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

  • Economics


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.

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