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Replacing the stability and growth pact?


The euro-zone is unique in its structure, whereby a single, federal monetary system co-exists with separate national fiscal and labour market management. Central federal competences in Brussels in these latter fields are much weaker than in other federal systems, such as the U.S., Australia, Canada, and Germany.

This separation, between a federal monetary policy and national fiscal and social policies, has caused numerous difficulties. With the member nation states unable to manage (to stabilize) their own economies from (asymmetric) shocks by the use of monetary and exchange rate policies, there would be a natural tendency for them to rely more on fiscal policy for that purpose. But there is then a danger that, in the absence of market discipline causing interest rates and exchange rates to move against, and punish, a country within the euro-zone when its fiscal policy is perceived by markets as imprudent and unsustainable, there would be a systemic temptation towards excessive fiscal deficits. That was the justification for the Stability and Growth Pact (SGP), now firmly established in the Amsterdam Treaty (1997).

But this latter constraint implies that countries within the euro-zone which are suffering from asymmetrically adverse economic conditions are left with no significant instruments of demand management to attempt to improve their economy once they have run up against their SGP deficit limit. What then remains are market mechanisms of wage/price adjustment, fostered where possible by structural reform. Sometimes such market mechanisms work reasonably successfully, as they appear to have done in Germany, where competitiveness has been restored by keeping down the growth of unit labour costs. Sometimes such market mechanisms have not worked sufficiently, as appears to be the case now in several countries in Southern Europe, for example Greece, Italy, Portugal and Spain. In either case there will be an over-powering temptation for such, relatively impotent, Ministers of Finance to blame the ECB for having 'excessively tight' policies, whether, or not, this is the case overall for the euro-zone. The consequent public wrangling has, at times, been unseemly.

Some academics, e.g., Padoan and Rodrigues [2004], have applauded the overall constraint on government demand management policies on the grounds that, when private sector agents have their 'backs to the wall', then structural reforms and greater labour (product) market flexibility will be encouraged. Others, e.g., Mabbett and Schelke [2005], doubt whether structural reforms, and flexibility, are promoted in conditions of economic uncertainty and distress.

It is not the purpose of this paper to discuss either the general issue of what economic conditions may be most conducive to such structural reform, or the more pressing particular question of how Italy, and the other Southern European countries, may escape from their current economic difficulties. Instead, this study adopts the more limited remit of asking how monetary/fiscal issues may be brought into better balance within the euro-zone.

In some part the move to monetary union may have been influenced by much the same 'backs to the wall' argumentation. There were some who realized that the adoption of the euro would introduce tensions between (federal) monetary policy on the one hand and (national) fiscal and other policies on the other, but who believed that such tensions might be creative, in the sense that they could hasten the transition to much wider political union. Some of the French 'monetarists' took this line.

Indeed, one possibility had been that further progress towards closer political union would have brought with it greater fiscal (and other policy) harmonisation and centralisation, but such hopes seem to have been dashed by the negative votes on the referendum on the Constitution by two key founder members of the EU. Moreover, the Stability and Growth Pact itself is in disarray. Its applicability in the future to any large country is in doubt and its asymmetric implementation on small countries is deeply resented by those same countries.

The Stability and Growth Pact was almost bound to fail. It was not in the self-interest of governments, at least in the larger countries of the euro-zone, to abide by it, once they had become members of the euro-zone. Moreover, the penalties for persistent infringement were neither credible nor politically acceptable. In other large federal countries, such as the U.S. or Australia, it is easier to strike a bargain between the federal centre and the subsidiary states. The states agree to abide by some version of a balanced budget commitment, and in return the federal centre provides both stabilisation and redistributive functions. Moreover, the scale of expenditure and revenue flows passing through the federal centre, as compared with the constituent states, means that the federal authority has the clout, though sometimes--as in Argentina--it lacks the political will, to force the constituent states to abide by their side of the bargain.

The size of the federal centre in the European Union is, however, much smaller relative to the constituent nation states than in other federal countries. Moreover, the remaining wide differences in stages of development, and in real income levels, plus the lack of political harmony between countries, and concerns about the possible establishment of dependency cultures, make the allocation of any redistributive function to the federal centre, beyond the present schemes, such as the Cohesion and Structural Funds, doubtful.

In the following section of this paper, I shall argue that the federal monetary policy needs to be supported by some, relatively small, shift of competences from the individual nation states to a, somewhat enlarged, federal budget in Brussels. This returns to earlier exercises that the European Commission (EC) put in motion in prior decades to examine what were the (minimum) fiscal changes necessary to support a single currency. The first of these exercises was the MacDougall Report [1977]. The second was the EC's Report on "Stable Money--Sound Finance," in which I served as an external expert, [see Goodhart and Smith, 1993]. This latter initiative was shelved by the EC after widespread hostility was expressed by the nation state members to the transfer of any further competences to the federal centre. Given the present problems of the euro-system, it would seem a good time to dust down this past work. (1)

