The Stability and Growth Pact: A Stability and Stagnation Pact?

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The Stability and Growth Pact A Stability and
Stagnation Pact?

• Paul De Grauwe
• University of Leuven

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Introduction

• Two issues concerning the Stability and Growth
  Pact (SGP).
• the long-term objective implicit in the Pact.
• the degree of flexibility provided by the SGP

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Long-term objective

• Consensus today budgetary policies should be
  such as to lead to sustainable government debt
  levels
• Maastricht Treaty has given a practical meaning
  to sustainability
• sustainable debt level is 60 of GDP.
• corresponding budget deficit consistent with this
  target debt ratio was put at 3 of GDP.
• Condition the nominal growth of GDP should be 5

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• Maastricht numerology has important implication
  (now largely forgotten by the European policy
  makers thanks to SGP)
• a country with a debt of 60 and a deficit of 3
  is not in danger of finding itself on an
  unsustainable debt path,
• provided that the medium run nominal growth of
  GDP is close to 5

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• Things have changed since the Maastricht Treaty
• Stability Pact introduced idea that governments
  should balance the budget over the medium run
• Implication the steady state debt ratio that
  countries should aim at was lowered from 60 to
  0.
• A formidable change in objectives, that went
  almost unnoticed at the time the stability pact
  was agreed upon.

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Hypothetical evolution of the debt ratios within
Euroland assuming that the member countries abide
by the pact, and assuming that nominal GDP
increases by 5 a year.
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• The GSP-rule may have some justification for
  Belgium, Greece and Italy as a temporary strategy
  to quickly reduce the debt levels.
• It has no economic justification as a permanent
  strategy.
• For the countries with debt levels of 60 and
  less it has no economic justification whatsoever.
  
• It is also politically unsustainable

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• Idea behind the SGP is very cynical about
  capacity of governments to make productive
  investments.
• Implicitly, the SGP takes the view that
  governments are incapable of making productive
  investments that will benefit future generations.
• Therefore its debt ratio should be zero.
• This view does not correspond to economic
  reality
• Governments, which invest in physical and human
  capital, do raise the productive capacity of
  nations, benefiting present and future
  generations.

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A stability and stagnation pact

• Requirement to bring the debt ratio to zero gives
  strong political incentives to reduce government
  investment
• governments are required to finance all new
  investments by current taxation,
• a large part of the benefits of these investments
  will be reaped by future governments,
• This gives an incentive to governments today to
  reduce these investments and only spend on items
  that benefit the present voters.
• Thus the GSP is likely to lead to lower
  government investments and thus lower growth.

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Why was the SGP introduced?
It was introduced to solve the problem of the
three highly indebted countries It made sense for
these three countries as a temporary strategy The
problem is that it was forced on everybody as a
permanent strategy
Three sinners
Everybody must suffer
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A return to the spirit of Maastricht

• the Maastricht sustainability criterion implies
  that a 3 budget deficit is approximately
  appropriate for most countries of the euro zone
• assuming that the nominal growth rate will be
  close to 5 as a steady state trend.
• Good reason to believe that this will be the case

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• Example
• France, Germany and Portugal,
• three countries that have been singled out by the
  procedures set out in the SGP.
• If these countries keep their budget deficits
  equal to 3, then their debt ratio stabilizes at
  60

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How much flexibility?

• The defenders of the stability pact argue that if
  countries keep a balanced budget over the
  business cycle, they will have enough flexibility
  during a recession allowing them to let the
  budget deficit increase up to 3.
• This should be sufficient for most countries to
  follow an anti-cyclical budgetary policy during
  most recessions

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• Thus the stability pact instructs countries to be
  on a high-speed declining debt path before they
  can hope to exploit the flexibility of the pact.
• The result of this idea is that the countries
  that are not on such a path, are forced to reduce
  their debt to GDP ratio during the present
  economic slowdown.
• there is no economic justification for most of
  the euro zone countries to follow such a strategy
  in normal times.

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• There is even less justification for such a
  policy prescription during a recession.
• During recessions, debt ratios tend to increase
• Such an increase is desirable to offset
  deflationary forces

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Again lets go back to spirit of Maastricht

• This has two components.
• countries set a medium term target for the debt
  ratio, say 60.
• in the short-run, deviations around this target
  are allowed so as to stablize the business cycle.
  
• Note this is the same as setting a 3 deficit on
  average over the business cycle and allowing
  deficits above 3 during recessions.
• Clearly the rule should be symmetrical, i.e.
  during booms the deficit should decline below 3.
  
• Without such symmetry the debt ratio cannot be
  stabilized at 60.

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Alternative debt criteria

• There is nothing sacred about 60
• One may argue that for some countries the
  sustainable debt ratio is lower than 60
• Here are the possible choices (assuming again 5
  nominal GDP growth)

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• Example
• Suppose, that the right debt ratio for Germany is
  40,
• this implies that the steady state deficit that
  Germany should aim at over the cycle is 2.
• Thus even under this more restrictive debt
  target, there is still no reason to impose a
  balanced budget over the cycle as the SGP does.
• One can also reasonably argue that the present
  deficit overshoot in Germany should be tolerated

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A Proposal

• 60 is maximum
• Each country declares target debt ratio below 60
  (e.g. 50)
• Warning mechanism starts when debt ratio comes
  close to 60
• Excessive deficit procedure is triggered when
  debt ratio gt 60

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Conclusion

• if the Maastricht 60 debt criterion is
  sustainable debt ratio to which countries can
  choose to converge
• then the present budgetary situations of France,
  Germany and Portugal are not troublesome,
• these countries should not be forced to increase
  taxes and reduce spending in the midst of an
  economic slowdown.
• if we have reasons to believe that the 60 norm
  is too high for these countries,
• then we have to identify the debt ratio that is
  sustainable for these countries.
• even in this case the policy prescriptions will
  be far removed from the SGP.

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Daniel Gros Rule is too slow for highly indebted
countries
Decline in debt ratio not really at a
satisfactory pace
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