Mr. Duisenberg comments on the importance of the European pact for
stability and growth Address by Dr. W.F. Duisenberg, President of the Netherlands Bank and
the Bank for International Settlements, on the occasion of his acceptance of the Business Week
Award, awarded by the Business Week Committee of the Economische Faculteitsvereniging of
the Erasmus University in Rotterdam on 20/3/97.
It is a great honour for me to accept one of the two Business Week Awards of
1997. I would like to thank the Business Week Committee for awarding me this prestigious
prize. Also, I would like to congratulate my fellow award-winner professor Franco Modigliani,
whose work has covered many fields in economics in general, and in the theory of monetary
policy and finance in particular.
As the theme of this year's Business Week, the organising Committee chose
"IMPACT: all things are in a flux and nothing remains". The first part of the theme, "impact", is
certainly valid for the world of banking and finance. Shifts in international capital flows have
important repercussions on economic developments in individual countries and regions. Changes
in interest rates influence economic decisions by private companies and households, and
consequently have an impact on our daily lives. Furthermore, the establishment of European
Economic and Monetary Union will drastically change the institutional setting of money and
monetary policy in the member states of the European Union, and will have a strong positive
impact on the economic development of Europe in the next century. The second part of this
year's theme, "all things are in flux and nothing remains", is somewhat more difficult for me to
subscribe to. Being a central banker, it is almost against my basic instinct to see all things as
being in flux and that nothing remains. By nature, central bankers are strongly in favour of
smooth and stable developments. However, this does not imply that we are against change. For
example, the movement towards European Economic and Monetary Union is a fundamental
change from the past. What is important is that changes which have a significant impact on
monetary and economic developments are embedded in structures of stability. The combination
of policy impact and stability, that is the crucial issue for central bankers. Therefore, in the
European Economic and Monetary Union, the policy impact and stability will be provided by an
independent European Central Bank, the primary objective of which is to maintain price
stability. To support this objective, the European Economic and Monetary Union will have
several institutional features which are aimed at providing an underlying framework of stability
for the ECB's monetary policy. For example, a mechanism for exchange rate stability is
presently being designed to ensure that the countries which do not meet the convergence criteria
in time can retain close links with the core group.
Moreover, a mechanism is presently being developed that aims at realising fiscal
stability in EMU as well. This mechanism is the pact for stability and growth, and was agreed
upon during the summit of the European Council in Dublin last December. Given the
importance of fiscal stability for achieving monetary and price stability in EMU, I would like to
touch upon three issues related to the pact for stability and growth. First, why do we need the
pact as a fundamental characteristic of EMU? Second, what are the elements of the pact? Third,
what are the misunderstandings about the pact?
The first issue - the reasons why we need a pact for stability and growth in
EMU - may be explained by my fundamental belief that a lack of fiscal discipline would
negatively affect the ability of the European Central Bank to achieve its primary objective to
maintain price stability. First, if the ECB is to be able to pursue a price stability-oriented
monetary policy, loose fiscal policies in Member States must be avoided, as such a situation
would endanger the credibility of the ECB and would place a heavy burden on the ECB's
monetary policy. Loose fiscal policies might push up interest rates, with the ECB being blamed
for pursuing an overly strict monetary policy. Although a central banker is used to being blamed
for all kinds of unsatisfactory economic developments, it is better to prevent this to the extent
possible. The pact aims at ensuring that fiscal discipline will be achieved, not only before the
start of EMU, but thereafter as well. Member States have agreed to pursue medium-term
objectives for a budget close to balance or even in surplus. The likelihood of interference with
monetary policy is thus reduced. As a result, the foundation for a stable and sound economic
development in Europe is established. Not without reason is the pact referred to as the pact for
stability and growth. Second, because of fiscal imbalances, aggregate demand can expand and
may directly cause upward pressure on prices. As a result, given its primary objective of price
stability, the ECB will be obliged to offset this expansion by implementing a restrictive
monetary policy. In the end, the European economy will be confronted with higher fiscal deficits
and higher interest rates, similar to the bad experiences of the seventies and early eighties. Third,
high and persistent fiscal imbalances indirectly fuel inflationary expectations, because they raise
the issue of sustainability. Fourth, an additional reason for the establishment of a pact for
stability and growth is the possible danger of "free rider" behaviour by individual Member
States. If national fiscal policies would not be governed by certain explicit and clear rules,
individual Member States could implement unbalanced fiscal policies and to a large extent pass
on the negative consequences to the other Member States. Fifth, the introduction of a stability
and growth pact will safeguard the fiscal convergence that has been achieved during recent
years, when EU Member States started to bring down fiscal deficits in order to meet the
Maastricht criteria. Sixth, against the background of growing government fiscal deficits, both in
Europe and the United States the fiscal situation of the government has become an issue of
growing academic concern. As a result, a substantial number of important studies on the need
for balanced budget rules have been published, establishing the theoretical framework for the
necessary change towards fiscal consolidation. It should be noted that fiscal imbalances of the
government are a relatively recent phenomenon. As has been stated regarding the United States
by Nobel prizewinner professor James Buchanan, who is one of the strongest supporters of
balanced budget rules:
"Traditionally, before the 1960's, governments had resorted to debt as a means of
financing only extraordinary expenditures, for the most part expenditures that were necessary to
finance wars and other short-lived emergencies. Public debt, so created, was always
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substantially reduced, or paid off, after most wars for most countries".