The main, but not the only, purpose of this transfer is to allow the federal centre to undertake partial stabilisation services within the euro-zone. It has been argued [Melitz and Vori, 1993] that the individual countries, or at least the larger ones amongst them, can undertake such stabilisation services internally. Even insofar as this is the case, and it is far from self-evident that it is, especially now that the SGP is in place, one of the purposes of the transfer of stabilisation functions would be simultaneously to give the asymmetrically and adversely affected recipient country more reason to be grateful for membership of the zone, and more concerned about potential penalties in exiting the zone. In other words the point of the exercise is, in part, to shift the political economy balance in favour of (continued) membership of the euro. An even simpler proposal, which I owe to Melitz [2003], is just to limit penalties for countries overstepping the SGP deficit limit to those which also have a debt ratio in excess of 60 %. Yet another proposal has been to make the SGP more flexible by accompanying it with the establishment of a market in tradable deficit permits, [Casella, 1999]. (2)

It may seem odd, and against the temper of the times, to react to the defeat of the referendums on the Constitution by arguing for some further fiscal centralisation. But in my view, it provides the minimum necessary to hold the euro-zone together in the longer term. I shall also note that the financial integration of the euro-zone provides an argument for some centralisation of possible fiscal measures for resolving a cross-border European financial crisis.

One of the key structural problems is that all the main institutions in the EU, Commission, Parliament, and so forth, contain all the member states, both those in the euro-zone and those outside it. But the need for federal centralisation is much more acute for euro-zone members, than for non-members. That raises a question whether some institutions, and some functions, can be focussed on euro-zone member states alone, particularly since the entry of the U.K., and Sweden into the euro-zone now seems to have been postponed to an indefinite future.

Nevertheless the scale of fiscal transfers from the federal centre in the euro-zone to the constituent nation states during asymmetric downturns is unlikely to be large enough to persuade them to abide by any self-denying ordinance on budget deficits. So, there is a need to support further federal stabilisation funding, when needed, by stronger market mechanisms to deter the emergence of unsustainable fiscal policies in the guise of a large, and growing, debt burden. What this requires is a complete re-think of the proper prudential capital requirements on financial intermediary holders of the debt of the constituent nation states. This is the subject of the third section.

This paper brings together two previously separate strands of my own work. The first, from Goodhart and Smith [1993], argues for a transfer of stabilisation functions to the federal euro-zone centre. The second, from Goodhart [2005] on "The Links between Fiscal and Monetary Policies on the one hand and Financial Stability on the other," proposes a market mechanism to replace the Stability and Growth Pact [also see Goodhart, 1992]. Taken together, as proposed here, this outlines a programme that could help to replace the SGP. I doubt, however, whether these proposals will be found acceptable. So I remain pessimistic.

Stable Money--Sound Finances

As the Maastricht Treaty (December 1991) on European Union, which paved the way towards the European System of Central Banks and a single currency, was drawing to its conclusion, the European Commission set up a joint EC/academic expert group to explore what changes, if any, needed to be made to Community public finance to underpin the prospective monetary union. The Directorates-General for Economic and Financial Affairs and for Budgets invited some nine independent academic experts, including myself, to contribute to this study. It was chaired by Horst Reichenbach, then acting Director of the Economic Service of Community Policy, and Marc Vanheukelen was its Rapporteur. The main Report, drafted primarily by the EC participants, entitled "Stable Money Sound Finances: Community public finance in the perspective of EMU" was published, after a considerable delay, in European Communities [1993], and the supporting papers, both by the academic experts and the EC economists and officials, were published, more or less simultaneously, under the title, "The Economics of Community Public Finance" in Goodhart and Smith [1993].

It is, perhaps, worthwhile recalling the background to this report. As the Report noted, p. 13,
   In 1977, the MacDougall report undertook a pioneering effort to
   assess in a systematic way the role of public finance in European
   integration. Building on an analysis of the role of the central
   budget in several federal and unitary States and on the insights
   from the available "fiscal federalism" literature, the MacDougall
   report formulated a number of policy recommendations, in particular
   towards strengthening the capacity of the EC budget. Following
   these recommendations, the budget would need to grow to a minimum
   of 2 to 2.5% of GDP. Although it did not elaborate the matter at
   any length, given the breakdown of the first EMU attempt, the
   MacDougall group deemed that the budget had to be raised to 5 to 7%
   of EC GDP for it to be compatible with monetary union.

      Despite the fact that little has come in the way of concrete
   execution of its policy recommendations, the MacDougall report can
   be seen as a benchmark for thinking about the EC budget because it
   took a far-sighted view and large parts of its analytical
   underpinnings remain valid. However, the normative economics of EC
   integration since the end of the 1970s have undergone appreciable
   changes as a result of, on the one hand, a better analytical grasp
   of and longer experience with the integration process itself, and
   of the altered views on the role and effectiveness of public
   economic intervention on the other. The debates on the contents and
   design of, first, an internal market, and, afterwards, an economic
   and monetary union, and the associated benefits and costs, have
   enabled a clearer insight into what EMU entails. The poor economic
   performance of most European countries between roughly 1975 and
   1985 has prompted strong doubts about the usefulness of
   discretionary policy activism in the macroeconomic domain.

   Instead, the emphasis has come to lie more on the need for
   structural adjustment in goods and factor markets, leading to a
   reappraisal of the microeconomic responsibilities of government by
   way of the provision of public goods, deregulation or reregulation
   and incentives related to taxes and transfers.

