The Maastricht dog that lost its bark: how the stability Pact has lost its relevance.

• Author: Gros, Daniel

When large numbers of drivers ignore the speed limit, it is good practice to reconsider its rationale and, if reaffirmed, to tighten enforcement, especially if the frequency of accidents increases. Hence, the EU Commission was right in launching a debate about the Stability and Growth Pact, which has been violated by an increasing number of EMU member countries. Unfortunately, however, the Commission's proposals for reform risk watering down the Pact, resulting in an erosion of fiscal discipline. In our view, countries presently struggling with excessive deficits should implement reinforced fiscal adjustment programs. The case for a consolidation of government finances against the background of present and prospective demographic changes remains very strong.

THE LONGER-TERM OUTLOOK

The Stability and Growth Pact was created in order to make the general prohibition against "excessive" deficits in the Maastricht Treaty operational. The Treaty, which introduced the constraints on fiscal policy, started from the assumption that nominal GDP would grow at 5 percent per year on trend and that a debt ratio of 60 percent of GDP was bearable. Consistent with these assumptions, it stipulated that government budget deficits must not exceed 3 percent of GDP.

In hindsight, this deficit limit appears rather generous. Reflecting the European Central Bank's's inflation target of less than 2 percent and real potential growth of probably only around 1 percent in Euroland, a more realistic assumption for Euroland nominal trend growth is around 3 percent. To stabilize the debt ratio at 60 percent of GDR the deficit would need to be capped at 2.1 percent. Moreover, aging of the Euroland population raises government liabilities not included in the debt ratio in the Maastricht definition. Hence, to keep governments solvent, the latter should decline over time, ensuring that total government liabilities do not increase on trend over the next half century. These facts are generally accepted. However, neither they, nor their obvious implication that the conditions in the Stability and Growth Pact should be tightened rather than loosened, are reflected in the current proposals for reform coming out of the Commission.

Surprisingly, the Commission seems also to have ignored a key argument in favor of raising the threshold for invoking exceptional circumstances. With the potential growth rate having declined in most eurozone countries, it is much more likely that countries will experience phases during which growth is "slow" by historical standards. Hence, when potential growth is slowing, authorities need to continuously update their view about...