fiscal stabilization will be in EMU. The main concern from the stabilization and OCA perspective is that the Stability Pact could hamper the operation of automatic stabilizers at the national level, just when they are most needed. In particular, the fear is that in a recession countries will be induced to undertake "perverse" procyclical measures in order to avoid hitting the 3 per cent deficit ceiling. The main recommendation from this line of argument is to formulate any deficit targets in terms of structural deficits or "constant-employment budget balance" (Eichengreen 1997) rather than actual deficits. The problem with the NAIRU-adjusted deficit targets, besides disputes about measurement, is that they provide no reassurance about the long-run sustainability of public finances, unlike the medium-run budget balance aim of the Pact.

The Stability Pact as an Incentive Device

How much of a constraint on fiscal stabilization the Stability Pact turns out to be depends, of course, on the average, structural, deficits that countries aim for, on the size of shocks and whether countries will decide to honour the 3 per cent ceiling in a recession or not.

Under uncertainty governments will equate the marginal cost of undertaking fiscal adjustment with the marginal benefit of reducing the risk of incurring penalties under the Stability Pact (Winkler, 1997a). Rational governments optimizing ex ante, will aim for a deficit much below the 3 per cent as a "cushion" against subsequent unfavourable shocks. If countries react to the Stability Pact in this way, automatic stabilizers need not necessarily be compromised as feared by Eichengreen (1997), in particular in view of the Stability Pact's exceptions in the event of unusually large shocks. The 3 per cent ceiling on the actual deficit could induce behaviour not much different from a target on structural deficits. The main difference is that countries can choose their target structural deficit for themselves, ie the optimal size of their "cushion" depending on their own preferences. Likewise, the choice of the nature and instruments of fiscal adjustment is left to the individual countries. The criticism of the 3 per cent target as arbitrary and "one-size-fits-all" (Eichengreen 1997) is therefore only partially justified. Moreover, the same criticism would equally apply to the alternative suggestions of NAIRU-adjusted deficit targets or a centrally-imposed reform of national budget procedures proposed by yon Hagen and Harden (1994).

Moreover, the Stability Pact explicitly calls on countries to keep their medium term budgetary positions close to balance or in surplus and if "the structural deficit is close to zero ... the operation of automatic stabilizers should still be available" (Lamfalussy 1997). Over the course of normal business cycle fluctuations the difference between actual and structural deficits is unlikely to exceed 3 per cent very frequently. Masson (1996) has calculated a standard deviation of ca. 2 per cent, suggesting that aiming for 1 per cent deficits or below might be sufficient. Eichengreen (1997) reports cases where European countries have experienced shifts in their fiscal positions exceeding 3 per cent, ie implying a violation of the Maastricht ceiling under the assumption that countries start out in fiscal balance, for four EU countries in the mid-70s, one country in the early 80s and five countries in the early 1990s. This inspires reasonable confidence that the Stability Pact need not be unduly restrictive in the face of "normal"-size business cycles.

The real question therefore becomes whether the Stability Pact's target range for structural deficits is desirable, realistic and credible and what happens in the early days of EMU if countries should enter with deficits right up against the 3 per cent ceiling and even without their economies being in the trough of a recession. A common line of defence for the Maastricht fiscal criteria is the argument that a substantial reduction in structural deficits and debt is required independently of EMU in particular in view of demographic trends in Europe (Masson 1996). From this reasoning prudent governments would be well-advised to perhaps even aim for budget surpluses on average in the coming decades. In this perspective the 3 per cent deficit ceiling does not appear to be excessively ambitious at all. Moreover, turning the critics' argument on its head, it has been argued that fiscal consolidation might be necessary precisely in order to regain the room for manoeuvre that allows automatic stabilizers to operate effectively. In the pre-EMU situation of a number of countries (eg Italy with deficits close to 10 per cent of GDP for much of the 1980s) market fears of further deterioration in public finances already effectively curtailed both the advisability and the effectiveness of letting automatic stabilizers operate fully. According to Buti et al (1997, p.13) EU countries with above-average pre-recession debt and deficits actually have pursued pro-cyclical policies in the past, reducing structural primary deficits in recessions by 1.2 per cent of GDP on average.

