Roel Beetsma, University of Amsterdam
Henrik Jensen, University of Copenhagen
Some economists view the Stability and Growth Pact (SGP) as counterproductive, because it tends to be particularly severe on economies in a recession. These countries are likely to run a relatively high deficit, and imposing sanctions on them for doing so would aggravate their situation. In this paper, we show how this potential disadvantage of the SGP could be addressed by making sanctions contingent on the observed state of the economy.
Our model features excessive deficits because in a monetary union governments do not fully take into account the externalities of their individual deficits via the common monetary policy. If the reference deficit level depends on the state of the economy (rather than being constant at 3% of GDP), the Pact still acts as a deterrent for fiscal profligacy (because it raises the marginal cost of a higher deficit), but the fine that a high-deficit country has to pay is reduced if the country is in recession.
A problem with such an arrangement is that it may lead to moral hazard: knowing that the sanctions for an excessive deficit will be softened when the observed state of the economy is bad, governments have too little incentive to undertake (unobservable) measures that improve the state of economy (e.g., structural reform, deregulation, etc), especially if such measures are politically costly. Hence, contingent sanctions create a trade-off between the benefits mentioned earlier and the loss from moral hazard. Despite the moral hazard, it turns out that if countries are ex ante identical, it is still optimal to allow for at least some contingency of the sanctions on the observed state of the economy. However, if governments differ in the political cost of exerting effort to improve the state of the economy, then those with the lowest cost will be opposed to contingent sanctions. These governments exert the highest level of effort and they suffer most from the spillovers created by the low effort exerted by the other governments. This may explain why the actual SGP allows the 3% deficit rule to be breached only under exceptional circumstances.
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