Federal Reserve Bank of San Francisco

FRBSF Economic Letter

1997-23 | August 15, 1997

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Fiscal Constraints in the EMU

Mark M. Spiegel

The current plan for a common currency in the European Monetary Union (EMU) includes a set of rules governing member countries’ government finances, known as the Growth and Stability Pact. This Pact, which was ratified in the June 1997 Amsterdam Summit, commits EMU members to government budget positions which are close to balance and specifies explicit sanctions for persistent excessive government deficits.

In agreeing on the Pact, the European Council stated that sound government finances “…are an essential condition for sustainable and non-inflationary growth and a high level of employment.” While this may well be true for an individual country, it is unclear why nations would feel a need to include such a pact in an international treaty. In particular, given that the 1992 Maastricht Treaty explicitly includes a “no bailout rule,” which prohibits the European Central Bank (ECB) from assisting a nation experiencing fiscal difficulties through accommodative monetary policy, it is unclear how chronic fiscal deficits in one EMU member nation would adversely affect its EMU partners.

In this Economic Letter, we examine the economic arguments for such a pact. We first review the contention by some economists that the arguments for such a pact are weak. We then argue that a macroeconomic framework developed by Woodford (1996), in which governments can run chronic budget deficits, can motivate the need for fiscal constraints. Moreover, this model appears to fit the stylized facts concerning the policy stances of prospective EMU members. Finally, we examine the details of the actual Growth and Stability Pact and compare them to the predictions of the Woodford model.

Critical responses to standard arguments for fiscal rules

The European Commission has highlighted three externalities associated with excessive deficits in the EMU: First, if a country’s debt becomes unsustainable, other EMU nations might be forced to bail it out–that is, the “no bailout rule” may not be credible. Second, failure to bail out an insolvent nation may cause an EMU-wide liquidity crisis, forcing the ECB to inject an inflationary amount of liquidity into the EMU. Finally, even when solvency is not at issue, it has been argued that fiscal rules can partially address problems with independent fiscal policies in the presence of cross-country interest rate spillover effects.

Buiter, Corsetti, and Roubini (1993) argue against the validity of all of these concerns. They argue that a no bailout rule, such as the one included in the Maastricht treaty, can indeed be credible. Their argument is that under a credible no bailout rule, a country pursuing an unsustainable deficit path would pay a premium in its Euro interest rate and eventually encounter credit rationing. As long as this premium is applied only to the problem country and the market truly believes that there will be no bailout of a problem debtor, then that debtor alone bears the cost of his borrowing. Other members of the EMU therefore have no incentive to conduct a bailout and a credible no bailout rule becomes achievable.

Second, there is the possibility that the ECB will be forced to monetize a liquidity crisis suffered in one insolvent country to prevent it from spreading to other nations in the EMU, leading to price instability. Buiter, et al., argue that this possibility is remote because of the ECB’s independence and its sole mandate of price stability. With this mandate, it is unlikely that the ECB will jeopardize price stability in an effort to address a liquidity crisis.

Finally, there is the contention that fiscal rules can help coordinate among nations pursuing independent fiscal policies in the presence of interest rate spillovers. For example, changes in government borrowing levels may affect interest rates across the European Community (EC). The interest rate policies which then maximize the welfare of the EC as a whole may not be the policies which countries would adopt independently. Nevertheless, Buiter, et al., argue that these effects are likely to be small, and there is no guarantee that fiscal constraints will move the EMU nations in the proper direction. Moreover, among EMU countries, Germany is the only nation whose borrowing could be large enough to lead to significant interest rate spillovers.

An alternative argument for fiscal rules

The arguments above suggest that there is little motivation for fiscal rules of the type adopted in the Maastricht Treaty. In contrast, Woodford (1996) demonstrates how such rules can be motivated in a model in which government budget shocks have real effects.

The macroeconomic framework he uses is very standard, with rational expectations, frictionless financial markets, and a monetary policy rule which does not respond to fiscal shocks. Under the common assumption that budget deficits must be balanced over time, government deficit shocks would have no real effects in this model. However, Woodford assumes that countries may run “chronic” budget deficits which need not be balanced over time, so long as the growth rate of the budget deficit is less than the growth rate of the economy, and this leads to real effects.

Since the budget is not balanced over time in Woodford’s model, an unexpected increase in the government deficit can temporarily increase both output and inflation. Increased current government deficits raise the present value of household wealth, increasing consumption and output levels. Since budget deficits have real effects in this model, a government policy of random fiscal shocks leads to price variability.

This latter result holds regardless of the response of monetary authorities. This is in contrast to other studies in which fiscal policy can lead to inflation because the central bank is eventually forced to monetize the government deficit. This problem can be addressed by a strong mandate for central bank independence, such as that guaranteed to the European Central Bank under Maastricht. However, when fiscal policy affects household wealth, central bank independence may not be sufficient to motivate price stability. Fiscal rules which constrain the government to balance its budget over time are also required.