Put in this perspective the trade-off between discipline and flexibility disappears, at least in the long-run, and the debate really is one about the transition period in the run-up to EMU and in the early years of Stage Three. Even here it has been argued that fiscal retrenchment need not always compromise output, especially if it restores confidence in public finances over the longer term (Giavazzi and Pagano 1991, Bertola and Drazen 1991, IMF 1995) - though the empirical evidence for "anti-Keynesian" effects appears to be mixed at best (Cour et al 1996, Hughes-Hallett and McAdam 1996). For high debt countries EMU-entry by itself should improve the fiscal outlook even in the short term via a reduction in the interest burden. The obvious way to reduce the risk of the Stability Pact imposing excessive constraints on fiscal stabilization in the early years of EMU is, of course, to insist on strict entry conditions and large enough safety margins for EMU participants from the start. It is important to recall that the Treaty not only establishes numerical reference values for the fiscal criteria but emphasizes the need for the sustainability of budgetary positions. The same point has been emphasized in the resolution of the German parliament from 2.12.1992 stating that compliance with the criteria must not only be statistical, but "durable" and "credible" (Deutscher Bundestag 1992). This could be read as being much like a condition on structural deficits which should prevent countries with a high risk of subsequently violating the 3 per cent ceiling from joining in the first place.

V. The Stability Pact and Monetary Policy

The considerations reviewed in the previous section may all be relevant for the cost-benefit analysis of the Stability Pact but they do not reflect the principal motive of the insertion of the fiscal criteria in the Maastricht Treaty, which is to facilitate the ECB's primary task of achieving low and stable inflation. The relevant spillovers in this perspective regard the negative effects of undisciplined fiscal policy on the incentives, credibility and performance of the common monetary policy. As is stated in para. 18 of Annex 1 of the Presidency conclusions of the Dublin summit (Ecofin 1996):

"Sound government finances are crucial to preserving stable economic conditions in the Member States and in the Community. They lessen the burden on monetary policy and contribute to low and stable inflationary expectations such that interest rates can be expected to be low."

The primary task of the Stability Pact is to safeguard the credibility of monetary policy both in the long term (by preventing excessive public debt build-up) and in the short run by keeping deficits in check and thereby reducing the risk of imbalances in the macroeconomic policy mix. Contrary to the presumption in the standard literature on the credibility of monetary policy and virtues of central bank independence (Rogoff 1985a, Walsh 1995) monetary policy does not operate in a vacuum. First, as pointed out by McCallum (1995), Jensen (1997) and Lohmann (1996), the commitment to delegate monetary policy must itself be credible. Second, even independent central banks depend critically on the support from fiscal and wage policies and the general public (Eijffinger and De Haan 1996) if they are to deliver low inflation at low real economic costs. These considerations mean that there is reason to be concerned about the likely performance of the European Central Bank - despite the legal independence it will enjoy, despite its explicit statutory commitment to the goal of price stability and despite the fact that it will face a fragmented set of fiscal players rather than a single Ministry of Finance. For it will not have its own stock of reputation on which to draw, nor can it count on receiving the necessary backing from the European public and the European economic policy process.

Consider the simple illustration of monetary-fiscal policy interaction in Figure 1. Payoffs are arbitrary and chosen to capture the benefits from fiscal and monetary policy paths being coordinated in the short run and mutually consistent in the long run. Conversely, if policymakers are on a collision course payoffs are much lower. For example, a lax fiscal policy combined with tight money leads to an unbalanced policy mix, high interest rates, currency appreciation and output losses. Note that both sides have an incentive to fall in line. Faced with lax fiscal policy, the monetary authorities will in the end be forced to accommodate and, likewise, when facing a tough ECB fiscal authorities will "chicken out" and accept discipline.

