Transcript Monetary Integration in Europe

Monetary Integration in
Europe
Jan Fidrmuc
Brunel University
Monetary Union
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Monetary union implies a choice between
exchange rate stability and monetary policy
autonomy
The impossible trinity: only 2 of the following
possible simultaneously:
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Full capital mobility
Autonomous monetary policy
Fixed exchange rates
Exchange-rate Regime Alternatives
1.
2.
3.
Free floating exchange rate
Managed float, target zone, crawling peg
Fixed exchange rate, currency board,
dollarization
Exchange-rate Regime Choice
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Adjustment to adverse shocks (business
cycles) using monetary policy

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Can be misused  inflation
Exchange-rate volatility and vulnerability to
speculative attacks
Political pressure on exchange-rate policy
Two Corners
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Only pure floats or hard pegs are robust:
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intermediate arrangements (soft pegs) invite
government manipulations, over or under
valuations and speculative attacks
pure floats remove the exchange rate from the
policy domain
hard pegs are robust to speculative attacks
Soft pegs are half-hearted monetary policy
commitments, so they ultimately fail
Metallic Money

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Before paper money, Europe was a de facto
monetary union.
Under metallic money (gold and/or silver) the whole
world was really an informal monetary union.
Formal unions only agreed on the metallic content of
coins to simplify everyday trading.
Countries cannot issue currency and cannot use the
exchange rate to adjust relative prices (e.g. to
reverse a current-account deficit or to stimulate
demand)
Adjustment occurs through prices and wages
The Interwar Period:
The Worst of All Worlds
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Paper money started circulating widely.
The authorities attempted to resume the gold
standard but:
 no agreement on how to set exchange rates
between paper monies
 an unstable starting point due to war legacy
 high inflation
 high public debts.
European Postwar Arrangements

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An overriding desire for exchange rate stability:
 initially provided by the Bretton Woods system
 the US dollar as an anchor and the IMF as
conductor.
Once Bretton Woods collapsed, the Europeans were
left on their own:
 the timid Snake arrangement
 the European Monetary System (EMS)
 the monetary union.
The Bretton Woods System Collapse

Initial divergence (dollar exchange rates).
The Snake Arrangement
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Agreement on stabilizing intra-European bilateral
parities.
No enforcement mechanism: too fragile to survive.
The EMS: Super Snake

