What Was the Economic Rationale?

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Adopted by the euro zone in 1997, the SGP was a political agreement that was set up to enforce budgetary discipline of the Member States, after the Euro was launched as part of the third stage of Economic and Monetary Union (EMU). It was designed to contribute to the overall climate of monetary stability and financial prudence to ensure the long term success of EMU. It is widely held view, particularly in the current state of affairs that governments are more inclined to spend than they can afford, thereby forcing future generations to burden this spending via higher taxes and resulting in so called “deficit bias” of national budgetary policies. The ageing population of EU, in which its citizen have generally led more active and healthy lifestyles, has resulted in people living longer. This has also had a significant impact of growth and contributed to strong pressures to increase public spending.

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Thus, continuous high deficits and excessive debt levels by governments have been a cause for concern, leading to greater expectations of inflationary pressures and consequently higher interest rates which may endanger the economic growth, welfare and financial sustainability of the economy. In particular, larger deficits induce a greater need for government financing through which it may issue more public bonds with higher yields to financial investors and thus “crowding out” private investment.

Moreover, such high deficits can have adverse spillover effects in the EMU, in which the costs of fiscal indiscipline are collectively experienced. For example, a substantial deficit by one member state may induce inflationary pressures in both that country and the euro area, enticing the ECB to ultimately raise interest rates which may become a concern for other members. 8 Thus, the existence of a collective negative externality calls for collective action.

The SGP provides a framework for the co-ordination of fiscal policies via a common fiscal rule that safeguards and encourages the long term sustainability of public finances by preventing Member States from continually running excessive deficits and debts. This fiscal co-ordination is necessary to achieve full EMU. Furthermore, there is need for co-ordination to be explicitly transparent to address the existence of a common externality as there are incentives for countries not to cooperate and divulge away from sound fiscal policies to “prevent countries from free riding on the coattails of others success without contributing”.

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