The potential for fiscal deficits to have real effects has important implications for a monetary union. A two-country version of the Woodford model demonstrates that a nation which pursues fiscally responsible policies will experience price instability in a monetary union with a nation which does not balance its budget over time. The only way for the fiscally responsible nation to maintain price stability is to finance the other nation’s budget deficit by running a countervailing budget surplus–an outcome that fiscally responsible nations clearly would find undesirable.

Details of the Growth and Stability Pact

The Growth and Stability Pact proposes regulations which strengthen the surveillance of budgetary positions and defines the procedure for handling excessive deficits. Under this pact, each EMU member is committed to a medium-term budgetary position of close to balance, or surplus. This policy allows for some movements of the budget deficit over a business cycle due to “automatic stabilizers.” For example, budgets which are balanced under full employment will go into surplus and deficit by themselves during booms and busts respectively, due to fluctuations in government revenues and social spending. Nevertheless, the stability pact forbids countries from running government deficits in excess of 3 percent of gross domestic product.

The surveillance measures are designed to insure that nations which are in danger of violating budgetary guidelines are identified early. Member states will be required to publicly announce stability programs which specify their budget objectives and make plans for adjustment in the government budget as needed to achieve compliance. The European Commission and the European Council will also monitor countries’ budget positions to give early warning to a member state whose budget path appears to be headed towards excessive government deficit.

The more controversial component of the Growth and Stability Pact concerns the provision of sanctions for nations running excessive deficits. The Commission will prepare a report whenever a nation’s actual or planned government deficit exceeds the 3 percent benchmark. The stability pact does make exceptions for excessive deficits resulting from major economic downturns. In order to qualify for exception, however, countries must suffer an annual fall in GDP of at least 2 percent. Such a downturn would be severe; for example, France has not experienced a downturn of this magnitude in the post-war era.

Should the European Commission report an excessive deficit, the Economic and Financial (ECOFIN) Committee will then report an opinion to the European Council concerning the Commission report. The European Commission, taking the ECOFIN report into account, will then recommend to the European Council whether or not to excuse an excessive deficit as exceptional.

The stability pact gives the European Council some discretion in making the decision whether or not to excuse the excessive deficit. In particular, it may consider an annual fall of less than 2 percent of exceptional nature in “… light of supporting evidence, in particular on the abruptness of the downturn or on the accumulated loss of output ….” The European Council Resolution on the Stability and Growth Pact provides a benchmark value of a 0.75 percent decrease in real output for an “abrupt downturn” meriting exception.

If the European Council does decide that an excessive deficit exists, it will set clear deadlines for policy adjustments. Countries with excessive deficits are expected to begin taking action within four months of the identification of a violation, and the deficit should be brought into compliance within a year of identification of a violation. If a member state fails to comply with the recommendations of the European Council, sanctions are to be imposed on the country in violation within ten months of identification of a violation. However, if the European Council perceives that the violating nation is complying with its policy recommendations, it may hold the sanctions in abeyance and continuously monitor the offending nation until its deficits are at acceptable levels.

In the event that sanctions are implemented, the stability pact calls first for countries to contribute non-interest bearing deposits of a fixed component, not to exceed 0.2 percent of GDP, and a variable component equal to 0.1 times the excess of the government deficit as a percent of GDP over 3 percent. The overall sanction amount cannot exceed 0.5 percent of GDP. There is still a difference of opinion concerning how this ceiling should be applied. Germany, the Netherlands, and the European Commission want the fines to be applied cumulatively, while most other member states want 0.5 percent of GDP to represent an “absolute ceiling,” even for a deficit which persists for a number of years.


The Woodford model matches a number of stylized facts surrounding the current debate on fiscal constraints in the EMU. First, traditionally fiscally responsible nations, such as Germany, are the strongest advocates of strict fiscal rules with sanctions. In Woodford’s model, these nations would have the most to lose in a monetary union with potentially fiscally irresponsible partners, as the maintenance of price stability requires the pursuit of government budget policies which accommodate those of their fiscally irresponsible partners. Second, the high degree of independence granted the European Central Bank under Maastricht is insufficient to motivate price stability in the presence of countries that pursue chronic budget deficits in the Woodford model. Some level of constraint on government borrowing also is required.

Of course, a stylized model such as Woodford’s gives us little guidance on the form and severity of fiscal constraints that are required. The current stability pact represents a stricter fiscal rule than that required for price stability in the Woodford model. This model requires only that governments have a credible commitment to balance their budgets eventually, rather than meet a deficit target each year. Nevertheless, the deficit path required to maintain such credibility with the public is unclear. Maintenance of government deficits below 3 percent of GDP may be required to achieve such credibility.

Mark M. Spiegel
Research Officer


Buiter, W., G. Corsetti, and N. Roubini. 1993. “Excessive Deficits: Sense and Nonsense in the Treaty of Maastricht.” Economic Policy 16, pp. 57-90.

Woodford, Michael. 1996. “Control of the Public Debt: A Requirement for Price Stability?” NBER Working Paper no. 5684.

Opinions expressed in FRBSF Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System. This publication is edited by Sam Zuckerman and Anita Todd. Permission to reprint must be obtained in writing.

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