Large Scale Fiscal Retrenchments: Long-Run Lessons from the Stability Pact

CEPR Discussion Paper Series No. 1843

Posted: 6 Aug 1998

See all articles by Andrew J. Hughes

Andrew J. Hughes

Cardiff Business School; Centre for Economic Policy Research (CEPR); Vanderbilt University - College of Arts and Science - Department of Economics

Peter McAdam

European Central Bank (ECB)

Date Written: March 1998

Abstract

This paper examines the potential consequences of imposing a stability pact? on the fiscal convergence criteria for monetary union. Various versions of the stability pact are possible. We examine the consequences of reducing the target deficit ratio to 1% and of refundable fines for those who exceed the 3% limit, specified in the Maastricht Treaty. We also consider the possibility of targeting structural, rather than actual, deficits. We find tax increases are necessary, and would have to be permanent, if the proposed deficit reductions are to be sustained below the 3% limit. We also find that changes in the policy mix are necessary -- a loosening in the real value of money relative to fiscal policy (but not necessarily in absolute terms) -- to avoid liquidity shortages or a debt explosion. Finally, and by far the most important result, is a sharp rise in real interest rates. In the longer term, this destroys investment, employment and output capacity. That is a more serious cost than short term losses in output itself.

JEL Classification: E63, F42, H62, H87

Suggested Citation

Hughes Hallett, Andrew J. and McAdam, Peter, Large Scale Fiscal Retrenchments: Long-Run Lessons from the Stability Pact (March 1998). CEPR Discussion Paper Series No. 1843, Available at SSRN: https://ssrn.com/abstract=106388

Andrew J. Hughes Hallett (Contact Author)

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Peter McAdam

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