Economics, 3rd Edition

The Stability and Growth Pact: A Ferocious Dog with No Teeth

The Stability and Growth Pact (SGP) was a set of formal rules by which members of EMU were supposed 

to be bound in their conduct of national fiscal policy. Its main components were as follows:

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 Members should aim to achieve balanced budgets.

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 Members with a budget deficit of more than 3 per cent of GDP will be subject to fines that may reach 

as high as 0.5 per cent of GDP unless the country experiences exceptional circumstances (such as a 

natural disaster) or a very sharp recession in which GDP declines by 2 per cent or more in a single year.

Clearly, however, if EMU members adhered to the SGP, then it would rule out any free rider prob-

lems associated with excessive spending and borrowing in any one member country by forcing mem-

bers to put a limit on the national government budget. The choice of a maximum budget deficit of no 

more than 3 per cent of GDP was related to a clause in the 1992 Maastricht Treaty that suggested that 

a ‘prudent’ debt-to-GDP ratio should be no more than 60 per  cent. This itself was perhaps somewhat 

 arbitrary – although it was very close to the actual debt-to-GDP ratio of Germany in 1992. To see, however, 

that a 60 per cent ratio of debt to GDP could entail ‘prudent’ budget deficits of no more than 3 per cent 

a year, let’s do some simple budgetary arithmetic. Suppose a country is enjoying real GDP growth of 

3 per cent a year and inflation of 2 per cent a year, so that nominal GDP is growing at the rate of 5 per cent 

a year. This means that the nominal value of its government debt can grow at a rate of 5 per cent a year 

and still be sustainable. But if the debt-to-GDP ratio is 60 per cent, this means that debt can increase by 

5 per cent of 60 per cent, or 3 per cent of GDP a year while keeping the debt-to-GDP ratio constant. In 

other, words, it can run a budget deficit of 3 per cent of GDP a year.

While, however, there was some logic in setting a maximum budget deficit of 3 per cent a year (given 

a maximum prudent debt-to-GDP ratio of 60 per cent), it is not clear why the SGP suggested that members 

should aim for a balanced budget. It should be clear from the budgetary arithmetic just discussed that it 

is not imprudent for countries to run small budget deficits as long as they are enjoying sustained long-

term growth in GDP. The effective straitjacketing of national fiscal policy that the SGP implied may have 

reflected a desire among the architects of EMU for the ECB to maintain an effective monopoly on demand 

management, so that its polices could not be countered by national fiscal policies.

The crucial question for the SGP, however, was whether or not the maximum allowable budget deficit 

would be enough for a country to let its automatic fiscal stabilizers come into play when it goes into reces-

sion. This is crucial in a monetary union because member countries will have already given up their right to 

pursue an independent monetary policy and they cannot use the exchange rate as an instrument of policy.

In practice, the SGP proved to be something of a toothless watchdog. As the euro area experienced 

sluggish growth in the early years of EMU, several member countries – and in particular France and 

Germany, two of the largest member countries – found themselves in breach of the SGP excessive deficit 

 criteria. However, both France and Germany  managed to  persuade other EMU members not to impose fines 

and, in 2004, the European Commission drew up guidelines for softening the SGP. These guidelines included 

considering more widely the sustainability of countries’ public finances on an individual basis,  paying more 

attention to overall debt burdens and to long-term liabilities such as pensions, rather than to a single year’s 

deficit. The consequences of the  financial crisis have made the limitation of the SGP even more clear.

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