Why the Pact has no impact: why the Stability and Growth Pact ultimately made no significant difference to the fiscal behavior of the eurozone major member economies.

• Author: Posen, Adam S.
• Position: Reports on global economy

A constraint on the euro's rise to international prominence has been the underperformance of the major eurozone economies (France, Germany, and Italy), and their apparent lack of fiscal discipline, ignoring the Stability and Growth Pact in response to their recent recessions. Seen through some European eyes, the disregard for the roles of eurozone budgetary conduct is both a failing of these national governments and a threat to the viability of the eurozone. It is neither. For these governments, unwillingness to adhere to the Stability and Growth Pact or to undertake major fiscal consolidation is a rational, if not optimal, response to economic realities. On the one hand, France, Germany, and Italy had the most to lose from giving up fiscal stabilization policy, because they were the European economies in which such policy would be most effective. There is a strong positive correlation between a developed economy's size and its fiscal responsiveness to business cycles, and a strong negative correlation between developed countries' openness and their fiscal responsiveness. In short, the countries most likely to benefit from fiscal policy rather than see its impact spill abroad are the ones that use fiscal policy the most.

On the other hand, these European economies are not candidates for Rubinesque virtuous cycles from fiscal consolidation to investment booms to growth back to budget surpluses (a la the United States in the 1990s). For expansionary consolidations to work, several factors are required. Interest rates must respond strongly to fiscal consolidation, which usually requires a high initial debt-to-GDP ratio and/or significant foreign-held debt. Business investment must respond strongly to interest rate reductions, which usually involves forward-looking and flexible corporations. Growth in productivity and employment must respond strongly to the increases in investment. And, to complete the cycle, government revenue must respond strongly to the increase in growth. (A little accompanying monetary accommodation does not hurt, either.)

Though these attributes did characterize the United States in the 1990s, they did not and do not characterize the large continental European economies, given their well-known structural problems. The initial debt conditions were seen only in Italy. And if there is no obvious near-term growth benefit from fiscal consolidation, the yielding of monetary sovereignty by national central banks to the European Central Bank makes the loss of national fiscal discretion to the Stability and Growth Pact more costly and increases these eurozone member nations' output volatility.

Thus, there was more to the Pact's breakdown than the oft-claimed but undocumented asymmetry of government behavior with respect to budget policy and the business cycle. In fact, an analysis shows that the introduction of...