These final sentences are, in some part, bureaucratic short-hand for a political appreciation that the member states of the EU would not countenance an expansion and an extension of the fiscal competences of the federal community on anything like the scale that the MacDougall Report has advocated as the minimum necessary to support EMU. Indeed, one reason for the temporary suppression of our own Report was to allow time for the Edinburgh agreement (1992) to be achieved on the medium-term development of EC public finances, without scaring the assembled Ministers of Finance that yet more would shortly be asked of them.

So there was a need for the Report to cut its coat to suit its cloth. As noted in the Summary and Conclusions in pp 6 and 7,

The central message of the report is that a small "EMU budget" of about 2% of Community GDP is capable of sustaining European economic and monetary union, including the discharge of the Community's growing external responsibilities (see Table 1).

This is clearly contrary to much of the conventional economic wisdom, reflected in the MacDougall report as well as in the literature on economic and monetary union. Three distinctive features of this report compared to previous analyses explain the difference in the group's conclusions:

(i) The principle of subsidiarity is applied rigorously.

(ii) No explicit role is foreseen for the Community budget in Community-wide macroeconomic stabilization.

(iii) While recognizing that strong political forces are at play and that the reduction of regional disparities is an important Community objective, the economic case for a permanent and substantial increase in interregional redistribution, as a direct consequence of EMU, is found to be weak.

In my view the most important, and possibly original, feature of the Report was that tailor-made stabilization mechanisms, to mitigate the effect of asymmetric shocks hitting individual countries, could be designed relatively inexpensively. Thus again in the Report, (same pages), it was noted that,
   In existing federations, central governments are responsible for
   fiscal policy, with their budgets regarded as a potential
   union-wide stabilization instrument alongside the single monetary
   policy. For Community-wide stabilization the monetary policy of the
   European system of central banks at EC level will be available in
   the same way as in existing federations. The group considers that,
   in addition, attention needs to be paid to the aggregate budgetary
   stance through the coordination of national budgetary policies.
   Making such coordination effective will thus be one of the main
   challenges in the future management of EMU. Nevertheless, the group
   concludes that no explicit role in Community-wide stabilization
   needs to be foreseen for the EC budget.

      In existing federations, the central budget has a significant
   regional stabilization effect. This takes place mainly through
   automatic stabilizers via budgetary flows principally serving other
   purposes, e.g., social security. There are very few explicit
   instruments designed to help regions in the case of economic

      The group shares the view of much of the literature on EMU that
   there is a strong case for a Community role in assisting Member
   States to absorb severe specific shocks. This is in order to
   compensate for the loss of the exchange rate as an adjustment
   instrument and for the loss of an independent monetary policy, and
   should help to prevent longer lasting economic deterioration which
   could increase the pressure for greater redistribution. It should
   also make it easier for Member States to respect fiscal discipline

      Moreover, the group's confidence in this unconventional
   conclusion rests on one of its main findings. Inexpensive and
   effective mechanisms can be operated for assisting Member States
   hit by adverse economic developments (shock absorption) if they are
   explicitly designed for this purpose rather than being the
   automatic implicit consequence of much larger budgetary flows
   serving mainly other purposes as in existing unions. Such a
   shock-absorption mechanism would provide a cushion against adverse
   developments in the Member States to a similar degree as automatic
   stabilizers do, for example, in the U.S. For a shock absorption
   scheme based on changes in unemployment rates, the group estimates
   that the average annual expenditure might be of the order of 0.2%
   of EC GDP.

The background to this central plank to the Report was Section V of the accompanying papers on "' The Economics of Community Public Finance," incorporating the following papers:

Goodhart and Smith [1993], Stabilization;

Majocchi and Rey [1993], A special financial support scheme in economic and monetary union: Need and nature;

Papaspyrou [1993], Stabilization policy in economic and monetary union in the light of the Maastricht Treaty provisions concerning financial assistance;

Italianer and Vanheukelen [1993], Proposals for Community stabilization and mechanisms: Some historical applications; and

Pisani-Ferry et al. [1993], Stabilization properties of budgetary systems: A simulation analysis.

This Report preceded the Waigel initiative to establish a permanent constraint on EU country deficit and debt projections, later metamorphosing into the Stability and Growth Pact agreed at the Amsterdam Treaty. Had this latter been in place in 1993, the argument that the major euro-zone countries could use their individual fiscal policies to stabilize adverse asymmetric shocks [Masson and Melitz, 1991] would have been somewhat weakened.

In any case the regional stabilization mechanism was not the main element in the proposed increase in EC fiscal expenditures from 1.2 percent of EC GDP (1992) to about 1.9 percent in the early years of a single currency. As shown in Table 1, p. 2, of the Report, external aid was projected as a larger share, and structural expenditures about as much.

Moreover the tax basis to finance the expansion of the federal community budget was spelt out. In my view the most obvious candidate not only was, but remains, the seignorage profits of the ECB. Given that the money supply, the euro, was to be, and now is, a unified, single euro-zone competence, it surely follows that the seignorage resulting should also be a federal receipt. The artificial formula, based on relative population and GDP, for dividing this up amongst the constituent nation states has no justification except that of making life easier for national Ministers of Finance. Other possible taxes were on C[O.sub.2] emissions, and, though this was more debatable, cash flow corporate taxes, see Report, pp 86-92, and the associated papers by Spahn [1988, 1993a; 1993b].