Figure 1: A Game of Chicken

 Fiscal Authorities
 tight policy lax policy

ECB tight policy 4, 2 -1, -1
lax policy 0, 0 1, 3

There are two Nash equilibria in the game of Figure 1. The central bank prefers the "tight" equilibrium (top-left) with tight monetary and fiscal policies, whereas fiscal authorities prefer the "lax" outcome (bottom-right) with relaxed policies. The payoffs are as in the standard "game of chicken" (except here we make the tight equilibrium the socially more attractive one), where players have an incentive to coordinate their actions but differ over the preferred outcome and therefore each side would like to precommit in advance. Depending on which side gains strategic leadership in this way, we can distinguish two regimes, "monetary dominance" and "fiscal dominance" in the terminology of Canzoneri and Diba (1996).

The game can be given economic interpretations both with respect to the long-run or the short-run strategic interaction between monetary and fiscal policymakers, as discussed in the following subsections. The long-run interpretation focuses on the intertemporal government budget constraint and the credibility of low inflation and no-bail-out promises. The short-run interpretation looks at the issue of the appropriate policy mix for macroeconomic stabilization. The Maastricht criteria can be seen as an attempt to secure pre-commitment to the monetary dominance regime, ie select the better of the two possible equilibria and in particular to avoid costly conflict (leadership battles) between monetary and fiscal policy.

Long-run credibility

A first link between fiscal and monetary variables can be established even in a simple Barro-Gordon (1983) framework. As stressed by De Grauwe (1996) the presence of nominal (long-term) debt undermines the central bank's anti-inflation incentives, because of the temptation to inflate away the stock of debt. His policy recommendations are either to suspend the voting rights of the representatives of high debt countries on the ECB board or to issue short term debt. The former solution runs against the spirit of the ECB as being an independent and collegiate European institution, the latter has the drawback of undermining ECB credibility in the short run, as public finances become more vulnerable to variations in short term interest rates.

More generally, monetary and fiscal policy are linked via the intertemporal government budget constraint, which says that a stream of expenditures can be financed via taxes, issuing bonds or printing money. Here a regime of "fiscal dominance" would mean that the government can precommit to a path of net deficits and thus ultimately force the central bank to inflate in order to avoid insolvency as in the "unpleasant monetarist arithmetic" of Sargent and Wallace (1981). Under "monetary dominance" the central bank can commit not to inflate (no explicit or implicit bail-out) and thus force the government to adjust its path of spending and taxes as in the "unpleasant fiscal arithmetic" of Winckler et al (1996).

In the model of Canzoneri and Diba (1996) in a regime of fiscal dominance the fiscal authorities do not respect the implications of the intertemporal budget constraint, which leads to current inflation irrespective of the central bank's monetary policy. The price level will then be determined by the present value government budget constraint, "by the dictates of fiscal solvency", and not by the supply and demand for money (Woodford 1995). This can happen even if the monetary authorities ignore the path of debt completely (eg only care about inflation) as long as fiscal policymakers do not follow a "Ricardian fiscal policy rule" (Woodford 1996), that offsets any change in debt exactly by a compensating change in the present value of future government surpluses. Under monetary dominance, by contrast, fiscal authorities conform to their long-run budget constraint and therefore the central bank is undisturbed in achieving its inflation target and enjoys "functional independence". The latter regime requires that primary surpluses respond to the level of debt in a systematic way.

Whether an economy finds itself in a monetary or fiscal dominance regime depends on financial markets' beliefs about whether primary surpluses will respond fast enough to rising government debt. A deficit rule, like the one endorsed by Maastricht and the Stability Pact, can be shown to ensure this responsiveness and thus establish monetary dominance and the "functional" as opposed to "legal" independence of the ECB. From this perspective the Stability Pact seems right in focusing on deficits rather than debt. However, large stocks of debt may reduce the credibility of the deficit rule if the required primary surpluses become too large. A debt criterion may still be important for this reason and also as a safeguard against manipulations of the deficit figures, which sooner or later require stock-flow adjustments and show up in the level of debt.

