Stabilization Pact Logic Turned On Its Head
As part of the European Monetary Union, there is something called "the stabilization pact" that would prevent members of the euro area from running too big budget deficits, no more than 3% of GDP except during recessions. The argument for this was that when the national exchange rates were abolished, countries with large deficits would no longer have to fear runs on their currencies, similar to the ones that forced Sweden, the U.K. and Italy out of the ERM in the early 1990s, and that the high deficits would destabilize the entire euro area once interest rates were made equal.
Yet this argument was actually flawed in several ways. First of all, while it is true that it will be easier to run a deficit within the EMU than in the old fixed exchange rate ERM system, it is not the case that it is easier to run deficits within the EMU than in a system of floating exchange rate. Indeed, it is arguably easier to run deficits with floating exchange rates as any market distrust would lower the value of its currency, which is generally welcomed by politicians.
And moreover, as the very large yield spread between German and Italian government bonds demonstrate, high deficits are in fact punished with higher interest rates within a monetary unions, as markets fear that countries with large deficits might leave the monetary union or default. The equality of interest rates within a monetary union only applies to the risk free interest rate, but as governments with large deficits like Italy are regarded as more risky because of that, they are disciplined.
Moreover, especially with exchange rates fixed, fiscal expansion in one country could provide a boost to exports in other countries. Thus, there is actually no need for a "stabilization pact" as the harmful effects of deficit financing will more or less entirely hit the country that pursues it.
I now see Keynesians Paul Krugman and Mark Thoma argue the opposite case, namely that relatively anti-Keynesian Germany (with Krugman talking of the "German problem") will be a "free rider", as much of the increase in demand from any Keynesian deficit increasing policy in France or Italy will go to the German export industry while Germany won't need to take on additional debt. This makes Keynesians worried that countries might not increase their deficits enough. Apart from the assumption that Keynesian policies are beneficial, I actually think they might be closer to the truth than the people who were behind the stabilization pact.
Yet this argument was actually flawed in several ways. First of all, while it is true that it will be easier to run a deficit within the EMU than in the old fixed exchange rate ERM system, it is not the case that it is easier to run deficits within the EMU than in a system of floating exchange rate. Indeed, it is arguably easier to run deficits with floating exchange rates as any market distrust would lower the value of its currency, which is generally welcomed by politicians.
And moreover, as the very large yield spread between German and Italian government bonds demonstrate, high deficits are in fact punished with higher interest rates within a monetary unions, as markets fear that countries with large deficits might leave the monetary union or default. The equality of interest rates within a monetary union only applies to the risk free interest rate, but as governments with large deficits like Italy are regarded as more risky because of that, they are disciplined.
Moreover, especially with exchange rates fixed, fiscal expansion in one country could provide a boost to exports in other countries. Thus, there is actually no need for a "stabilization pact" as the harmful effects of deficit financing will more or less entirely hit the country that pursues it.
I now see Keynesians Paul Krugman and Mark Thoma argue the opposite case, namely that relatively anti-Keynesian Germany (with Krugman talking of the "German problem") will be a "free rider", as much of the increase in demand from any Keynesian deficit increasing policy in France or Italy will go to the German export industry while Germany won't need to take on additional debt. This makes Keynesians worried that countries might not increase their deficits enough. Apart from the assumption that Keynesian policies are beneficial, I actually think they might be closer to the truth than the people who were behind the stabilization pact.
posted by stefankarlsson at 5:54 PM
2 Comments:
Stefan,
Do you think the riots in Greece (which i am told are partly a reaction to severe economic pressures) are in any way an indication of the future of the Euro ?
No, at most they are an indication of the future of Greece. They appear to be just a bunch of spoiled leftist hooligans who refuse to accept the need for sound public finances. If the Greek government can't overcome the leftist hooligans, then Greece is in trouble. But as Greece is so small, it won't have much effect on the euro area as a whole.
Leaving the euro area and devaluing the currency wouldn't solve the problems any more than it did for Hungary, something likely even the left-wing opposition understand.
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