Monetary Integration in Europe

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Monetary Integration in Europe

• Jan Fidrmuc
• Brunel University

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Monetary Union

• Monetary union implies a choice between exchange
  rate stability and monetary policy autonomy
• The impossible trinity only 2 of the following
  possible simultaneously
• Full capital mobility
• Autonomous monetary policy
• Fixed exchange rates

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Exchange-rate Regime Alternatives

1. Free floating exchange rate
2. Managed float, target zone, crawling peg
3. Fixed exchange rate, currency board, dollarization

4
Exchange-rate Regime Choice

• Adjustment to adverse shocks (business cycles)
  using monetary policy
• Can be misused ? inflation
• Exchange-rate volatility and vulnerability to
  speculative attacks
• Political pressure on exchange-rate policy

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Two Corners

• Only pure floats or hard pegs are robust
• 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

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Metallic Money

• 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

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The Interwar Period The Worst of All Worlds

• 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.

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European Postwar Arrangements

• 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.

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The Bretton Woods System Collapse

• Initial divergence (dollar exchange rates).

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The Snake Arrangement

• Agreement on stabilizing intra-European bilateral
  parities.
• No enforcement mechanism too fragile to survive.

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The EMS Super Snake

• EMS European Monetary System
• A EU arrangement all EU members are part of it
• ERM Exchange Rate Mechanism
• An agreement to fix the exchange rate
• ERM jointly managed
• 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

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EMS Past and Present

• 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)

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Preview The Four Incarnations of the ERM

• 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.

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Four Incarnations of the EMS
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The ERM Key Features

• 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.

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The ECU

• A basket of all EU currencies.

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Evolution From Symmetry to DM Zone

• First a flexible arrangement
• different inflation rates long run monetary
  policy independence
• frequent realignments.

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Evolution From Symmetry to DM Zone
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Evolution From Symmetry to DM Zone

• 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.

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The DM Zone

• 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.

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Breakdown of the DM zone

• 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.
• Bad luck
• 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
• the Bundesbank sets limits to unlimited support.

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Lessons From 1993

• 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)

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The Wide-Band ERM

• Way out of crisis
• wide band of fluctuation (15)
• a soft ERM on the way to monetary union

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ERM-2

• 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
• 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

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ERM Members
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Current ERM-2 Members
Country Date of ERM 2 membership Band of fluctuation
Denmark 1 Jan. 1999 2.25
Estonia 27 June 2004 15
Lithuania 27 June 2004 15
Latvia 2 May 2005 15
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ERM-2 vs ERM-1
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Optimum Currency Areas
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Optimum Currency Areas?

• What currency, or exchange-rate arrangement, is
  optimal?
• For individual countries, groups of countries or
  regions within a country
• What economic criteria should be used?

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E.g. California in the early 1990s

• Is it optimal for California to use the US
  dollar?

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The Economic Toolkit

• There are benefits and costs involved in adopting
  a common currency.
• The solution has to involve trading off these
  benefits.

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In a Nutshell

• Benefits
• No transaction costs, no exchange-rate
  uncertainty
• Decreasing with size of currency area
• Costs
• Economic and political diversity
• Loss of monetary and exchange rate instruments
• Increasing with size of currency area

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OCA Theory

• Focus on the costs of common currency
• Especially on asymmetric shocks
• What are they?
• What problems do they cause in currency unions?
• How can their effects be mitigated?

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Example A demand shock

• Real exchange rate, EP/P, must depreciate to
  restore competitiveness
• Either prices fall or nominal exchange rate
  depreciates.
• If not overproduction and unemployment

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Symmetric Shock

• 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.

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Asymmetric Shock

• Only one country is affected countries share
  common currency Problem!
• Country As real exchange rate must depreciate
  both vis-à-vis ROW and Country B

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Asymmetric Shock

• Country A wants a depreciation.
• Country B is unhappy depreciation would lead to
  excess demand and inflationary pressure.

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Asymmetric Shock

• Country B wants no change.
• Country A is unhappy because of excess supply and
  unemployment.

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Asymmetric Shock

• Common central bank considers preferences of both
  countries and allows partial depreciation
• Nobody is happy.

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Asymmetric Shock

• In the long, the problem is solved.
• How?

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Asymmetric Shock

• 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.

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Implications of Asymmetric Shocks

• 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.

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Six OCA criteria

• Three economic criteria
• Labor Mobility (Mundell)
• Diversification (Kenen)
• Openness (McKinnon)
• Three political criteria
• Fiscal risk-sharing
• Homogeneity of preferences
• Solidarity

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Criterion 1 (Mundell) Labour Mobility

• An OCA is an area within which labour moves
  easily (including across national borders).

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Criterion 1 (Mundell) Labour Mobility

• Labour moves from A to B
• The two supply curves shift
• Equilibrium is restored without
  disinflation/inflation.

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Criterion 1 (Mundell) Labour Mobility

• 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.

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Criterion 2 (Kenen) Production Diversification

• 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.

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Criterion 3 (McKinnon) Openness

• 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.

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Criterion 3 (McKinnon) Openness

• 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.

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Criterion 4 Fiscal Transfers

• 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.