EMS = European Monetary System
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ERM = Exchange Rate Mechanism
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A EU arrangement: all EU members are part of it
An agreement to fix the exchange rate
ERM jointly managed
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Changes in exchange rates agreed by all members
Fluctuations between +/-2.25% and +/-15%
Mutual support to prop up exchange rates when needed
Allows prompt realignments
Deutschemark gradually emerged as the anchor
EMS: Past and Present
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EMS originally conceived as solution to the end
of the Bretton Woods System
Gradually it became DM centered
The speculative crisis of 1993 made the
monetary union option attractive
Now ERM is the ante room for EMU entrants
The UK and Denmark opted out from ERM
membership
All the others are expected to enter the ERM
sooner or later (cf. Sweden)
Preview: The Four Incarnations of the
ERM
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1979-82: ERM-1 with narrow bands of fluctuation
(2.25%) and symmetric.
1982-93: ERM-1 centered on the DM, shunning
realignments.
1993-99: ERM-1 with wide bands (15%).
From 1999: ERM-2, asymmetric, precondition to
full euro-area membership.
Four Incarnations of the EMS
The ERM: Key Features
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A parity grid:
 bilateral central parities
 associated margins of fluctuations.
Mutual unlimited support:
 exchange market interventions
 short-term loans.
Realignments:
 tolerated, not encouraged
 require unanimous agreement.
The ECU:
 not a currency, just a unit of account
 took some life on private markets.
The ECU
A basket of all EU currencies.
Evolution: From Symmetry to DM
Zone
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First a flexible arrangement:
 different inflation rates: long run monetary policy
independence
 frequent realignments.
Evolution: From Symmetry to DM Zone
Inflation
18
France
16
Germany
14
Italy
Netherlands
12
10
8
6
4
2
0
1950-1972
1973-1978
1979-1985
1986-1991
1992-1998
Italy 1980-1998
4
125
120
3
115
2
110
1
105
0
100
95
-1
90
-2
85
-3
80
1980
1983
1986
Current Account
1989
1992
1995
1998
Real Exchange Rate (previous year)
Evolution: From Symmetry to DM
Zone
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However: realignments:
 barely compensated accumulated inflation
differences
 were easy to guess by markets  speculative
attacks
The symmetry was broken de facto.
The Bundesbank became the example to follow.
The DM Zone
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What shadowing the Bundesbank required:
 giving up of much what was left of
monetary policy independence
 aiming at a low German-style inflation rate
 avoiding realignments to gain credibility.
Breakdown of the DM zone
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Bad design:
full capital mobility established in 1990 as part of
the Single Act
ERM in contradiction with impossible trinity unless
all monetary independence relinquished.
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Bad luck:
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German unification: a big shock that called for
very tight monetary policy
the Danish referendum on the Maastricht Treaty.
A wave of speculative attacks in 1992-3:
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the Bundesbank sets limits to unlimited support.
Lessons From 1993
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The two-corner view:
 even the cohesive ERM did not survive
 go to one of the two corners
 monetary union
 or floating exchange rate
Interventions cannot be unlimited:
 need more discipline and less support
Speculative attacks can hit even robust
systems and properly valued currencies (i.e.
self-fulfilling crises)
The Wide-Band ERM
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Way out of crisis:
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wide band of fluctuation (15%)
a soft ERM on the way to monetary union
ERM-2
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ERM-1 ceased to exist on 1 January 1999 with
the launch of the Euro.
ERM-2 was created to
 Host currencies of old EU members who
cannot or do not want to join euro area:
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Denmark and the UK have derogations
Only Denmark has entered the ERM-2
Sweden has no derogation but has declined to
enter the ERM-2
Host currencies of new EU members before
they are admitted into euro area
ERM Members
Current ERM-2 Members
Country
Denmark
Date of ERM 2 Band of
membership
fluctuation
1 Jan. 1999
±2.25%
Estonia
27 June 2004
±15%
Lithuania
27 June 2004
±15%
Latvia
2 May 2005
±15%
ERM-2 vs ERM-1
ERM-1
ERM-2
Symmetric, no anchor
currency
Asymmetric, all parities
defined vis a vis euro
Margin explicitly set
‘Normal’ (±2.25%) and
‘standard’ (±15%)
bands
Automatic unlimited
interventions
ECB explicitly allowed to
suspend intervention
Optimum Currency Areas
Optimum Currency Areas?
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What currency, or exchange-rate
arrangement, is optimal?
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For individual countries, groups of countries or
regions within a country
What economic criteria should be used?
E.g.: California in the early 1990s
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Is it optimal for California to use the US dollar?
The Economic Toolkit
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There are benefits and costs involved in adopting a common currency.
The solution has to involve trading off these benefits.
In a Nutshell
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Benefits:
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No transaction costs, no exchange-rate
uncertainty
Decreasing with size of currency area
Costs:
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Economic and political diversity
Loss of monetary and exchange rate instruments
Increasing with size of currency area
OCA Theory
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Focus on the costs of common currency
Especially on asymmetric shocks
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What are they?
What problems do they cause in currency unions?
How can their effects be mitigated?
Example: A demand shock
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Real exchange rate, EP/P*, must depreciate to restore
competitiveness
Either prices fall or nominal exchange rate depreciates.
If not: overproduction and unemployment
Symmetric Shock
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Same demand shock in two similar countries that share the
same currency and, therefore, exchange rate:
No problem. The same real XR adjustment as before.
Asymmetric Shock
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Only one country is affected; countries share common
currency: Problem!
Country A’s real exchange rate must depreciate both vis-à-vis
ROW and Country B
Asymmetric Shock
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Country A wants a depreciation.
Country B is unhappy: depreciation would lead to excess
demand and inflationary pressure.
Asymmetric Shock
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Country B wants no change.
Country A is unhappy because of excess supply and
unemployment.
Asymmetric Shock
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Common central bank considers preferences of both
countries and allows partial depreciation
Nobody is happy.
Asymmetric Shock
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In the long, the problem is solved.
How?
Asymmetric Shock
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Prices decline in country A and rise in country B.
Real exchange rate adjusts because of price adjustment.
Equilibrium is restored in both countries through disinflation
and recession in A and inflation and expansion in B.
Implications of Asymmetric Shocks
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Both countries affected adversely when they share
the same currency.
Also the case when a symmetric shock creates
asymmetric effects (e.g. oil price effects on oil
exporting and oil importing countries).
This is an unavoidable cost.
Next questions:
 what reduces the incidence of asymmetric
shocks?
 what makes it easier to cope with shocks when
they occur?
Answer: six OCA criteria.
Six OCA criteria
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Three economic criteria
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Labor Mobility (Mundell)
Diversification (Kenen)
Openness (McKinnon)
Three political criteria
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Fiscal risk-sharing
Homogeneity of preferences
Solidarity
Criterion 1 (Mundell):
Labour Mobility
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An OCA is an area within which labour moves easily (including
across national borders).
Criterion 1 (Mundell):
Labour Mobility
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Labour moves from A to B
The two supply curves shift
Equilibrium is restored without disinflation/inflation.
Criterion 1 (Mundell): Labour Mobility
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In an OCA labour (and capital) moves easily, within
and across national borders.
Caveats:
 labour mobility is easy within national borders but
difficult across borders (culture, language,
legislation, welfare benefits, etc.)
 capital mobility: difference between financial and
physical capital; physical capital is less mobile
than financial capital
 with specialization of labor, skills may also matter;
migrants may need retraining.
Criterion 2 (Kenen): Production
Diversification
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OCA: countries whose production and
exports are widely diversified and of similar
structure.
If production and exports are diversified and
similar, there are few asymmetric shocks and
each of them is likely to be of small concern.
Criterion 3 (McKinnon): Openness
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OCA: Countries which are very open to trade and
trade heavily with each other.
Traded vs non-traded goods:
 traded good: prices are set worldwide
 a small economy is price-taker, so the exchange
rate does not affect competitiveness.
If all goods are traded, domestic goods prices must
be flexible and exchange rate does not matter for
competitiveness.
Criterion 3 (McKinnon): Openness
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Depreciation makes exports less expensive and
imports more expensive
If countries are very open to trade, they tend to use
a lot of imported goods in the production process
Then, depreciation is ineffective:

