GIGA MASTER-FINAL

2
Table of Contents
Abbreviations......................................................................................................................................................5
Chapter 1 – Introduction....................................................................................................................................6
1.1 Problem Area......................................................................................................................................6
1.2 Problem Formulation .........................................................................................................................9
1.3 Project Design.....................................................................................................................................9
1.4 Philosophies of Science ................................................................................................................... 11
1.5 Analytical Structure......................................................................................................................... 12
1.6 Empirical Data ................................................................................................................................. 12
1.7 Critique of Sources .......................................................................................................................... 14
1.8 Limitations....................................................................................................................................... 15
1.9 Bias .................................................................................................................................................. 16
Chapter 2 – Theoretical Basis...........................................................................................................................17
2.1 Monetarism..................................................................................................................................... 17
2.2 Keynesianism................................................................................................................................... 18
Chapter 3 – The Pacts.......................................................................................................................................20
3.1 The Stability and Growth Pact......................................................................................................... 20
3.2 The Euro Plus Pact........................................................................................................................... 22
3.3 The Scoreboard ............................................................................................................................... 24
Chapter 4 – The Debate of the Pact .................................................................................................................26
4.1 Main criticism of the SGP ................................................................................................................ 26
4.2 New-Keynesianism and the SGP...................................................................................................... 28
4.3 Monetarism and the SGP ................................................................................................................ 29
Chapter 5 – The Mechanisms of a Monetary Union ........................................................................................31

5.1 Optimum Currency Area.................................................................................................................. 31
5.2 Monetarism and the Monetary Union ............................................................................................ 33
Chapter 6 – The Public and Private Sector .......................................................................................................35
6.1 Public Sector Deficit......................................................................................................................... 35
Figure 6.0: Government Deficit .................................................................................................. 36
6.2 Public Debt ...................................................................................................................................... 37
Figure 6.1: Government Debt...................................................................................................... 37
6.3 Fiscal Policy Instruments ................................................................................................................. 37
6.4 Budgetary Convergence .................................................................................................................. 40
6.5 Private Sector Debt.......................................................................................................................... 41
Figure 6.2: Total Debt to GDP (UK)........................................................................................... 43
Figure 6.3: Total Debt to GDP (Spain) ....................................................................................... 44
Figure 6.4: Total Debt to GDP (Germany).................................................................................. 45
6.6 Real Estate Bubble........................................................................................................................... 46
6.7 Analytical Summary Part I ............................................................................................................... 48
Chapter 7 – Competitiveness ...........................................................................................................................50
7.1 Exchange Rate and Real Effective Exchange Rate........................................................................... 50
Figure 7.0: Exchange Rate .......................................................................................................... 51
7.2 Fixed Exchange Regimes.................................................................................................................. 51
7.3 The Balance of Payments ................................................................................................................ 54
7.4 The Balance of Payments in the EU................................................................................................. 55
Figure 7.2: Current Account........................................................................................................ 56
7.5 The Return of New Keynesianism?.................................................................................................. 57
7.6 Unit Labour Cost.............................................................................................................................. 59

Figure 7.3: Competitiveness........................................................................................................ 60
Figure 7.4: Unit Labour Costs..................................................................................................... 61
Figure 7.5: Labour Productivity.................................................................................................. 62
7.7 Analytical Summary Part II .............................................................................................................. 63
Chapter 8 – The Political Arena........................................................................................................................66
8.1 What Went Wrong? ........................................................................................................................ 66
8.2 Denmark and the Euro Plus Pact..................................................................................................... 68
8.3 Political Discussion .......................................................................................................................... 73
Chapter 9 – Conclusion.....................................................................................................................................76
9.1 Future Prospects.............................................................................................................................. 77
Bibliography......................................................................................................................................................79
Appendix...........................................................................................................................................................87

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Abbreviations
BoP: Balance of Payments
DKK: Danish Krone
ECB: European Central Bank
EFAC: Economic and Financial Affairs Council
EMU: European Monetary Union
EP: European Parliament
EPP: Euro Plus Pact
EU: European Union
EUR: Euro
GDP: Gross Domestic Product
GNP: Gross National Product
IT: Italy
OCA: Optimum Currency Area
PT: Portugal
R&D: Research and Development
REER: Real Effective Exchange Rate
SGP: Stability and Growth Pact
UK: United Kingdom
ULC: Unit Labour Cost

