Euro and the Stability and Growth Pact

Discussion in 'Economics' started by fadz, May 15, 2007.

  1. fadz


    The Euro was officially used in circulation in 2002 in 13 European Union countries as well as a few countries outside the union such as Andorra and Monaco. There were a lot of arguments for and against adopting the Euro. Some EU countries decided to opt out of the monetary union, like UK and Denmark. While the new EU participants are in the process of joining.

    It can be said that the biggest beneficiary of adopting the single currency would be the business sector. There has always been a high degree of intra-EU trade with the free movement of goods and services, as well as labour and capital. With the adoption of only one currency, it would help to reduce transactions costs and provide more stability in their operations. Firms are now insulated from the various shocks attributed to dealing with multiple currencies such as exchange rate fluctuations and the need to perform hedging operations hence able to plan their investments more efficiently.

    Consumers also benefit from the Euro. Now they’re able to compare prices of various products irrespective of where the products come from within the Eurozone.This forces firms to be more competitive in their pricing as the consumer has the choice of buying from a place that's able to offer lower prices. Tourists would be able to travel easier without the need to change their money every time and again which could be costly.

    However, it has been said the main disadvantage of entering the Eurozone was that the national governments had to relinquish their right to manage monetary policy which is now controlled by the European Central bank (ECB). This may help to explain the reluctance of some countries such as the UK to join the Euro. Without monetary policy, the countries are less able to react to adverse economic conditions and have to rely solely on fiscal policy such as tax cuts and increased government spending which has a time lag effect where the benefits of such measures would only be felt after a few months or years.

    To enter the Euro, each country also has to adhere to the Stability and Growth Pact (SGP). Basically the SGP has a few requirements that they have to adhere to. The 2 main conditions would be that the national governments must ensure that their annual budget deficit levels do not exceed 3% of GDP and control public debt so as to be below 60% of GDP. These conditions were hard on member countries, like Italy and Greece which were barely able to fulfill the conditions of joining the monetary union. The ECB was also entrusted with the task of ensuring a low inflation rate within the eurozone.

    The reason for formulating the SGP was to help promote fiscal responsibility among the Eurozone governments. It was feared that some member countries, now without monetary policy would increase spending dramatically after entering the Euro. This would cause high inflation and public debt which can have negative effects towards the stability and the ability of the ECB to maintain the value of the Euro. Since the Euro is now used in other countries as well, this doesn’t only affect the country that was fiscally irresponsible but also the other countries. We may use the case of Italy which before entering the Euro had public debts in excess of 100% of GDP and a large portion of annual GDP was used to service these debts. Italy would be tempted to borrow more to finance its spending because of the ability to borrow at lower interest rates at the expense of the other countries higher credit ratings.

    The SGP also encourages the governments to be prudent in spending where they would pay their debts or invest in profitable projects during good economic times to enable them to ride through the bad economic times much more better. Since they paid up their debts, they some room to increase their borrowings again during recessions to cover for any excess spending that might be required to pull the economy back up.

    Having said that, the SGP can be arguably blamed for the poor economic performance that has plagued the Euro countries. As I said above some countries just barely met the convergence criteria and fulfill the conditions in the SGP. There wouldn’t be too much of a problem if the global economy was good because increased trading and the positive business climate would be able to increase somewhat the abilities of national governments to manage their debts.

    However, when the euro was officially circulated in 2002, major global economies such as the US started to slow down partly due to the September 11 attacks as well as the spike in the oil price because of the volatile conditions in the oil producing countries especially in the Middle East. With consumer spending declining, national governments were under pressure to increase their spending but this was made impossible by the SGP because providing fiscal stimulus such as cutting taxes or increasing public spending would result in them breaching the SGP. In fact, some countries did breach it such as France and Germany triggering the Excessive Deficit Procedure (EDP). They were sanctioned by ECOFIN, the body responsible for administering the governments’ compliance with the SGP.

    Unable to accept this, accommodations were reached and new resolutions were added into the SGP. This time, the SGP was more flexible and took in various factors such as business cycles (boom or bust) or if was attributed to achieving European policy goals before deciding to trigger the EDP. No country has ever been fined (which is the most extreme measure under EDP) yet because the new revisions made it more ambiguous and countries can come up with a lot of excuses to explain the breaches thus questions arise in regards to the effectiveness of SGP.

    The fact that the SGP had to be revised in a sense validates the argument that the Stability and Growth Pact was too rigid and didn’t leave national governments a great deal of alternatives to deal with economic downturns in their respective economies. The inability of respective governments to provide sufficient fiscal stimulus could offer an explanation as to why the Euro countries have experienced low growth rates for such a long time. Compare that with for example the UK which has been able to achieve better economic performance for it still has both monetary and fiscal policy. Even if the monetary side was fixed, the government still has quite a free hand in adjusting the fiscal side but this option for the euro countries is limited by the SGP. Therefore we can say that their hands are essentially tied.

    It would be unfair to put the blame squarely on the SGP for all the economic woes in the euro area. There are also a wide range of factors such as the ageing population requiring increase in welfare or the rigid and heavily regulated labour market.

    The question I have is regarding the Stability and Growth pact and whether it should be changed or altered in any form. In its current position, one can’t avoid asking the question as to whether the SGP might have limited the potential that the euro economies could’ve achieved if fiscal policy were allowed to be more flexible.

    Any constructive comments or alternative views on the topic are most welcomed :)
  2. economies are best helped by non-intrusive governments imo. high spending and borrowing by government is intrusive.