Depreciation  imports more expensive  domestic prices
rise.
Criterion 4: Fiscal Transfers
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Countries that agree to compensate each
other for adverse shocks form an OCA.
Transfers can act as an insurance that
mitigates the costs of an asymmetric shock.
Transfers stimulate demand  demand curve
shifts back.
Transfers exist within national borders:
 implicitly through the welfare system (e.g.
unemployment benefits)
 explicitly in some federations.
Criterion 5: Homogeneity of
Preferences
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Countries that share a wide consensus on
the way to deal with shocks form an OCA.
Matters primarily for symmetric shocks:
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May also help for asymmetric shocks:
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prevalent when the Kenen criterion is satisfied.
better understanding of partners’ actions
encourages transfers.
Different interest groups enjoy political power
in different countries.
Criterion 6: Solidarity
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Countries that view themselves as sharing a
common destiny better accept the costs of
operating an OCA.
A common currency will always face
occasional asymmetric shocks that result in
temporary conflicts of interests
This calls for accepting such economic costs
in the name of a higher purpose.
A summary
Very
Open
(McKinon)
Product
differentiation
(Kenen)
Low likelihood
of asymmetric
shocks
YES:
OCA
NO:
Need adjusment
Labour
mobility
(Mundell)
YES:
OCA
NO:
need adjustnent
Flexible
wages and
prices
YES:
OCA
Transfers
NO:
need political
support
Homogeneity
of
preferences
Solidarity
Is Europe An OCA?
•Each point represents
correlation between
demand and supply
shocks of particular
country with the eurozone average.
Correlation of demand and supply shocks with Euro area
0,8
0,6
ITA
demand shocks
0,4
POL
ESP
0,2
IRL
ROM
0
DK
GR
SVK
CZE
-0,2
S
FRA
HUN
EST AUT
FIN
GER
PRT
NLD
BEL
UK
SVN
-0,4
LTU
-0,6
-0,2
LVA
0
0,2
0,4
supply shocks
0,6
0,8
•Source: Korhonen and
Fidrmuc (2001)
Is Europe An OCA?
Is Europe An OCA?
Is Europe An OCA?
Is Europe An OCA?
Is Europe An OCA?
Is Europe An OCA?
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Little labor mobility within countries and intra-EU
(cf. USA)
EU countries generally open and diversified
EU budget low (1% of GDP) and used for
administration, CAP, regional and structural
funds, not to counter asymmetric shocks

