3.
Unfunded Obligation Measures for EU Countries
Jagadeesh Gokhale*
3.1 Introduction
Europe is undergoing two major transitions - demographic and economic. First, the
populations of many European countries are aging rapidly as their baby-boom generations
approach and enter retirement, human longevity continues to increase, and fertility rates
remain well below replacement. Second, thirteen European countries have joined in a
monetary union (EMU) by adopting the euro as a common currency, and more countries
are to join the EMU during the next few years. The objective of monetary union is to
eliminate exchange rate risks and streamline product pricing and price comparisons of
similar goods and services across member nations to induce greater competitive
efficiencies. Entering a monetary union implies surrendering control over monetary
policymaking, but all current and prospective EMU nations would largely retain
sovereignty in setting fiscal policies - except for the loose overall constraints set under
the latest Maastricht agreement.
Both transitions will place tremendous but conflicting pressures on Member States’
domestic national budgets. Decision makers will face growing demands to increase public
expenditures and fulfil promises of retirement and health care benefits to retirees
precisely when growth in labour forces and tax bases slows. That points toward larger
future fiscal deficits and growing debt levels. At the same time, policymakers will face
growing pressures from the “EMU club” to maintain low deficits, prevent increases in
interest rates, and maintain European investment levels. Exercising proper economic
stewardship during these twin transitions will become more difficult if policymakers
remain poorly informed about the likely consequences of making alternative policy
choices.
To streamline the process of monetary union, prospective EMU member countries
adopted the Stability and Growth Pact in 1997 (SGP-97). Along with the Treaty of the
European Union, SGP-97 provided the framework of rules for coordinating fiscal policies
across EMU members - both current and prospective ones. It was generally accepted that
without such coordination, member states would have stronger incentives to follow
“short-sighted” fiscal policies causing chronic budget deficits and higher debt-to-GDP
ratios. If carried too far, such policies would erode the European Central Bank’s ability to
The author thanks Alan Auerbach, Martin Larch, Joao Nogueira Martins, William Niskanen and
Peter Vandoren for helpful discussions during the preparation of this manuscript and Joanne Fung
for excellent research assistance. Use of data from Eurostat and the UK’s Economic and Social Data
Service is hereby acknowledged. All opinions expressed herein are those of the author and not
necessarily those of the Cato Institute.
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