While my own paper, joint with Stephen Smith, was strongly supportive, the key papers were by EC economists, the first by Italianer and Vanheukelen [1993], and the second by Pisani-Ferry et al. [1993]. The conclusions of the first of these papers read as follows (p. 505),
   The first conclusion is that, based on an estimated annual cost
   equal to some 0.2% of Community GDP, a full stabilization mechanism
   could be set up which would, on average, provide approximately the
   same degree of stabilization as in the United States. The main
   reason why such a high degree of stabilization can be achieved at
   relatively little cost is that, other than in existing federations
   where stabilization properties are usually a by-product of the tax
   and transfer system, the mechanism proposed here is explicitly
   designed for stabilization purposes. Consequently, its efficiency
   in terms of the degree of stabilization obtained in relation to the
   costs of the system is much higher than that in existing

      A second conclusion, however, is that the full stabilization
   scheme, although being simple and operational, could not be devoid
   of the standard problems involved in stabilization: Identification
   of the shock, an implementation lag and possibly a procyclical
   bias. Nevertheless, it was demonstrated on the basis of two
   different cross-section/time-series estimations for all Community
   Member States that there is a clear link between the evolution of
   the unemployment indicator used for the system and shocks to GDP
   growth in the same year. When the latter variable was replaced by
   its lagged value, this did not change the estimation result.
   Moreover, due to the fact that the scheme is based on changes in
   unemployment rates but consists of intergovernmental transfers, the
   problem of moral hazard with respect to individuals, which is
   usually associated with Community unemployment benefit schemes, is

      The third conclusion is that if, for any reason, the full
   stabilization mechanism is not deemed to be desirable, a limited
   stabilization scheme can be devised at equal or lower cost which,
   as a form of insurance, can nevertheless provide a reasonable
   degree of stabilization in the case of an individual shock above a
   certain threshold. The overall degree of stabilization of both the
   full and the limited stabilization mechanism depends mainly on
   three parameters which ultimately would need to be determined
   politically: The minimum threshold for the relative unemployment
   change which qualifies for payment, the size of the payment and the
   maximum annual payment per Member State. Table 6 gives some
   examples of different scenarios, with their historical cost and
   estimated stabilization properties.

Despite being offered a purpose-built stabilisation scheme, giving as much stabilisation to adversely affected nation states (or regions depending on the structure of the system) as in the U.S., but at a tiny fraction of the cost, the Report was badly received at the time by the representatives of the nation states, roundly rejected and thrown on one side. Indeed it entered the oubliette of rejected Reports, to become almost entirely forgotten.

There was no doubt many reasons for this rejection. At least five can be identified:

(a) An inbuilt disinclination amongst national Ministers of Finance for any transfer of competences, on either the expenditure or the revenue side, from themselves to the Community federal budget.

(b) A concern about the moral hazard implication of any insurance (stabilisation) scheme. Thus the ultimate resolution to asymmetric shocks is usually held to be greater labour market (wage) flexibility. Would intra-euro-zone transfer payments reduce the pressure to introduce structural changes to enhance such flexibility?

(c) A belief that a euro-zone stabilisation scheme was not necessary, since member countries could do just as well on this front on their own, [Melitz and Vori, 1993].

(d) Melitz and Vori [1993] also argued that a stabilisation scheme based on relative movements in unemployment or income, or even on first differences of these variables, could easily cross the borderline into redistribution, because such variables tend to be auto-correlated.

(e) A lack of appreciation that there was any necessary connection, or interaction, between having a federal monetary system and a complementary fiscal system.

Some of these arguments have, in my view, become weaker over time. The idea that labour market reform is more likely to be successful when unemployment is high, or product market reform when profits are squeezed, is not self-evident. In an article in the Financial Times, August 31, 2005, p. 15, on "Only teamwork can put the euro-zone on a steady course," Pisani-Ferry wrote that,
   This interdependence matters especially for measures that are
   costly in the short run, because a lower interest rate can help to
   offset their adverse effects and improve their overall balance.
   This is the case for many reforms. Labour market reforms may
   increase unemployment before they lower it if they create anxiety
   and lead firms to shed labour faster than they create new jobs.
   Product market reforms may also depress growth because incumbents
   react immediately to the loss of rents while entry only develops
   over time. This is why reform is easier when accompanied by
   monetary expansion (to offset the negative effects of reform on
   aggregate demand) and fiscal stimulus (which also helps to
   compensate the losers). This kind of strategy can be followed
   outside the eurozone, not within it--unless reforms are

So a stabilising fiscal transfer, when a euro-zone country is suffering an asymmetric adverse shock, is, it can be argued, just as likely to promote, as to deter, structural reform.

Moreover, self-stabilization implies the assumption of greater debt within the country, whereas a fiscal transfer from the euro-zone spreads the debt burden more widely. Insofar as there is any validity in neo-Ricardian analysis about the dampening effect on present expenditures of future expected taxes, a cross-border fiscal transfer would, euro for euro, be more stimulating than the self-stabilisation. Furthermore, the operation of the Stability and Growth Pact has meant that there have been quite strict limits to the extent that euro-zone countries can self-stabilise by fiscal means, at least without breaking, or bending, the terms of the SGP.