There are a number of other papers that have explored the fiscal-monetary policy interaction that could be interpreted to underpin a situation as in Figure 1 in more detail such as Mourmouras and Su's (1995) differential debt stabilization game, Beetsma and Bovenberg (1995a, b) and Beetsma and Uhlig (1997) who focus on seigniorage and government myopia as causes for a debt bias and justifications for fiscal constraints to complement central bank independence. The picture is complicated in models that introduce fiscal policy coordination issues on top of the fiscal-monetary interaction as in Jensen (1996), Bryson et al (1993) and Levine and Pearlman (1992). In such settings fiscal coordination may be bad if the common monetary policy lacks credibility with the private sector. This mirrors an earlier result by Rogoff (1985b) showing that coordination of a subset of players can be counterproductive. In other words, in a second best world, removing one distortion in the presence of another may make matters worse. If the central bank cannot precommit, fiscal coordination would reduce the credibility of the central bank further, supporting the Maastricht choice of fiscal constraints rather than full-fledged fiscal coordination.

Agell et al (1996) have a version of the coordination cum commitment story with a more Keynesian flavour, ie not based on the inflation tax as the link between fiscal and monetary policy (which arguably is of scant empirical relevance). The government faces an ex ante trade-off between stimulating economic activity and containing budget deficits. It may or may not heed the intertemporal budget constraint, while for the monetary authorities both discretion and commitment via permanently fixed exchange rates (monetary union) is considered. Under discretion both inflation and deficits will be high, ie the situation of a wage-devaluation cycle with debt build-up. Under monetary union inflation will be low, but the deficit bias is worsened, which provides a case for introducing fiscal constraints when moving to EMU.

Our contention is that the Stability Pact can be seen as a means of strengthening the independence of the ECB and its ability to resist pressures to ease monetary policy (Masson, 1996).

Short-term credibility and policy-mix

Critics of the Stability Pact have argued that "discipline is a long-term issue" and that, if anything, restrictions should be placed on the debt stock rather than on current deficits (Pisani-Ferry 1996). From the Canzoneri-Diba (1996) perspective of the previous subsection, by contrast, what matters is the responsiveness of current deficits to a debt build-up and therefore a deficit rule can be sufficient. Discipline becomes a short-term issue because the long-run deficit-debt dynamics can affect inflation expectations and current inflation directly.

In addition to the long-run compatibility of fiscal and monetary policy paths as reflected in the interaction via the intertemporal government budget constraint, the choice of policy-mix also becomes important in short-term macroeconomic management. Conflicts between fiscal and monetary authorities can be very costly, as the episodes of Reagonomics in the early 1980s and in the wake of German unification demonstrate. In terms of Figure 1 a lax fiscal policy stance confronted with tight monetary policy gives rise to a leadership battle, where each side tries to secure its preferred equilibrium. The long but unbalanced struggle of many European economies to regain stability over the course of the 1980s also illustrates the costs of an unbalanced policy mix (Allsopp and Vines 1996, p. 97), resulting from a credibility bias towards monetary policy (strongly constrained by the EMS) but too lax fiscal regimes. The story here applies both to the medium-to-longer term disinflation effort as well as the short run.

In the case of EMU the short-run concern over an unbalanced policy-mix mainly relates to the fear that undisciplined fiscal policies (in the aggregate) will force the ECB to keep short term interest rates higher than desirable in order to offset inflationary pressures. More generally, if other economic agents affecting the determinants of inflation (fiscal authorities and wage setters in particular) do not play their part the ECB will either be induced to accommodate (ie accept the fiscal dominance outcome) or impose great real economic costs in an attempt to reassert its leadership. The Stability Pact can be seen as a (blunt) safeguard to limit the extent to which the ECB will be confronted with this dilemma and to safeguard its strategic leadership. Again the criteria are an (imperfect) substitute for an explicit or implicit coordination mechanism via common institutions or a shared stability culture. They try to limit the risk that the ECB's independence is tested or contested too severely.

