The Return of the Deficit: Public Finance in Belgium over 2000-2010

1. The European Context. Evolving Governance in the EU: From the SGP to Hell and Back?

The European Context 25 The European Context evolving governance in the eu: From the sgP to hell and back?1 Guy Quaden, Jan Smets, and Geert Langenus2 On 1 January 1999, at the start of the so-called Stage Three of the Economic and Monetary Union, eleven EU Member States took the historic step of introducing a new common currency. The creation of the euro was as much a political decision as an economic one: the adoption of a common currency was considered to be a logical and necessary step in the gradual process towards greater European integration. Meanwhile, the euro has firmly established itself on the world stage, the European Central Bank has successfully kept euro area inflation rates low in accordance with its mandate, and six additional Member States – three of which were until relatively recently part of countries that were located behind the ‘Iron Curtain’ – have joined the monetary union. From a purely economic point of view the move to a single currency and a unified monetary policy for the euro area countries was not entirely uncontroversial. First, it is widely recognised that the euro area countries to some extent fell short of the theoretical benchmarks for an optimum currency area. The relatively low degree of labour mobility between countries and the lack of an important cyclical fiscal transfer 1. This article reflects the views of the authors and not necessarily those of the National Bank of Belgium. We would like to thank, without implicating them, Jef Boeckx, Hugues Famerée, Hans Geeroms and LucVan Meensel for helpful comments and discussions. 2. Guy Quaden is Honorary Governor of the National Bank of Belgium, Jan Smets is Board Member of the National Bank of Belgium. Geert Langenus is member of the Research Department of the National Bank of Belgium. 1. 26 The Return of the Deficit system were thought to be significant weaknesses as this reduced the area’s capacity to deal with asymmetric shocks and developments. In such an environment, the flexibility of prices and labour markets becomes all the more important (Ilzkovitz et al, 2007). Secondly, and more generally, doubts were raised regarding the longevity of currency unions between different countries where only monetary policy is fully centralised. It was feared that, given the heterogeneity of the participating countries in particular, political conflicts could arise over the economic policies that ought to be implemented. Around the turn of the century, at least some observers were convinced that the euro was an institutional adventure, boosted by the historic momentum, which was doomed to fail because of the lack of political union. At the same time, there was some moderate optimism in the early years of the euro that participating economies would converge further and that the criteria for optimum currency areas were to some extent endogenous: euroland may not have been an optimum currency area at the start but could become one over time (e.g. De Grauwe and Mongelli, 2005). In addition, a common currency could in itself foster greater political integration . This was clearly the intention when the euro was introduced. However, the common currency sailed into heavy seas when the sovereign debt crisis hit Europe towards the end of the decade. Policy-makers have recently resorted to highly exceptional measures to keep the ship afloat. A key success factor for cross-border monetary unions is the absence of externalities, i.e. the union’s capacity to avoid policies – and, in particular , irresponsible ones – in one participating country spilling over to other participating countries or to the common monetary policy. In this connection, an independent central bank and the ban on taking on debts issued by other Member States (the so-called ‘no-bail-out’ clause), both guaranteed in the Treaty on the Functioning of the European Union, and cornerstones of the EMU architecture, are of the utmost importance . However, it was clear from the outset that, in the longer term, the smooth functioning of the euro area would crucially depend on the degree of economic convergence between the participating countries and success in consolidating public finances. Diverging economic trends across participating countries may complicate the identification of the The European Context 27 appropriate monetary policy stance, while sizeable fiscal imbalances may ultimately undermine the credibility of the commitment to low inflation and raise inflation expectations. In this article we review the developments in the governance framework of the European Monetary Union. We...