It is certainly the case that one could not base a stabilisation scheme (without redistributive content) on differentials between levels of income or unemployment. But it is implausible that countries would suffer greater declines in income, or increases in unemployment, than other euro-zone countries, on a persistent basis. Moreover, if they did, pressures on them to exit the euro-zone would grow. Take the example of Italy. It is hypothetically possible that continuing lack of competitiveness could lead incomes (unemployment) to grow slower (faster) than in the other euro-zone countries for several years in a row. It is also arguable that in such circumstances fiscal support from other members of the euro-zone would not help to resolve the basic problem, of lack of competitiveness. But if the basic alternatives would then seem to be to bite the bullet in the labour market, or to leave the euro, might a modicum of fiscal help from the other countries of the euro-zone make the first choice more palatable? Also such fiscal assistance could be made repayable in the event of a net debtor country exiting the euro, (but not otherwise).

Finally, realisation that the success of a currency depends crucially on its relationship with the fiscal, and other, policies of the central sovereign body is beginning to become more widely understood. The failure to make that mental link, largely due to errors in mainstream monetary theory, on which I have written elsewhere, e.g., Goodhart [1998], and the consequent weakness of the monetary/fiscal relationships in the euro-zone, was always the single currency's fundamental weakness. If the constituent nation states are going to abide by fiscal rules, and thereby limit their ability to adjust their own economies to a shock, they need to expect to gain something in return. Imposing non-credible, and politically unacceptable, penalties for transgression of the SGP was never going to be successful, certainly not on its own.

The (implicit) bargain in most federal countries is that the constituent states abide by fiscal rules, while the central federal government provides the main redistribution and stabilisation functions. For reasons outlined in the Report, pure redistributional transfers were not advocated. Thus the Report noted, p. 6, that,
   The explicit instruments for interregional redistribution should
   attempt to minimize the inherent dangers of interregional
   redistribution: distributional inertia preventing funds from being
   allocated according to changing needs; aid dependency leading to
   higher factor prices, hindering rather than fostering productivity
   gains and innovation; "grantsmanship," profiting often richer and
   better organized recipients; moral hazard, i.e., creating
   eligibility artificially; and simple economic inefficiency, i.e.,
   "cathedrals in the desert."

Also see the papers in Sections II and IV of "The Economics of Community Public Finance."

In truth, the targeted stabilisation mechanism outlined in the Report was purposefully thinned down to be as small as possible, and yet make a significant difference. It was never expected, or intended, to offset asymmetric shocks completely. Yet it would have a political economy function as well. It would represent a benefit, in facilitating adjustment, from membership in the euro that would help to counter the costs in not being able to adjust to asymmetric shocks that euro-zone membership brings with it. Otherwise a country, facing rising unemployment, with no macro-economic means to respond, may be all the more tempted to exit the euro, and go it alone.

Even, however, with the addition of some centralised stabilisation mechanism, the larger euro-zone nation states will still be tempted to run large deficits during periods of slow, or negative, growth. We discuss how to counter such temptation, and in the process to get rid of the SGP, in the following section.

That leaves the remaining objection to the proposal to introduce a centralised euro-zone stabilisation scheme, which is that national Ministers of Finance (and their officials) are generally opposed to losing any competences to the federal community budget. Note that such a stabilisation scheme would only be applicable, for obvious reasons, to euro-zone countries. Those EU countries, such as the U.K. and Sweden, which are not members of the euro-zone would not benefit, since the scheme would hardly be applicable to them. This suggests that such fiscal decisions should be the province of the euro-zone heads of state. Again Pisani-Ferry [2005] has put the point well; he wrote,
   First, the institutional framework needs to be adapted. The
   eurozone finance ministers who meet in the eurogroup do not set the
   reform agenda. The heads of government who are in charge of that
   agenda never meet in eurozone format. Neither do the labour or
   economy ministers. A eurozone meeting of the heads of government
   would remind them of their responsibility for the sustainability of
   the currency area that they have created, and would allow them to
   discuss their reform agendas and confront the effects of their

There would, however, be constitutional and institutional problems in shifting the balance of government from the European Union more widely to the narrower euro-zone. All the main institutions, Commission, Parliament, Court, are established at the wider EU level. It was never envisaged that the EU would be split on a quasi-permanent basis, with a long-standing division between a central euro-zone group and a penumbra of member states with independent monetary policies. Can the euro-zone continue successfully without supporting fiscal, and related, governance mechanisms? But if such governance mechanisms were established at the euro-zone level, what would happen to the established wider EU institutions? These are deep questions, which go beyond the scope of this paper.

Of course, it remains quite probable that the euro-zone politicians on their own would still reject a mutual self-help federal stabilisation scheme. That would just underline the key point that it is inherently extremely difficult to combine a single federal monetary system with a decentralised system in which fiscal and most other sovereignty is retained at the nation state level. The euro system is not only unique; it is also uniquely unbalanced, as between the federal monetary system and the national fiscal systems.