The Stability Pact attempts to pre-empt any potential leadership battles between fiscal and monetary policy in favour of the ECB and to prevent an unbalanced policy-mix of a lax fiscal stance and tight money. Here, it is not quite clear how the European Council Resolution on Growth and Employment, adopted at French insistence in Amsterdam, might play out. It calls for "developing the economic pillar" and "enhancing policy coordination" under Articles 102a and 103 of the Maastricht Treaty (European Council 1997). Meanwhile it seems certain that an informal Euro-X Council will serve as a forum for the discussion of economic policy among EMU participants. This could be harmful for stability if it undermines the strategic leadership of the ECB, but it could also be helpful if policy-coordination serves to provide support for the ECB's objectives and contributes to finding an appropriate policy-mix.

VI. Conclusion

The Stability Pact's orientation towards a zero budget deficit in 'normal' times is consistent with its 3 per cent deficit ceiling being used as a flexible margin of response in adverse conditions. Unfortunately, though, it seems possible that countries will enter Stage Three with deficits close up against the ceiling. The European Commission's November 1997 point forecasts for the budget deficits of the countries likely to form a broad-based EMU - that is, all EU countries except the UK, Sweden, Denmark and Greece - shows six countries in 1999 with deficits still at 2.2 per cent or more, a further two with deficits above 1.5 per cent and three (of the smaller countries) in surplus. If these forecasts are only somewhat too optimistic, the provisions of the Stability Pact would face an early test just at the time when the new ECB will be keen to establish its reputation. The seriousness of the problem (the strain on the ECB and the Stability Pact) will depend on the exact cyclical position of the European economies and on how strictly the Maastricht entry criteria will be applied. In this light, the scope for a trade-off between the Stability Pact and the entry criteria (Artis 1996) appears to be limited.

Yet, while there is some reason to doubt the effectiveness of the technical provisions of the Stability Pact in guaranteeing the desired discipline and flexibility in practice, the mere fact that Member States have agreed to subject national budget policies to a concerted European joint discipline is of great significance on two counts. First, conceding concerted fiscal discipline in order to safeguard the leadership and credibility of the ECB may be an important step towards further implicit or explicit coordination of policies, whilst also serving as an important signal to the financial markets of Europe's credibility credentials that may help build stability reputation ahead of the leap into EMU (Masson 1996). Second, the conclusion of the Stability Pact also represents a small, but important, transfer of national sovereignty in the budgetary field. Unlike Gros (1996) and Thygesen (1996) we believe that there is a nexus between Political Union and Monetary Union. Putting a lot of faith in codified rules as in the Stability Pact and statutory central bank independence, is a reflection of the German Ordo-liberal tradition in economics, but may be misplaced unless the rules are built on strong political legitimacy. Failing a source of legitimacy the rules risk being ignored or of becoming the object of serious conflict. Monetary stability and political cohesion in Europe may yet become lost in the "Bermuda triangle" between national and European institutions and responsibilities. Here, too, the Stability Pact serves as an important test.

Appendix A

Key provisions of the European Council Resolution on the Stability and Growth Pact (Council Resolution 97/C 236/01)

Member States

1. commit themselves to respect the medium-term budgetary position of close to balance or in surplus set out in their stability or convergence programmes [...];

5. will correct excessive deficits as quickly as possible after their emergence; this correction should be completed in the year following its identification, unless there are special circumstances;

7. commit themselves not to invoke the benefit of Article 2 paragraph 3 of the Council Regulation on speeding up and clarifying the excessive deficit procedure unless they are in severe recession; in evaluating whether the economic downturn is severe, the Member States will, as a rule, take as a reference point an annual fall in real GDP of at least 0.75%.

The Commission

3. commits itself to prepare a report under Article 104c(3) whenever there is the risk of an excessive deficit or whenever the planned or actual government deficit exceeds the 3% of GDP reference value, thereby triggering the procedure under Article 104c(3);

4. commits itself, in the event that the Commission considers that a deficit exceeding 3% is not excessive and this opinion differs from that of the Economic and Financial Committee, to present in writing to the Council the reasons for its position;

5. commits itself, following a request from the Council under Article 109d, to make, as a rule, a recommendation for a Council decision on whether an excessive deficit exists under Article 104c(6);