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Chapter 1 – Introduction
The goals and contents of this project were inspired from discussions of the recent financial crisis in
the EU perspective. The ongoing debate in the EU on bailouts and financials problems led to a
revision of the economic policies of the European countries and the interrelationship between
member states and the EU. Keeping this in mind we decided to work with the Stability and Growth
Pact and the newly created Euro Plus Pact. We feel there is something to contribute with in this
area, as it creates an interesting framework of knowledge regarding the assumptions and effects of
different schools of economics and the consequences they have on the economy. Further it allows
us to describe the relationship and interdependence of politics and economics on both a national and
an international level. Lastly the project has a very “real” dimension to it, insofar as it describes
current and ongoing problems and challenges for our society.
1.1 Problem Area
As basis for economic stability and security in the so-called Euro-zone has been the debated
”Stability and Growth Pact.” This pact has been criticized from many angles; in its traditional form,
called SGP-I, for being too rigid, but also after its reformation in 2005, called SGP-II. Criteria such
as the requirement of a maximum deficit on state budgets of 3%, have been exposed to especially
harsh criticism.1
A later attempt to meet this criticism came in October 2010, in the form of a
proposal made by a task-group under the European Council led by its president, Herman van
Rompuy, as well as the European Commission.2
This version was called SGP-III. This proposal was
also met with harsh criticism, for not meeting the demands for a less rigid pact. In fact, it was
criticized for being an even more rigid version of SGP-II. In the words of Paul De Grauwe:
”[...] the European Commission now proposes SGP-III; a
considerably tighter version of SGP-I. […] I want to argue that
1
Web: Stability and Growth Pact
2
Web: Van Rompuy task force agrees need for budgetary sanctions

7
SGP-III is a very bad idea. […] it is based on a wrong diagnosis
of the causes of the debt crisis in the Euro-zone.”3
Furthermore: The SGP has in all its forms included mainly monetarist tools for stabilizing the
economy,4
exemplified in the desire to cut public spending and keep deficits in check. Keynesians
have of course been quick to criticize the monetarist pact, but also politicians and monetarist
economists have criticized its contents.
Amidst the debate of how to stabilize the Euro-zone, the SGP has been reformulated and
reconstructed numerous times, but one central concept has remained throughout: The fact that the
SGP focuses on the issues within the public sector. Budget deficit criteria and spending regulations
have been the norm, and although the various iterations of the SGP have had different ways of
handling rules for the public sectors in the member states, not once have either of these iterations
mentioned the private sector and its problems. How can this be so, when so many attribute the cause
of the financial crisis to irresponsible banks and an increasing private sector debt from “bad” loans?
In other words, there seems to be some merit in the suggestion that the financial crisis was caused
by problems in the private sector - not the public5, 6, 7
- and it strikes us as odd that this is not a
concern that the SGP has dealt with.
Through the years of its existence, criticism of both economic and political nature has hit the
SGP in all of its forms. When the financial crisis of the late 2000s hit, it shook the foundations of
the SGP. The SGP was to be an iron clad treaty, securing stability and thereby rendering bailouts
obsolete. Clearly, it did not succeed. The question then arises whether the SGP failed because the
treaty was not upheld, that is, a lack of sanctions and actions against members who broke or failed
to meet the criteria of the treaty. Or alternatively whether it was because the very essence of the
treaty was fundamentally flawed, so that even if upheld it would not be able to prevent a crisis.
Regardless of these questions, when the recession hit, it became clear that the SGP had not worked
as intended, and that a new treaty or a major revision was needed. On March 10, 2011, a suggestion
3
Web: Why a Tougher Stability and Growth Pact is a Bad Idea
4
Web: Monetarism and Monetary Policy – The Case of the Euro
5
Web: We Need to Curb Private Sector Debt
6
Web: Financial Crisis and Bank Lending
7
Web: How Government can Discourage Private Sector Reliance on Short-Term Debt