Also in Europe, during the sixties and the early seventies, budgets close to
balance or even in surplus were regarded as normal. It will not be a surprise that I think that we
should go back to normal. For example, the average of total government gross debt for the
present 15 EU Member States in 1970 was 34.6% of GDP. In 1995, this figure had risen to
71.7% of GDP, a doubling in 25 years. In the case of the Netherlands, the figure for government
debt rose from almost 47% of GDP in 1980 to around 80% of GDP in 1995, an increase of 70%
in just 15 years. However, the rapid growth of government debt did not result in a significant
reduction of unemployment. On the contrary: the doubling of the average EU government debt
level in 25 years was accompanied by a more than quadrupling of the average unemployment
level. Also in the Netherlands, rapid increases in government debt were attended by increasing
unemployment levels. These recent experiences show that accommodative fiscal policies are not
a guarantee for reducing unemployment.
Let me now briefly discuss the second issue - what are the elements of the pact
for stability and growth? The pact for stability and growth will take the form of two regulations,
and a political resolution from the European Council. The resulting regulatory framework
represents a judicious balance between prevention - via the strengthening of the surveillance of
budgetary policies - and deterrence - via the establishment of a dissuasive set of rules. The pact
will oblige Member States (or the "ins") to submit stability programmes. In these programmes,
medium-term budgetary targets will be stipulated, which should be set close to balance or even
at a small surplus. Non-euro Member States (or the "pre-ins") will submit convergence
programmes. Furthermore, the pact will include a sanction mechanism that will be used when
countries fail to meet the 3% reference value. If the Council of Ministers judges that a Member
State has an excessive deficit, sanctions would, as a rule, be imposed in the calendar year
following the year in which the excessive deficit was recorded or identified. The sanction would
consist of a non-interest-bearing deposit between 0.2% and 0.5% of GDP. In the case of the
Netherlands, this would imply a maximum fine of somewhat over 3 billion guilders. The third
element of the pact, the European Council resolution, will reflect the political commitment to a
strict and timely application of all the provisions of the pact. Thus, the resolution will provide
firm political guidance to the parties who will implement the pact for stability and growth. Both
regulations, together with the resolution, constitute an important framework for stability. If the
countries adhere to the provisions of the pact, they will observe a safety margin in respect of the
fiscal deficit to make sure that, even in times of cyclical adversity, the deficit will not exceed the
3%-reference value of the Maastricht Treaty. The stability pact aims at ensuring that countries,
once they have joined EMU, will continue to abide by the rules for sound public finance.
Finally, I would like to address some misunderstandings about the pact. It is often
said that the major drawback of the pact for stability and growth is that it takes away all
flexibility and sovereignty in the budgetary area. This is not correct. As soon as a structural
budgetary position of close to balance is reached, any negative cyclical development is allowed
to feed into the deficit, that is, up to the 3% limit, agreed upon in the Maastricht Treaty six years
ago. Calculations show that this gives ample room for the so-called automatic stabilisers to do
their job. That is to say, if in times of economic fortune Member States establish sound fiscal
positions, they will have sufficient budgetary room to react adequately to economic downturns.
In this respect, the pact for stability and growth is nothing more than the communal equivalence
of the Dutch saying "Save first, spend later". Thus, budgetary flexibility is explicitly part of the
pact. As regards sovereignty, it has to be recalled that only the level of the deficit will be
restricted. No limits or guidelines will apply to the size or composition of government receipts
and expenditures. The sovereignty of national parliaments will remain fundamentally intact. In
my opinion, it is even of the utmost importance that this sovereignty will remain intact: if the
stability and convergence programmes are to be credible, they have to be supported by the
national parliaments. Some critics of the pact claim that it allows for too much flexibility. To
them, I would like to emphasise that the pact for stability and growth will introduce a high
degree of automaticity in the assessment of Member States' budgetary policies. Only under
exceptional circumstances - such as occurred in less than 6% of the cases in the past 35 years -
may Member States be allowed a budget deficit above the 3%-reference value of the Maastricht
Treaty; even then this excess will need to be temporary and limited. Thus, the pact constitutes a
careful balance between flexibility and automaticity, and between prevention and deterrence. As
you might know, the details of the pact for stability and growth are now being worked out. I
expect that at its June 1997 meeting in Amsterdam, which will be hosted by De Nederlandsche
Bank, the European Council will reach full agreement on this most important issue.
To conclude, from a central banker's perspective, the crucial issue for stable and
sound economic developments is the impact of stability. More specific, what is important is the
impact of price stability, achieved through the interrelated set of monetary stability, exchange
rate stability and fiscal stability. That is why the pact for stability and growth is one of the
cornerstones of the EMU. It will establish a foundation of fiscal stability under the operations of
the European Central Bank, and thereby contribute to the impact of its policies.