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.
[...] Mundell-Fleming Model with floating rates and Perfect Capital Mobility r r B LM LM LM' BP BP A IS' A C B IS IS IS' Y Y Effect of a Budget Expansion Effects of a Monetary Expansion Yield interest rates world rates (international market) Thanks to this IS-LM model in an open economy we can analyze the effect of economic policies: Budget expansion The increase in G (public expenditure) causes a shift of IS (balanced goods market) from the left to the right. [...]
[...] All the member states can be made better off if constraints are imposed on the amount of debt that each fiscal authority can issue.” According to Chari and Kehoe, desirability of imposing constraints depends critically on the extent to which the monetary authority can commit to its future policies.” But they two readings of the Maastricht treaty dealing with the one ensures complete commitment to future monetary policy, thanks to its independence) and thus, there's no need for constraints, the other is based on the majority rule which doesn't provide any guarantee of commitment and then, there's a need for fiscal constraints. [...]
[...] the economic models: the necessity to limit budget deficit (milton friedman's theories and the mundell-fleming model) The idea of a Pact of stability which was promoted by German Finance Minister Theo Waigel and the German Bundesbank came from a macroeconomic model that we can be qualified as “monetarist”. Milton Friedman, the of the Monetarist School in Chicago opposed the Keynesian theory. According to him, budget deficit was not an effective tool of macroeconomic governance: it created inflation and did not even manage to stimulate economic activity (because of Ricardian or rational expectations). [...]
[...] The Political Application: Convergence Criteria and the Stability Pact The governments have used these theories to develop the Stability Pact. The need for a stability pact has to be understood as a result of the decision to unify the monetary policy of the 12 states of the Eurozone. Before the EMU was launched, there were two opposite theories concerning the organization of budget policies. Some considered that member states should be able to run them freely as they had already lost control over exchange rates and monetary policies. [...]
[...] First, we may notice that the decision to sanction financially a state that failed to adopt corrective measures is rare and can be seen as a measure of last resort. The Excessive Deficit Procedure is not so rigid. The Stability Pact is made of three elements: if the governments don't respect their commitment to limited deficit (element there are still preventive elements before the sanctions The country has the possibility to negotiate with the Commission when it receives the recommendation and the advice to correct its “stability program”. [...]
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