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for a reform of the SGP was on the table of the Economic and Financial Affairs Council (EFAC).8
On March 11, the Heads of State in the Euro-zone met to formulate a new pact – one that would
attempt to meet the criticisms of the SGP head on, and create a new basis for economic stability in
the Euro-zone.9
On March 15, The Council of the European Union met and ratified the need for
reform, enabling the president to start negotiations with the European Parliament (EP).10
On March
25, the Euro Plus Pact (EPP) was finally agreed upon,11
although many details and specifics remain
to be decided. Our first goal should then include a broad understanding of the economic basis for
the SGP, the EPP, and what has changed.
Following this economic debate, another question arises: that of political viability. Some argue
that the SGP was first and foremost ineffective due to its failings in the area of politics. Due to a
lack of sanctions, it was impossible to make sure the agreement was kept, and as countries broke the
rules of the pact and no action was taken from the Commission, mistrust ran rampant and faith in
the pact dissolved.12
When the Commission finally took steps to enforce the pact,13
the influential
economies, Germany and France, refused to answer to the rules of the pact, effectively numbing any
credibility the pact may have had.14
Thus, it is not sufficient to only discuss the economic
perspective of the SGP and the EPP, one must also think in terms of whether a pact – economically
viable or not – will have any bearing in the political reality. To better understand the role of politics
we will look at the political landscape of Denmark.
This report will take a look at the SGP, and the consequences it has had on the European
economy. It will then discuss the EPP from this perspective – does it meet the criticism of the SGP,
and will it help to solve the problems that still exist after ten years with the Stability and Growth
Pact?
8
Web: Note on Economic Governance
9
Web: Conclusions of the Heads of State or Government of the Euro Area of 11 March 2011
10
Web: Counsil Reaches Agreement on Measures to Strengthen Economic Governance
11
Web: 'Euro-Plus-Pact' Agreed Admid Portugal Crisis
12
Web: Will The New Stability and Growth Pact Succeed?
13
Web: Budgetary Sanctions Hit Germany and France
14
Grauwe (2009); p. 245-246

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1.2 Problem Formulation
Which factors contributed to the failure of the SGP and to what extent have these factors been
ratified in the EPP?
1.3 Project Design
In order to answer our problem formulation we have devised five research questions which will be
answered throughout the chapters and as such will lead the project. They are:
What are the key factors in the SGP and the EPP?
What are the key points of criticism from the debate surrounding the SGP?
How does the monetary union work?
What are the key theoretical concepts relating to the pacts?
What are the main political concerns relating to the pacts' viability?
The project is divided into the following chapters:
Chapter 1 – Introduction:
This chapter consists of our problem area, problem formulation, project design, analytical structure,
philosophy of science, empirical foundation, critique of sources, limitations and bias. The chapter
will introduce the reader to the methodological choices made and give a general outline of the
project and its different parts.
Chapter 2 – Theoretical Basis:
In this chapter we take a look at the core concepts from the key theories for the project:
Keynesianism and monetarism. We create a basic outline of these economic schools of thought, to
serve as basis for a more detailed theoretical discussion further on in the project.
Chapter 3 – The Pacts:
In this chapter we answer the first research question “What are the key factors in the SGP and the
EPP?” This is done by introducing three texts; The SGP, The EPP and The Scoreboard, all of which

