Extending the (EMU) Stability and Growth Pact to Take Care of Global Imbalances

Last week Eswar Prasad had an interesting article in the Financial Times on how to deal with global imabalances. As the G-20 seems to be taken the issue of global imbalances seriously, there is the question of how to make their commitment operational.

Reducing global imbalances requires a reductio in national imbalances between income and spending or, in other words, between saving and investment. The difficulty is that this imbalance is the result of both government and private sector imbalances. Because it is difficult to think about how to effectively impose a balance on private income and spending, the only valid alternative seems to be addressing large imbalances in government spending.

This is the suggestion of Eswar Prasad:

“The scheme would work as follows. The G20, in consultation with the IMF, develops a simple and transparent set of rules for governments on policies that could contribute to global imbalances – for instance, that government budget deficits and current account balances (deficits or surpluses) should be kept below 3 per cent of national GDP”

If deficits go beyond 3% there is a financial penalty (implemented through the SDR holdings of the IMF). If we focus on budget deficits, this looks like the Stability and Growth Pact under which EMU governments have lived for several years. There is a limit on budget deficits (3%) and a set of mechanisms to enforce this limit.

The history of the Stability and Growth Pact has shown us that it does not work. While it provided some discipline in the earlier years, we soon realized that there were many issues associated to its implementation that have led to failures to comply with the limits and a revision of the Pact that has left very little power over national government balances. The issues were many:

– What do you mean by 3%? You probably want to adjust this by the cycle, but then how do you adjust it by the cycle? Do you allow for exceptional circumstances?
– How do you punish government? Who decides that governments should be punished? (in the case of EMU, it was the council of finance ministers who had to punish some of its own members, not very effective).

In practice, many countries ended up with deficits above 3% without significant consequences. There were also periods where the government deficit was below 3% but the government was clearly helping create a current account imbalance (i.e. the government should have had a large surplus as opposed to let’s say a 2% deficit).

The G-20 commitment to address global imbalances is no doubt a good step in the right direction but it is unclear how this commitment will translate into specific outcomes or actions.

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