It is also unbalanced in another, but quite similar, dimension. This is that macro-monetary policy resides, at the federal level, with the Governing Council of the ESCB, but responsibility for systemic financial stability and crisis management resides with the nation states. As Padoa-Schioppa [2004] has written, in his Chapter on "Supervision in Euroland," in Regulating Finance,
   This essay will focus on another, less fundamental but still
   important novelty of the euro-area's monetary constitution. It will
   discuss the novelty of abandoning the coincidence between the
   jurisdiction of monetary policy and the jurisdiction of banking
   supervision. Monetary policy embraces the twelve countries that
   have adopted the euro, whereas banking supervision remains
   national. Just as there is no precedent of any comparable size of
   money disconnected from states, there is no precedent for a lack of
   coincidence between the two public functions of managing the
   currency and controlling the banks. In the run-up to the euro this
   feature of the system was explored, and some expressed doubts about
   its effectiveness.

This latter divorce, in my view, arises largely from another facet of the monetary/ fiscal imbalance in the euro-zone. This is that the resolution of a financial crisis can prove very expensive. The only present source of funds to meet such crisis calls is to be found in taxpayers' money in each individual nation state. If the individual euro-zone Treasuries are to bear the costs of financial rescues, they are going to want to be able, if not to run the show, at least to have a veto, a control, over any use of their own funds. He who pays the piper calls the tune.

Whereas it is generally believed that the initial decision to give no clear-cut prudential role to the ECB was due to the ideological position at the time of the Bundesbank and the German representatives at Maastricht, the deeper and longer-lasting barrier is the absence of any euro-zone fiscal competence in support of ECB crisis management. Indeed, absent any such fiscal back-up, the ECB may even be reluctant to participate in Lender of Last Resort (LOLR) operations, because such LOLR actions may leave a central bank open to the risk of loss, depending on collateral and margin requirements. Without fiscal support, the ECB may prefer the member National Central Banks, with their access to national Treasuries, to take full responsibility for any necessary LOLR action.

So the argument here is that, should there be a desire to centralise the financial stability function in the euro-zone, alongside the single macro monetary policy function, then the very first priority is to identify how the associated necessary fiscal support may also be centralised. There are various possible ways of doing so, and I intend to do further research on this, in conjunction with Dr. D. Schoenmaker of the Netherlands Ministry of Finance, [see Goodhart and Schoenmaker, 2006]. Perhaps the simplest alternative would be to allow the EC to borrow, in order to raise funds to resolve and settle a cross-border financial crisis. As in the case of the Tripartite Standing Committee on Financial Stability in the UK, restriction on undue resort to such usage of funds could be achieved by giving each party to the exercise, that would be the EC, the ECB, any separate Euro supervisory body, and perhaps also the main national bodies involved, a veto to prevent the use of such rescue funding.

How to Replace the Stability and Growth Pact

Walter Wriston of Citibank is notorious for having claimed that "Sovereigns never go bankrupt." This is not necessarily so, even when the sovereign offers debt denominated in its own currency. When, however, a sovereign, or a subsidiary layer of government, issues debt in the currency of another party, then the debtor can no longer meet its obligations by printing money to do so, thereby reducing its real cost by inflation. In this case, of foreign currency debt, the choice on the debtor reverts to two, i.e., raise the requisite funds or default. That raises the potentiality for default considerably.

Most emerging market economies (EMEs) find it hard to borrow much in their own domestic currencies. Lenders fear the temptation for such government borrowers of subsequently inflating away the real value ('original sin'), and the markets for such debt are thin, with large bid-ask spreads and sizeable other transaction costs. The roll-call of EMEs who have defaulted on their foreign currency debts is long, and needs no repeating.

But just as EMEs cannot issue debt denominated in their own currency, nor can subsidiary governments, at regional, provincial, state, local, municipal levels. When federal control of subsidiary-level deficit financing is weak, as has been the case in Argentina and Brazil, for example, then this tends to work back to weaken fiscal control at the federal centre. There are several reasons for this:

(1) Financial: Many local banks and other financial intermediaries (OFIs) hold so much local government debt that they would also be driven into default by the failure of their local government. So the initial public sector default could/would generate a wider financial sector debt/default spiral. So the subsidiary government cannot be allowed to default and must be bailed out.

(2) Political: The collapse of a major subsidiary government with large outstanding debts would adversely affect so many other stakeholders (beyond the banks and OFIs) that it would adversely impinge on the standing of the political party in office at the federal centre.

(3) Reputational: The default of a major local governmental body would cause an immediate review, and re-rating of all other possibly similar-based bodies, and indeed very possibly of the federal government itself. There could be a contagious crisis.

For all these reasons there has usually been an (implicit) contract between the federal and the provincial (subsidiary) layers of government. On its side the subsidiary (State) government agrees to some fairly stringent (often Federally imposed) constraints on its ability to run deficits. On the other hand the Federal government implicitly (or even explicitly) guarantees the debt of the lower level governments, and, partly through automatic stabilisers and partly directly, offsets adverse asymmetric shocks affecting differing regions by a system of inter-regional fiscal transfers.