US: 1$ fall in state GDP compensated by 0.10-0.40$
increase in net transfers
 Glass half full or half empty
The Endogeneity of OCA Criteria
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Living in a monetary union may help fulfil the
OCA criteria over time.
Would the US be an OCA without a single
common currency?
Will the existence of the euro area change
matters too?
The Endogeneity of OCA Criteria: Two
views
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Optimistic view (Frankel and Rose, European
Comission):
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Pessimistic view (Krugman):
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Deepening trade integration  intra-industry trade
and spillovers effects  greater symmetry of shocks
 OCA criteria more likely fulfilled once common
currency introduced
Deepening trade integration  greater
specialization  greater vulnerability to countryspecific shocks
No firm conclusion so far
The Endogeneity of OCA Criteria:
Optimistic View
T
Divergence
OCA
EU
T
Trade integration
The Endogeneity of OCA Criteria:
Pessimistic View
T´
Divergence
OCA
EU
T´
Trade integration
Trade
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Eliminating exchange rate volatility by
adopting a common currency raises trade:
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Estimates: +50-100%
‘border effect’ literature provides similar estimates.
EMU: preliminary evidence (Baldwin et al.,
2008)
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Trade among EMU countries has increased by
approx. 5% compared to other countries.
Labour Markets
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Mobility may not change much, but wages could
become less sticky.
Two views:
 the virtuous circle: labour markets respond to
enhanced competition by becoming more flexible
 the hardening view: labour markets respond to
enhanced competition by increasing protective
measures that raise stickiness.
The jury is still out.
Are the Other Criteria Endogenous?
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Transfers:
 currently no support for more taxes to
finance transfers.
Homogeneity of preferences:
 no expectation that it will change soon.
Solidarity:
 no expectation that it will change soon.
UK and EMU membership
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UK negotiated a formal opt-out from the obligation
to pursue EMU membership
UK policy set out in 1997
UK committed in principle to join the EMU
But would only join if there is a clear and
unambiguous economic case for joining
To assess whether there is such a case, the
Treasury devised 5 economic tests
If all 5 tests are passed, the final decision is to be
made by the British people in a referendum
UK Treasury’s Five Economic Tests
1.
2.
3.
Convergence in business cycles and economic
structures: There has been convergence but not
yet enough, and important differences remain,
especially in the housing market  euro-area
interest rates unlikely to be optimal for the UK. 
Flexibility if problems emerge: UK labor market is
more flexible than others, but still not sufficiently
so. 
Investment: UK membership in the euro-zone
would boost FDI inflows to the UK. 
UK Treasury’s Five Economic Test
4.
5.
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Financial Service and the City: Euro-zone
membership would strengthen the competitive
position of the City. 
Growth, stability and employment: Joining the
EMU would allow the UK to benefit through
increased trade, investment, competition ( lower
prices) and productivity growth. 
Treasury’s proposal: Joining now would not be in
the national economic interest.
Source: HM Treasury, UK membership of the
single currency: An assessment of the five
economic tests, June 2003.
In the End
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Monetary union is not only about economics.
 EU is not a perfect OCA
 a monetary union may function, at a cost.
The OCA criteria tell us where the costs will
arise:
 labour markets and unemployment
 political tensions in presence of deep
asymmetric shocks.
European Monetary Union
The Long Road to Maastricht and to
the Euro
The Maastricht Treaty
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A firm commitment to launch
the single currency by January
1999 at the latest.
Five convergence criteria for
admission to the monetary
union.
Formalization of central banking
institutions.
Additional conditions mentioned
(e.g. the excessive deficit
procedure).
The Maastricht Convergence Criteria
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Inflation:
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Long-term interest rate:
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not to exceed by more than 1.5 per cent the average of
the three lowest rates among EU countries.
not to exceed by more than 2 per cent the average
interest rate in the three lowest-inflation countries.
ERM membership:

