The Stability And Growth Pact And Experiential Discussion Economics Essay

Published: Last Edited:

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.


The focus of the current paper is on the issues of the reform of the euro area in the ways of establishment of a fiscal union and of the Satibility and Growth pact. The research questions of the paper are 'Does the euro area need a common fiscal policy and governace? and What made it impossible for the Stability and Growth Pact to work as an efficient fiscal regulator of member states?' The paper is mainly concentrating on the member states of the euro zone, hence the case of the eight members states not meeting the Maastrich convergence criterias and also of the United Kingdom and Denmark, who opted-out of the single currency system will not be discussed. The main aim of the paper is to give a coherent and sensible answer to the research questions by firstly analyzing the theoretical background of the need of a fiscal policy and secondly by considering various aspects of the euro area in the past and the present.

Theoretical background - the role of fiscal policy

The two major macroeconomic policy instruments are the Neoclassical or so-called Orthodox and the Heterodox approaches. In macroeconomic theory the role of fiscal, monetary and wage policy are identified and discussed by the two instruments by focusing on different economic elements of these policies. The Orthodox find that for monetary policy the main purpose is to achieve price stability as if inflation is above target, interest rates will rise and so as a result aggregate demand falls which is highly affecting investment and exchange rates. Hence price stability is essential for the coordination of market economy and this can be most effectively reached by the quantity theory of money or by inflation targeting. For the Heterodox, monetary policy's most crucial role is to promote investment through long-term interest rates.

Focusing on the role of fiscal policy, the Neoclassical view rejects the need for fiscal policy as the market system is able to stabelize itself, whereas no policy coordination is needed as supply and demand will adjust to price signals generating stability. The Neoclassicals are warning against higher interest rates, a sin their perception fiscal deficit can cause an increase in the demand for borrowing which results in higher interest rates and finally int he "crowding out" of private investment. The Heterodox have a different as without a coordinated fiscal policy higher unemployment can be experienced. As aggregate demand is unstable an active fiscal policy is needed in order to stabeelise the demand at higher leve of employment. If aggregate demand falls, output falls, and as a threat unemployment rate is starting to rise, therefore the government needs to manage aggregate demand. Basically for the Heterodox the lack of active fiscal policy results in economic disaster. The Heterodox are also highlighting that the Neoclassical view is wrong stating that fiscal policy is driving up interest rates as there is no evidence for that.

Broadly speaking the major differences among the two macroeconomic policy instruments are rooted in the need for policy coordination, fiscal policy and the target of the market system.

The Stability and Growth Pact and experiential discussion

The European Monetary Union was primarily established in order to reduce the exchange rate fluctuation among member states - so to keep their currencies within ± 2.25 per cent against the central rate (goal of the European Monetary System with the ECU) - and to give to the weaker economies a great opportunity of becoming the part of a larger economic unit. [1] 

The establishment of a real currency, the euro in 1999 instead of the European Credit Unit which was only a single unit of account, based on the basket of member states' currencies, have given the possibility for the European Single Market to reduce expenditures among member states by using one single currency among them. As for the French, it has been a great motivation that the euro could have become a great alternative to the US dollar. And it did become the first major alternative to the dollar since 1945, indeed. Nevertheless, the euro is still mainly used in trade with the European periphery, first of all with Eastern-Europe, and especially after the economic crisis of 2008 when in 2010 the European Banking System has got close to a collapse, the international role of the euro has significantly backslidden.

Whereas, the paper is focusing only on the members of the eurozone, it must be also highlighted that the euro area has right now only seventeen members and there are ten potential future members from the twenty seven member states. Among the ten states outside of the common currency, eight of these countries did not meet the Maastricht convergence criterias - set up in 1992 - and two of them, so Great Britain and Denmark meeting the criterias, opted-out of the system. The divided feature of the Monetary Union gives a for the birth of a two-speed Europe where a core and a periphery group are sharing different right sin decision-making. As not all member states are part of the monetary unification, making enhanced economic coordination has become impossible, not mentioning the disadvantages for the "outsiders" at the potential creation of a common fiscal policy. [2] 

The Stability and Growth Pact, established in 1997 was basically a German proposal to enhance the Maastricht convergence criterias. The aggravation concerned the government deficit target, as it could not be more than the three per cent of GDP and it had to be zero per cent of the GDP over an economic circle. The pact has introduced the so-called "excessive deficit procedure" (EDP) which had the original deadline of one year. [3] 

The Stability and Growth Pact's fiscal coordination has showed a „hybrid nature of European macro-economic governance". As the SGP allocated primacy to annual budgets as a shift from the Keynesian economic theory, to long-term fiscal coordination. [4] Nevertheless the Stability and Growth Pact has failed to distinguish the deficit emerged from invest spending and investment.

