The Stability and Growth Pact is an essential element of the European Monetary Union and has been often criticized. One of the sharpest and most violent attacks came from the President of the European Commission, which is supposed to be the watchdog of the Treaties and laws, Romano Prodi who declared in an interview to Le Monde that "the Stability Pact is stupid, like all decisions which are rigid." This comment provoked a large debate, as many center-right MEPs and governments consider that the President of the Commission (as well as other politicians like Commissioner Pascal Lamy who said it was "medieval" or the Chancellor of the Exchequer Gordon Brown) should not criticize a rule that is so important for the EMU. The difficulties faced by many countries to meet the Pact requirements (in terms of deficit and debt) legitimize the question whether states should stick to the pact or not. If we consider like Keynes that states should focus on growth and employment and use budget deficits to achieve full employment, then the "rigidity" of the Pact is dangerous, but we should analyze the reasons why other politicians and economists advocate the respect of the Pact.
[...] Some considered that member states should be able to run them freely as they had already lost control over exchange rates and monetary policies. It was the only way to ensure macroeconomic regulation and correct the failures of the market (and react to negative conjunctures, especially to “regional shocks”) as the monetary policy was a global policy one, only oriented towards price stability. The second theory was that some member states would not care about the sustainability of their financial situation and the consequence over monetary and exchange policy (which was not under their responsibility): the other (law abiding) states would thus have to bear the burden of those “free riders”. [...]
[...] Moreover the monetarists insist on the benefits of committing to a “credible low-inflation low-debt regime”.[3] Germany was considered as a model in Europe and as an example to imitate: its independent central bank managed to ensure a stable and strong currency (Deutsche Mark), the budget was balanced and the economic growth was rapid. To understand why budget deficit is not effective, we can also use the Mundell-Fleming model[4] (or IS-LM model in an open economy). If we consider that we live in a situation of floating exchange rates and that the Eurozone is one economic (with a single currency), we can apply the Mundell-Fleming results: monetary policy is effective, not budget deficit. [...]
[...] The internal balance is now in B but it's a situation of external imbalance which results in domestic interest rates higher than world rates There's a trend to revaluation of the domestic currency which has a negative effect on the exports: there is then a shift to the left of the IS curve. We are back to the initial position Monetary expansion The increase in M (monetary mass) causes a shift of LM (balanced money market) from the left to the right. [...]
[...] Prodi proposed to develop more coordinated economic policies and to change the Excessive Deficit Procedure (EDP). The Commission “shall consider whether the excess over the reference value [that is the of the GDP] is only exceptional and temporary and whether the ratio remains close to the reference value”. Moreover, Commission report should appropriately reflect development prevailing cycling conditions, the implementation of policies in the context of the Lisbon agenda and policies to foster R&D and innovation”. The Commission has thus to try to understand the reasons of the deficit and tolerate it under certain conditions (to finance infrastructure, innovation or because of a bad conjuncture). [...]
[...] As governments decided to keep a certain autonomy (instead of creating a real integrated economic government), there was a need for rules that none can deny. The Stability Pact has proven its utility and one should consider that the 2005 reform will enable it to overcome the consequences of the French-German crisis. We must stick to the Stability Pact because it is the only way to have an effective monetary policy. The Pact still lets some margin for fiscal policies. [...]
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