There is no basis for such a bargain amongst the major countries and the federal institutions in the euro-zone. The federal institutions in the EU have neither the ability, nor the wish, to guarantee the deficits of the subsidiary state governments. The ECB is admonished not to support failing State governments, and there is no fiscal competence at the federal level either to make inter-regional transfers in response to asymmetric shocks or to support the ECB in meeting the burden of bailing out a failing State government. So the federal government in the EU neither can, nor wants to, carry out its part in the kind of implicit bargain observed in other federal systems.

Since there is no quid-pro-quo from the federal side, it is not surprising that the (large) nation state governments in the euro-zone chafe at the constraints imposed on their freedom of fiscal action by the Stability and Growth Pact, despite the fact that the SGP gives them more fiscal flexibility than available to subsidiary state governments in many other federal countries, e.g., in U.S. Absent observance of the SGP, excessive deficits in the EU could be a major potential source of financial fragility.

An additional problem is that the financial regulators, being mostly public sector bureaucrats themselves, are prone to be 'captured' by, to be unduly concerned with, their masters, and their masters' concerns, in Ministries of Finance. Thus regulators are inclined to give low risk-weightings to nation state debt irrespective of whether such debt is in foreign currency or domestic currency form. The independent ratings agencies are better in this respect, but may still be somewhat swayed by political pressure. In particular, there is no appropriate risk weighting for concentrations of (bank) holdings of the debt of a single obligor. Thus Belgian banks hold vast quantities of Belgian Government debt; Italian financial intermediaries massive holdings of Italian government debt, and so forth. In the absence of a strict, and strictly observed, SGP, this is a source of danger.

If the SGP is found to be unenforceable, or so relaxed as to be ineffective, this danger would need to be recognised. What should be done is then to relate the risk-weighting to the proportion of the portfolio represented by any single obligor's debt, where that debt was denominated in foreign currency form, (remembering that the euro is effectively a foreign currency for the member nation states, in the sense that no member nation state has any control over the printing press). Thus, under an appropriate risk weighting, a bank might hold up to, say, 2 1/2 percent of its assets in the debt of any one such obligor, at the risk weighting applied to that obligor. Beyond that, and on an increasing scale, the risk-weighting applied to concentrations of such risk would rise. The idea would be effectively to limit the holdings of, say, Greek government debt in Greek banks and other Greek financial intermediaries.

The purpose would be to try to ensure that, if a euro nation state defaulted, it would not drag down its own financial system into a messy collapse with it. By the same token a euro nation state government which was increasing its debt would have to persuade the wider market, beyond its own domain, to buy that debt. There would no doubt be transitional problems. Nevertheless imagining the counterfactual of thinking through what would happen if the financial intermediaries in the highly indebted euro-zone countries were induced to lighten their holdings of such debt significantly, indicates what a powerful mechanism of market control this could be.

Ignoring the real transitional problems, could one impose appropriate prudential requirements on concentrations of foreign currency government debt, and then leave the control of euro-zone fiscal deficits to market mechanisms alone, junking the SGP entirely into the dustbin, alongside other failed institutional devices? One of the main advantages, however, of joining the euro-zone for those countries with relatively high debt ratios was that it brought down the interest rates that they had to pay on their own debt below the levels that they could have obtained on their own. If this benefit, of euro-zone membership, was to be (progressively) removed, the case for them remaining in (or joining) the euro-zone would be significantly weakened. Some of the other euro-zone members states might, however, view that with equanimity.

Another major problem is that the market's penalty for 'excessive' deficit/debt is to push up required yields, and this leads to a knife-edge (saddle-point) condition. If fiscal conditions appear good, default risk is perceived as low, which helps to keep interest rates low, which in turn helps to keep down the deficit, which keeps fiscal conditions looking good. Then assume some adverse event occurs which raises perceived default risks. Then required yields rise, which raises the deficit further, which makes fiscal conditions look worse. In one of the key supporting papers of the Delors Committee, Lamfalussy [1989] argued the need for an accompanying fiscal constraint to the single currency on the grounds that markets do not move continuously. They appear to move late, (in response to a worsening fiscal position), but when they do, to do so abruptly and, perhaps, excessively.

Moreover, even if the financial reason (1 above) for bailing out a financially failed nation state was removed, or at least much mitigated by this proposal, that would still leave reasons (2) Political and (3) Reputational and Contagion. Nevertheless, the apparent problem is not one of deficits, or debt levels, per se, but rather one of fiscal (un)sustainability and potential default. What is fiscally sustainable, or not, is a hideously difficult question; it depends on future configurations of growth, real interest rates, demography, the balance of state/private commitment to pensions, education, health, and so forth, which are inherently unknowable. One potential institutional suggestion, which might be valuable, (whatever the balance between market mechanisms of control over euro-zone nation state government deficits and SGP-type mechanisms), would be to establish at the central EU level an independent, academic body of economists, to assess the long-term sustainability of each nation state's fiscal sustainability, and to report. To ensure such independence, and academic standing, appointment would be made by the leading economic society in each country, not by Ministers. An exactly similar proposal has been put forward by Frankel [2005].