The main goal of the fiscal instruments was to help member states balancing their budgets by setting up sanctions as it has been crucial to avoid collapse because of the higher interest rates generated by the later inflation. Even together with the preventive -economic policy coordinations- and punitive arms -"excessive deficit procedure"- the fiscal policy coordination of the pact has failed to succeed. [5] 

The Stability and Growth Pact was finally relaxed in 2005 after even Germany and france, the two leading economies of the eurozone have failed to keep their government budget deficit under 3 percent of the GDP for several years. It soon became clear that the Stability and Growth Pact has ordained for the member states to achieve unreachable goals.

Romano Prodi the then existing President of the European Commission has agreed that Stability Pact did not reach its target and he also called it "stupid". As he claimed: „The pact is imperfect. We need a more intelligent tool and more flexibility." [6] 

For the eurozone and the European Monetary Union sustainability is the most important for functioning accurately. As the Stability and Growth Pact has failed to maintain long-term stability of government budget deficits, other central coordination is need in order to maintaiun the long-term stability of public finances. Even the Maastricht Treaty (1992) has drawn the attention of the member states to avoid such fiscal policies which can cause an unstable balance of payments. As members of the European monetary union, the seventeen member states' national fiscal policy plays a crucial role in policy coordination and to maintain sustainable public finances. However this is not enough, and ttransferring national level policies and economic sovereignity to the European level is required, and most possibly cannot be avoided anymore. [7] 

The lack of common fiscal policy has also contributed to the uneffectiveness of first economic 'crisis-plans'. The European Union did not response enough effectively to the real economic threatments of the financial crisis when the European Economic Recovery Plan has got established in the end of 2008. The Recovery plan failed to diminish the total effectsof the financial crisi and this was rooted in the uncoordinated national policies and measures used by the member states. [8] Later in 2010 at the peak of the crisis the so-called "long-term refinancing operations" have been set up when the European Central Bank provided banks a three year long loan with one per cent interest rate and no conditions.

If there is no active fiscal coordination supporting monetary decisions and vice versa, previous experiences show that no market economy can survive. As the european union has no common fiscal coordination today it is questionable wether the monetary union with its seventeen membersates will survive the economic crisis, or not. A fiscal union is needed where the taxation and budgets are resolved by a central decision making plenum. Throughout a coordinated fiscal policy, in difficult times money could be shifted from strong economies to weak ones. A coordinated fiscal policy supporting the European Monetary Union should serve two main practical purposes:

- Firstly „to allow the determination of a global fiscal policy in a way that is sufficiently responsive to evolving domestic and international requirements"

- and Secondly „to avoid tensions arising from excessive differences between the public sector borrowing requirements of individual member countries". [9] 

Nevetheless, political implementation of a common fiscal policy could be difficult as a shift towards fiscal policy also involves a major shift from economic union to political union. As being still too close to the peak of the 2007/2008 economic crisis, the governments are unwilling to give up their political or further economic sovereignity. Currently the implementatio of a fiscal policy on European level seems most impossible as the governments are afraid of losing decision making, as if a government looses its fiscal policy, it looses control over economic decisions. Fort he member states of the Monetary Union the single currency did not mean equally single government, only easier and cheaper trade and macroeconomic stability. It is another issue that these countries have already lost control over their economies and as no monetary policy can survive without a fiscal policy it would be more beneficial adapting to a common European fiscal policy.


Supporting the heterodox view of fiscal policy.

No monetary policy can survive without a central and well designed fiscal policy, however most possibly the implementation of a central fiscal governance - especially after the economic crisis of 2007/2008 in politically so uncertain times - would be risky and most difficult as the member states would be afraid of losing more of their control over thier economies. However, without a doubt it can be easily stated, that the member states of the euro zone have already lost controll over their economies.

Without a common European fiscal policy the future of the euro zone is vague.