Stability and Growth Pact: What Was the Economic Rationale?

Topics: European Union, Council of the European Union, Treaty of Lisbon Pages: 8 (2886 words) Published: July 7, 2011
What was the economic rationale for the implementation of the Stability and Growth Pact (SPG) when the single currency was launched? To what extent is the SGP now redundant?

The Maastricht Treaty of the European Union signed in 1992, established a set of convergence criteria which had to be met by each Member State before it could adopt the Euro. This was to ensure that economic development within the Economic and Monetary Union (EMU) is balanced so that all Member States joining the Euro entered on the basis of similar economic conditions and sound public finances.1 Thus, the Stability and Growth Pact (SGP) ensures EU Member states continue to observe the Maastricht convergence criteria. Adopted by the euro zone in 1997, the SGP was a political agreement that was set up to enforce budgetary discipline of the Member States, after the Euro was launched as part of the third stage of Economic and Monetary Union (EMU). It was designed to contribute to the overall climate of monetary stability and financial prudence to ensure the long term success of EMU. 2 It is widely held view, particularly in the current state of affairs that governments are more inclined to spend than they can afford, thereby forcing future generations to burden this spending via higher taxes and resulting in so called “deficit bias” of national budgetary policies. The ageing population of EU, in which its citizen have generally led more active and healthy lifestyles, has resulted in people living longer. This has also had a significant impact of growth and contributed to strong pressures to increase public spending. Thus, continuous high deficits and excessive debt levels by governments have been a cause for concern, leading to greater expectations of inflationary pressures and consequently higher interest rates which may endanger the economic growth, welfare and financial sustainability of the economy. In particular, larger deficits induce a greater need for government financing through which it may issue more public bonds with higher yields to financial investors and thus “crowding out” private investment. Moreover, such high deficits can have adverse spillover effects in the EMU, in which the costs of fiscal indiscipline are collectively experienced. For example, a substantial deficit by one member state may induce inflationary pressures in both that country and the euro area, enticing the ECB to ultimately raise interest rates which may become a concern for other members.8 Thus, the existence of a collective negative externality calls for collective action. The SGP provides a framework for the co-ordination of fiscal policies via a common fiscal rule that safeguards and encourages the long term sustainability of public finances by preventing Member States from continually running excessive deficits and debts. This fiscal co-ordination is necessary to achieve full EMU. Furthermore, there is need for co-ordination to be explicitly transparent to address the existence of a common externality as there are incentives for countries not to cooperate and divulge away from sound fiscal policies to “prevent countries from free riding on the coattails of others success without contributing”.20As a result, the SGP incorporates a “strict set simple of rules” designed to prevent countries from fiscal profligacy to solve problems of collective action. Also, the absence of independent monetary and exchange rate instruments for individual countries as a consequence of the EMU strengthens the rationale for stabilisation of the economy via fiscal policy, as the only remaining instrument. Thus, the SGP aims to ensure that this single instrument is available at all times to deal with idiosyncratic shocks, preferably by automatic fiscal stabilisation. As it has proven to be more effective in the euro area than discretionary fiscal policy, which is hampered by longer decision making lags prone to deficit bias via political business cycles. In fact, the key rationale...
Continue Reading

Please join StudyMode to read the full document

You May Also Find These Documents Helpful

  • Stability and Growth Pact Essay
  • The Stability and Growth Pact: Pros and Cons Essay
  • Economic growth Essay
  • Economic Growth Essay
  • China’s Economic Growth and Development Essay
  • Essay about economic growth
  • What Was the Japanese “Economic Miracle?” Essay
  • Essay on economic growth

Become a StudyMode Member

Sign Up - It's Free