One of the main hypotheses, or themes, of this paper has been that the basic problems of the euro arise from a common error in monetary theory. This (mainstream) error is to assert that the functions and development of money involve primarily the minimisation of transactions costs, in a context which can be quite separate from government and the various functions of the State. Consequently relatively little attention was paid to the crucial issue of what accompanying fiscal reforms needed to be made to support the euro. The main exception, the Stability and Growth Pact, initiated by Theo Waigel of Germany, was badly designed. There were few, arguably no, offsetting benefits (carrots) for countries committing themselves to give up their own abilities to use fiscal policy to mitigate asymmetric shocks, and the disciplinary mechanism (stick) was badly designed. The earlier attempt by the EC in its Report "Stable Money--Sound Finances" [1993] to do this exercise had been rubbished, and forgotten.

It is an opportune time to resurrect this Report. A well designed, and specifically engineered, stabilisation function could be transferred to a central euro-zone budget, largely, perhaps entirely, financed by shifting the seignorage receipts from the euro to that same budget. The prohibition of borrowing against future revenues could be lifted, allowing the euro-zone to provide fiscal support to help handle cross-border financial crises. All this would involve euro-zone fiscal institutions, since the issues of stabilisation and crisis handling are germane to the euro-zone countries, but not to the EU non-members.

Even despite the carrot of intra-zone fiscal transfers to help countries respond to asymmetric shocks, there would still be incentives, pressures, and temptations for politicians in constituent nation states to indulge in unwise and unsustainable deficit finance. It is not sensible to try to deal with this by self-imposed fines. The Stability and Growth Pact should be junked. The way forward is to recognise that sizeable accumulations of the debt of such constituent nation states are truly risky, especially when piling up in the banks and financial intermediaries of that same country. There needs to be a rising marginal capital requirement applied to the holding of the debt of any one obligor, so long as that obligor does not have command over the printing press, (and perhaps even when it does, but at a more gradual gradient). The aim is to prevent euro-zone nation states parking their excessive debt in partly captive domestic financial intermediaries.

Making the financial system of a constituent nation state safe in the event of the default of its own government would make the no-bail-out provision much more, but far from fully, credible. A further reform would be to establish a European-wide fiscal institute, whose members should be appointed by the countries' leading economic associations, not by politicians, to provide independent assessments of the sustainability, or otherwise, of each country's fiscal policies. One would expect ratings agencies and markets to take note.

I believe that this package of reforms would work. But I doubt very much whether any of it will be put into practice.


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(1) Also see Feldstein [2005].

(2) Countries would be allocated permits to run a deficit up to the SGP limit. A country which expected its deficit to exceed that limit could bid for permits from a country expecting to undershoot its own limit. "At the time final fiscal statistics are made public for example by the end of April of the following year--each country must have in its account a sufficient number of permits..." Any country not in compliance "faces a steep fee." While this is the kind of nice idea that good economists put forward, it is impractical. Why would (large) countries be any more likely to pay such a fine than to honour the existing SGP penalties? There would be immense pressure on official statisticians to manipulate the figures for the fiscal deficit. Trading would have to be on the basis of ex ante expectations, but the fines would be on the basis of ex post outcomes. So the imposition of fines would often arise on the basis of unforeseen shocks, perhaps of a nature that would make a fine seem unfair and inappropriate.

More generally, contracts of this kind, which as Casella notes have been successfully used for trading in pollution permits, are more easily introduced within a single sovereign country. The sovereign establishes a legal system, e.g. for settling disputes, and can deploy a range of sanctions against those who infringe its laws, including contract law. It is, to say the least, doubtful whether the federal centre within the euro-zone has the legal infrastructure and capacity to impose sanctions on its member nation state governments that this kind of approach would require.

CHARLES A.E. GOODHART, Financial Market Group, London School of Economics--United Kingdom. Presidential Address at the Sixty-First International Atlantic Economic Conference, March 15-19, 2006 Berlin, Germany. My thanks are due to Peter Kenen, Jacques Melitz, Warren Mosler, Waltraud Schelke and Randy Wray and to the editors of this journal for their most helpful suggestions, corrections, and advice. All remaining errors are my own.

EC Expenditure in the Early Years Following
the Introduction of a Single Currency and
Comparison with the 1992 Budgets

                            Indicative           %
Expenditure Categories     %  of EC GDP      of Share

Agricultural                 0.4 to 0.5          23
R&D, infrastructure,        0.15 to 0.2          10
  energy, education,
Structural expenditure       0.4 to 0.5          23
   Cohesion Fund)
External aid                0.5 to 0.55          27
   (including EDF *)
Expected outlays              About 0.2          12
  under regional
Other                               0.1           5

Total                      1.75 to 2.05         100

                             1992         % of Share
                           Budget as        in 1992
                           % of 1992       Including
Expenditure Categories        GDP           EDF *

Agricultural                  0.67            56
R&D, infrastructure,          0.06             5
  energy, education,
Structural expenditure        0.32            27
   Cohesion Fund)
External aid                  0.07             6
   (including EDF *)
Expected outlays               --            --
  under regional
Other                         0.07             6

Total                         1.19           100

* EDF = European Development Fund.
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Author:Goodhart, Charles A.E.
Publication:Atlantic Economic Journal
Geographic Code:4EUUK
Date:Sep 1, 2006
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