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Criterion 5 Homogeneity of Preferences

• Countries that share a wide consensus on the way
  to deal with shocks form an OCA.
• Matters primarily for symmetric shocks
• prevalent when the Kenen criterion is satisfied.
• May also help for asymmetric shocks
• better understanding of partners actions
• encourages transfers.
• Different interest groups enjoy political power
  in different countries.

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Criterion 6 Solidarity

• 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.

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A summary
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Is Europe An OCA?

• Each point represents correlation between demand
  and supply shocks of particular country with the
  euro-zone average.
• Source Korhonen and Fidrmuc (2001)

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Is Europe An OCA?
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Is Europe An OCA?
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Is Europe An OCA?
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Is Europe An OCA?
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Is Europe An OCA?
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Is Europe An OCA?

• 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

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The Endogeneity of OCA Criteria

• 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?

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The Endogeneity of OCA Criteria Two views

• Optimistic view (Frankel and Rose, European
  Comission)
• Deepening trade integration ? intra-industry
  trade and spillovers effects ? greater symmetry
  of shocks ? OCA criteria more likely fulfilled
  once common currency introduced
• Pessimistic view (Krugman)
• Deepening trade integration ? greater
  specialization ? greater vulnerability to
  country-specific shocks
• No firm conclusion so far

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The Endogeneity of OCA Criteria Optimistic View
T
OCA
EU
Divergence
T
Trade integration
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The Endogeneity of OCA Criteria Pessimistic View
T
OCA
EU
Divergence
T
Trade integration
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Trade

• Eliminating exchange rate volatility by adopting
  a common currency raises trade
• Estimates 50-100
• border effect literature provides similar
  estimates.
• EMU preliminary evidence (Baldwin et al., 2008)
• Trade among EMU countries has increased by
  approx. 5 compared to other countries.

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Labour Markets

• 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.

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Are the Other Criteria Endogenous?

• 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.

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UK and EMU membership

• 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

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UK Treasurys Five Economic Tests

• 1. 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.
  ?
• 2. Flexibility if problems emerge UK labor
  market is more flexible than others, but still
  not sufficiently so. ?
• 3. Investment UK membership in the euro-zone
  would boost FDI inflows to the UK. ?

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UK Treasurys Five Economic Test

• 4. Financial Service and the City Euro-zone
  membership would strengthen the competitive
  position of the City. ?
• 5. Growth, stability and employment Joining the
  EMU would allow the UK to benefit through
  increased trade, investment, competition (? lower
  prices) and productivity growth. ?
• Treasurys 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.

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In the End

• 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.

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European Monetary Union
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The Long Road to Maastricht and to the Euro
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The Maastricht Treaty

• 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).

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The Maastricht Convergence Criteria

• Inflation
• not to exceed by more than 1.5 per cent the
  average of the three lowest rates among EU
  countries.
• Long-term interest rate
• 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.

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The Maastricht Convergence Criteria

• Budget deficit
• deficit less than 3 per cent of GDP.
• Public debt
• 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

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Interpretation of the Convergence Criteria
Inflation

• Fear of allowing in unrepentant inflation-prone
  countries.
• Result convergence in inflation rates before
  EMU entry

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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.

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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

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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.
• Average ? many countries had more than 60
• Several countries debt increased further after
  1991

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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.

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The Debt and Deficit Criteria in 1997
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Architecture of the monetary union
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A Tour of the Acronyms

• 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 (N27).
• The Eurosystem the ECB and the NCBs of euro area
  member countries (N16).

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The System
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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?

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Objectives (1)

• The Maastricht Treatys 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.

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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?

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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.

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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).

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EONIA Co.
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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 (23 years)
• compare inflation forecasts and target, and act
  accordingly.

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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?

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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 Feds
  independence.

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The Eurosystem Weak Accountability

• The Eurosystem must report to the EU Parliament.
• The Eurosystems President must appear before the
  EU Parliament when requested, and does so every
  quarter.
• But the EU Parliament cannot change the
  Eurosystems independence.

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Inflation Record so far

• A difficult period
• oil shock in 2000
• worldwide slowdown
• September 11
• stock market crash in 2002
• Afghanistan, Iraq
• Financial crisis since 2007

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The Euro Too Weak First, Then Too Strong?
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Growth record
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Inflation Convergence and No Major Asymmetric
Shocks
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Fiscal Policy and the Stability and Growth Pact
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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
  inter-temporal 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.

104
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.

105
Automatic Stabilizers
106
Automatic vs Discretionary

• Discretionary actions a voluntary decision to
  change tax rates or spending.

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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

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The Deficit Bias

• The track record of EU countries is not good.

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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.

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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)

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Summary Should Fiscal Policy Independence be
Limited?

• The arguments in favor of restrictions
• serious externalities
• a bad track record.
• The arguments against
• Fiscal policy is the only remaining macroeconomic
  instrument
• national governments know better economic
  conditions at home.
• EU solution Stability and growth pact

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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

113
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

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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

115
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.

116
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.

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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.

118
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.

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The Early Years (Before Slowdown)
120
The November 2003 decision
121
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

122
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

123
And now?