The Council

3. is invited to impose sanctions if a participating Member State fails to take the necessary steps to bring the excessive deficit situation to an end as recommended by the Council;

4. is urged to always require a non-interest bearing deposit, whenever the Council decides to impose sanctions on a participating Member State in accordance with Article 104c(11);

5. is urged always to convert a deposit into a fine after two years [....], unless the excessive deficit has in the view of the Council been corrected;

Appendix B

Key Articles of the Council Regulation on speeding up and clarifying the implementation of the excessive deficit procedure (Council Regulation (EC) No. 1467/97):

Article 2

1. The excess of a government deficit over the 3% reference value shall be considered exceptional and temporary [...] when resulting from an unusual event outside the control of the Member State concerned and which has a major impact on the financial position of the general government, or when resulting from a severe economic downturn. In addition, the excess over the reference value shall be considered temporary if budgetary forecasts as provided by the Commission indicate that the deficit will fall below the reference value following the end of the unusual event or the severe economic downturn.

2. The Commission when preparing a report under Article 104c(3) shall, as a rule, consider an excess over the reference value resulting from an economic downturn to be exceptional only if there is an annual fall of real GDP of at least 2%".

3. The Council when deciding, according to Article 104c (6), whether an excessive deficit exists, shall in its overall assessment take into account any observations made by the Member State showing that an annual fall of real GDP of less than 2% is nevertheless exceptional in the light of further supporting evidence, in particular on the abruptness of the downturn or on the accumulated loss of output relative to past trends.

Article 3

3. The Council shall decide on the existence of an excessive deficit [...] within three months of the reporting dates [...].

4. The Council recommendation [....] shall establish a deadline of four months at the most for effective action to be taken by the Member State concerned. The Council recommendation shall also establish a deadline for the correction of the excessive deficit, which should be completed in the year following its identification unless there are special circumstances.

Article 4

2. The Council, when considering whether effective action has been taken [...], shall base its decision on publicly-announced decisions by the Government of the Member State concerned.

Article 5

Any Council decision to give notice to the participating Member State concerned to take measures for the deficit reduction in accordance with Article 104c(9) shall be taken within one month of the Council decision having established that no effective action has been taken in accordance with Article 104c(8).

Article 6

Where the conditions to apply Article 104c(11) are met, the Council shall impose sanctions in accordance with Article 104c(11). Any such decision shall be taken no later than two months after the Council decision giving notice [...].

Article 7

If a participating Member State fails to act in compliance with the successive decisions of the Council [...], the decision of the Council to impose sanctions, [...], shall be taken within ten months of the reporting dates [...]. An expedited procedure will be used in the case of a deliberately planned deficit which the Council decides is excessive.

Article 9

1. The excessive deficit procedure shall be held in abeyance:

* if a Member State concerned acts in compliance with recommendations made in accordance with Article 104c(7),

* if a Member State concerned acts in compliance with notices given in accordance with Article 104c(9).

Article 11

Whenever the Council decides to apply sanctions to a participating Member State in accordance with Article 104c(11), a non-interest beating deposit shall, as a rule, be required. [...]

Article 12

1. When the excessive deficit results from non-compliance with the criterion relating to the government deficit ratio in Article 104c(2a), the amount of the first deposit shall comprise a fixed component equal to 0.2% of GDP, and a variable component equal to one tenth of the difference between the deficit as a percentage of GDP in the preceding year and the 3% of GDP reference value.

2. Each following year, [...]. The amount of an additional deposit shall be equal to one tenth of the difference between the deficit as a percentage of GDP in the preceding year and the 3% of GDP reference value.

3. Any single deposit [...] shall not exceed the upper limit of 0.5% of GDP.

Article 13

A deposit shall, as a rule, be converted [...] into a fine if two years after the decision to require [...] a deposit, the excessive deficit has in the view of the Council not been corrected.

European University Institute and CEPR, European University Institute. We would like to thank two anonymous referees for helpful comments on a previous draft. Correspondence should be addressed to: Department of Economics, European University Institute, Badia Fiesolana, 1-50016 San Domenico di Fiesole (Firenze), Italy.

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