at least two years in ERM without being forced to
devalue.
The Maastricht Convergence Criteria
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Budget deficit:
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Public debt:
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deficit less than 3 per cent of GDP.
debt less than 60 per cent of GDP (or diminishing
and approaching 60% at satisfactory pace)
Note: Fulfilment of criteria was observed on
1997 performance for decision in 1998.
The convergence criteria give little regard to
standard OCA arguments
Interpretation of the Convergence Criteria:
Inflation
Fear of allowing in
unrepentant
inflation-prone
countries.
 Result:
convergence in
inflation rates before
EMU entry

10.00
5.00
0.00
1991
France
Spain
Belgium
Greece
1992
1993
1994
1995
1996
1997
1998
Italy
Germany
Portugal
average of three lowest + 1.5%
Interpretation of the Convergence
Criteria: Long-Term Interest Rate



It may be easy to bring inflation down in 1997
and then let go again.
Long-term interest rates incorporate bond
markets’ expectations of future inflation.
Requires convincing markets that inflation will
remain low also in the long term.
Interpretation of the Convergence
Criteria: ERM Membership


Same logic as with the long-term interest rate: need
to convince the markets.
Furthermore, maintaining a fixed XR for two years
demonstrates commitment to strict monetary
discipline
Interpretation of the Convergence
Criteria: Budget Deficit and Debt (1)



Historically, all big inflation episodes born out of
runaway public deficits and debts.
Hence requirement that house is put in order before
admission.
How were the ceilings chosen?:
 deficit: the German golden rule


Deficits should only finance infrastructure expenditure 
approx. 3% of GDP
debt: the 1991 EU average.

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Average  many countries had more than 60%
Several countries’ debt increased further after 1991
Interpretation of the Convergence
Criteria: Budget Deficit and Debt (2)


Problem No. 1:
 a few years of budgetary discipline do not
guarantee long-term discipline
 excessive deficit procedure once in euro
area.
Problem No. 2: deficit and debt ceilings are
arbitrary.
The Debt and Deficit Criteria in 1997
Architecture of the
monetary union
A Tour of the Acronyms

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
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National Central Banks (NCBs) continue operating
but with no monetary policy function.
A new central bank at the centre: the European
Central Bank (ECB).
The European System of Central Banks (ESCB): the
ECB and all EU NCBs (N=27).
The Eurosystem: the ECB and the NCBs of euro
area member countries (N=16).
The System
How Does the Eurosystem Operate?



Objectives:
 what is it trying to achieve?
Instruments:
 what are the means available?
Strategy:
 how is the system formulating its actions?
Objectives (1)

The Maastricht Treaty’s Art. 105.1:
‘The primary objective of the ESCB shall be to maintain price
stability. Without prejudice to the objective of price stability,
the ESCB shall support the general economic policies in the
Community with a view to contributing to the achievement of
the objectives of the Community as laid down in Article 2.’


