Even if one were to conclude that some collective insurance system is indeed desirable, there
remains the question of how to design such an arrangement. In Section 4, we examine a
number of proposals that have surfaced.
2. The Fiscal Dominance Case for the SGP
There are a number of justifications for the SGP. Two of them are unconvincing. It is argued
that that one country’s deficit stands to raise the euro area interest rate and thus impose a cost
externality on all other countries. This view seems rooted in an IS-LM view of the world.
Even then, since Europe is financially integrated in world markets, its interest rate is
essentially exogenous, especially as each member country is “small”. A more elaborate
version allows for interest rate parity and argues that a deficit raises the interest rate through
expected depreciation. The theory behind this assertion is at best weak and, importantly, there
is no evidence linking budget balances to the exchange and interest rates. The only evidence
is that investors discriminate among borrowers, which means that there is no externality.2
Another argument in favor of the SGP is that it is a form of coordination among national
fiscal authorities. Here again, the need for coordination must rest on some substantial
externality that is demonstrated. Moreover, even if such an externality were to exist, it would
remain to establish that the SGP-induced coordination is optimal. There is no theoretical or
empirical evidence that this is the case.3
The fundamental argument in favor of the SGP is that fiscal indiscipline can become the
source of inflation. It is based on solid empirical evidence. Indeed, it is well known since (at
least) the hyperinflation episodes of the 1920s that fiscal indiscipline can lead to inflation.
The theoretical interpretation has been elaborated by Sargent and Wallace (1981), Canzoneri
et al. (2001) and Woodford (2001) among others. It can be briefly summarized with the
government budget constraint:
(1) Bt+1-Bt=itBt-(1+it)[St+(Mt+1-Mt)],
where St is the primary budget surplus in period t, it the interest rate and Bt and Mt are the
beginning of period stocks of public debt and base money, all expressed in nominal terms.
Dividing by the nominal GDP PtYt and denoting the total public sector debt as Dt = Bt + Mt,
(1) can be rewritten as:
this is the case, iterating (2) forward, we get:
(2)
Dt
PtYt
St i
--1--
PtYt 1 + it
Mt+1 ï
PYt )
+ ρt
t+1
PY
t+1 t+1
where Pt = ( P +Y )-1
Pt+1 Yt+1
Pt Yt
is the growth-adjusted real interest rate factor. Public sector
solvency requires that the transversality condition limT →∞ (∏Ts=-t1ρs )
Dt
ptyt
be satisfied. When
2 For empirical evidence showing that investors indeed discriminate among public borrowers in the
euro area see Bernoth et al (2004).
3 Krogstrup and Wyplosz (2006) conclude that the pact is far from optimal.
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