Article 2: The objectives of European Union are a high
level of employment and sustainable and non-inflationary
growth.
In summary:
 fighting inflation is the absolute priority
 supporting growth and employment comes next.
Objectives (2)



Making the inflation objective operational: does the
Eurosystem have a target?
It has a definition of price stability:
“In the pursuit of price stability, the ECB aims at
maintaining inflation rates below, but close to, 2%
over the medium term.”
Leaves room for interpretation:
 how far below 2 per cent?
 what is the medium term?
Instruments (1)




Channels of monetary policy:
 longer run interest rates
 credit
 asset prices
 exchange rate.
These are all beyond central bank control.
Instead it can control the very short-term interest
rate: European Over Night Index Average (EONIA).
EONIA affects the channels through market
expectations.
Instruments (2)




The Eurosystem controls EONIA by establishing a
ceiling, a floor and steering the market in-between.
The floor: the rate at which the Eurosystem accepts
deposits (deposit facility).
The ceiling: the rate at which the Eurosystem stands
ready to lend to banks (marginal lending facility).
In-between: weekly auctions (main refinancing
facility).
EONIA & Co.
7
6
5
4
3
2
1
0
Jan-99
Jan-00
EONIA
Jan-01
Jan-02
Deposit rate
Jan-03
Jan-04
Marginal lending
Jan-05
Main refinancing
Jan-06
Comparison With Other Strategies


The US Fed:
 legally required to achieve both price stability and
a high level of employment
 does not articulate an explicit strategy.
Inflation-targeting central banks (Czech Republic,
Poland, Sweden, UK, etc.):
 announce a target (e.g. 2 per cent in the UK), a
margin (e.g. ±1%) and a horizon (2–3 years)
 compare inflation forecasts and target, and act
accordingly.
Independence and Accountability

Central banks should be independent:




governments may be tempted to use the ‘printing
press’ to finance expenditure
Misbehaving governments are eventually
punished by voters.
What about central banks? Independence
removes them from such pressure.
A democratic deficit?
Redressing the Democratic Deficit

In return for their independence, central
banks should be accountable:



to the public
to elected representatives.
Examples:


The Bank of England is given an inflation target by
the Chancellor. It is free to decide how to meet the
target, but must explain its failures (the ‘letter’)
The US Fed must explain its policy to the
Congress, which can vote to reduce the Fed’s
independence.
The Eurosystem Weak Accountability



The Eurosystem must report to the EU
Parliament.
The Eurosystem’s President must appear
before the EU Parliament when requested,
and does so every quarter.
But the EU Parliament cannot change the
Eurosystem’s independence.
Inflation: Record so far
Euro Area Inflation
A difficult period:
•oil shock in 2000
•worldwide
slowdown
•September 11
•stock market
crash in 2002
•Afghanistan, Iraq
•Financial crisis
since 2007
3.5
3
2.5
2
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
1.5
1
0.5
0
The Euro: Too Weak First, Then Too
Strong?
Effective echange rate (1999Q1=100)
110
100
90
80
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Growth record
Inflation Convergence and No Major
Asymmetric Shocks
Fiscal Policy and the Stability
and Growth Pact
The Fiscal Policy Instrument




Fiscal policy: the only macroeconomic policy
instrument left at the national level in monetary
union
Borrowing is a substitute for fiscal transfers: intertemporal smoothing of shocks.
Yet, its effectiveness is questionable.
Expectations (Ricardian equivalence):




deficit today  higher tax tomorrow
tax cut today may not be permanent
Slow implementation: agreement within government,
approved by parliament, carried out by bureaucracy,
taxes not retroactive.
Result: countercyclical actions can have procyclical
effects.
Automatic vs Discretionary

Automatic stabilizers:
 tax receipts decline when the economy slows
down, and vice versa
 welfare spending rises when the economy slows
down, and vice versa
 no decision needed, so no lag: countercyclical
with immediate effect
 rule of thumb: deficit worsens by 0.5 per cent of
GDP when GDP growth declines by 1 per cent.
Automatic Stabilizers
Automatic vs Discretionary

Discretionary actions: a voluntary decision to
change tax rates or spending.
Should Fiscal Policy be Subject to
Collective Control?



Yes, if national fiscal policies cause externalities.
Income externalities via trade:
 national business cycles spill-over to other
countries via their impact on imports/exports
 trade intensity increased by monetary union
Borrowing cost externalities:
 one common interest rate
 heavy borrowing  capital inflows  appreciation
of the euro
The Deficit Bias

The track record of EU countries is not good.
EU public debt (% of GDP)
80
70
60
50
40
30
20
1970
1974
1978
1982
1986
1990
1994
1998
2002
2006
What is the Problem with the Deficit Bias?

Lack of fiscal discipline in parts of the euro area
might concern financial markets and:


raise borrowing costs: unlikely, markets can
distinguish among countries.
More serious is the risk of default in one member
country:

capital outflows and a weak euro

pressure on other governments to help out

pressure on the eurosystem to help out.
Answer to Default Risk:
The No Bailout Clause

The no-bailout clause:
Overdraft facilities or any other type of credit
facility with the ECB or with the central banks of
the Member States (hereinafter referred to as
‘national central banks’) in favour of Community
institutions or bodies, central governments,
regional, local or other public authorities, other
bodies governed by public law, or public
undertakings of Member States shall be
prohibited, as shall the purchase directly from
them by the ECB or national central banks of debt
instruments. (Art. 101)
Summary: Should Fiscal Policy
Independence be Limited?

The arguments in favor of restrictions:



The arguments against:



serious externalities
a bad track record.
Fiscal policy is the only remaining macroeconomic
instrument
national governments know better economic
conditions at home.
EU solution: Stability and growth pact
The Answer to Default Risk:
Stability and Growth Pact




SGP: formal implementation of the Excessive Deficit
Procedure (EDP) mandated by the Maastricht
Treaty.
The EDP aims at preventing a relapse into fiscal
indiscipline following entry in euro area.
The EDP makes permanent the 3 per cent deficit
and 60 per cent debt ceilings and foresees fines.
Evolution of SGP:



Original Pact: 1999 – November 2003
Limbo: November 2003 – March 2005
Adapted Pact: March 2005, in increase flexibility
How the Pact Works

A limit on acceptable deficits: 3% of GDP

A preventive arm


Aims at avoiding reaching the limit in bad years

Calls for surpluses in good years
A corrective arm

Aims at encouraging prompt action when deficit is above
limit

Sanctions applied if limit repeatedly breached
Exceptional Circumstances



Negative growth or accumulated loss of
output over a period of low growth
exceptional
Taking account of ‘all relevant factors’
No specific definitions
The Procedure

When the 3% is not respected:







the Commission submits a report to ECOFIN
ECOFIN decides whether the deficit is excessive
if so, ECOFIN issues recommendations with an
associated deadline
the country must then take corrective action
failing to do so and maintaining deficit below 3 per
cent triggers a recommendation by the
Commission
ECOFIN decides whether to impose a fine
the whole procedure takes about two years.
The Fine Schedule

The fine starts at 0.2 per cent of GDP and rises by 0.1 per
cent for each 1 per cent of excess deficit.
How is the Fine Levied



The sum is withheld from payments from the EU to
the country (CAP, Structural and Cohesion Funds).
The fine is imposed every year when the deficit
exceeds 3 per cent.
The fine is initially considered as a deposit:
 if the deficit is corrected within two years, the
deposit is returned
 if it is not corrected within two years, the deposit
turns into a fine.
Issues Raised by the Pact


Does the Pact impose procyclical fiscal policies?:
 budgets deteriorate during economic slowdowns
 reducing the deficit in a slowdown may further
depress growth
 a fine both worsens the deficit and has a
procyclical effect.
The solution: a budget close to balance or in surplus
in normal years.
The Early Years (Before Slowdown)
Austria
Belgium
Finland
France
Germany
Greece
Ireland
Italy
Luxembourg
Netherlands
Portugal
2001
1998
Spain
-6
-4
-2
0
2
4
6
8
The November 2003 decision
France
Germany
2
2
1
1
0
0
-1
-1
-2
-2
-3
-3
-4
-4
1999 2000 2001 2002 2003 2004 2005 2006
1999 2000 2001 2002 2003 2004 2005 2006
The November 2003 decision


ECOFIN decides to suspend the Pact
The European Court of Justice:



recognizes the right of ECOFIN to interpret the
pact
rules that the suspension decision is illegal
The governments commit to re-examine the
pact
The March 2005 decision

Principles of the pact of upheld



3 % deficit limit
fines, to be decided by ECOFIN
Flexibility introduced


Will take into account debt level
Will take into account growth over recent years
And now?