10
are introductory texts that outlines the contents of the legal documents. This chapter will
furthermore create the basis for the rest of the project as these three are our object of research.
Chapter 4 – The Debate of the Pact
The aim of this chapter is to outline the debate of the SGP and in doing so we will answer the
second research question “What are the key points of criticism from the debate surrounding the
SGP?” This chapter will furthermore work as an introduction to some of the concepts that we will
be treating in the analysis.
Chapter 5 – The Mechanisms of a Monetary Union:
In this chapter we introduce the theory of Optimum Currency Area and a general outline of the
principles of a monetary union and in doing so we answer the third research question “How does
the monetary union work?” As the monetary union is at the centre of the discussion in this project,
it will serve well as a basis for theoretical arguments made in the analysis.
Chapter 6 – The Public- and Private Sector:
This chapter is the first of two chapters which answer the fourth research question “What are the
key theoretical concepts relating to the pacts?” Furthermore we will start the analysis in this chapter
combining the theory with empirical data. The chapter focuses, as the title denotes, on the public
and the private sector, with special attentions to the exclusion of the problems with the private
sector. The chapter will conclude by summing up the analytical points made throughout the entire
chapter.
Chapter 7 – Competitiveness:
The focus in this chapter is mainly on the EPP and will be the final of two chapters answering
research question four: “What are the key theoretical concepts relating to the pacts?” As the
previous chapter, this will be analytical in nature combining theory and empirical data. The chapter
consists of the three parts: Unit Labour Cost (ULC), Real Effective Exchange Rate (REER) and
Balance of Payments (BoP). These are concepts which have been introduced with the EPP and The
Scoreboard and acts as a measurement for competitiveness. The chapter will conclude by summing
up the analytical points made throughout the chapter.

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Chapter 8 – The Political Arena:
With this chapter we introduce a new angle to the project; the political reality surrounding the pacts.
The chapter will answer the fifth research question “What are the main political concerns relating to
the pacts’ viability?” As the two previous chapters this will be analytical in nature. The chapter
starts out by introducing the political concerns of Marco Buti regarding the SGP, followed by an
introduction to the political climate in Denmark in relation to the EPP. The chapter concludes by
combining the two sections, assessing whether the EPP has taken former political problems, held
within the SGP, into consideration.
Chapter 9 – Conclusion:
This chapter will join the analytical points made throughout the three previous. It holds our
conclusion, in which we answer our problem formulation: “Which factors contributed to the failure
of the SGP and to what extent have these factors been ratified in the EPP?” Finally we will end the
chapter by giving our answer to which future prospects we think the EPP has, based on the
knowledge gained throughout the construction of this project.
1.4 Philosophies of Science
This chapter will introduce the scientific methodology of this project. The primary source in this
project will be the critical realism as detailed in Macroeconomic theory and in Videnskabsteori i
Samfundsvidenskaberne. As critical realists, the methodology originates from the ontology of our
research object.15
This means that our axiomatic approach is that facts exist independently of
research (objectivism), but further, it also means that facts and relationships between them are
subject to change, particularly over time. The main epistemological consideration in this case is that
causal relationships are inter related, as such economy should not be seen as a number of fixed
closed systems that assume a general equilibrium, except when necessary to explain a
relation(which is not to be assumed to explain causality). Rather, the economy should be considered
as a holistic system of interrelated parts that explains relations between different actors, within a
partially acknowledgeable framework and an uncertain future. To clarify this principle, the
contrasting idea would be one of many fixed systems that uses theory to explain reality; instead we
15
Fuglsang & Olsen (2004); p. 146

12
use empirical data to explain and discuss the veracity of models.
Based on these ideas, the structure of the macroeconomic system is highly complex.16
Simply
put, everything is interrelated; therefore any description of the economic landscape will be
superficial. This is because regardless of whether the researcher is a positivist or a critical realist, a
monetarist of a Keynesianist, the facts will seem fairly straightforward: GDP, Balance of Payments
etc. are not particularly disputable. The dissimilarities arise once researchers attempt to clarify the
relationship between the different facts, and how they affect one another through the system over
time.17
In this framework, the first goal is to create an outline of the macroeconomic landscape. This
allows the researcher to zoom in on markets and institutions, for example the unemployment, and
its relationship with growth. With these in mind, an analysis of theories should look at the
interrelationships of theory and data, events and relationships, and how to use these to develop
hypotheses and method.
1.5 Analytical Structure
Throughout our project we will analyse the correlation between the theories used and the empirical
data we present. This in turn means that we will have a fluent analysis through chapters five, six
and seven. At the end of chapter five and six we will have a summary of the analytical points made
throughout the chapters. In chapter seven, which is rather short, the chapter ends with the analysis
of the data presented.
1.6 Empirical Data
The empirical data presented in this project consists of two sets with different purposes. The first set
is mainly based on legal documents, counting The Stability and Growth Pact, The Euro Plus Pact
and the Scoreboard. In addition to the legal documents, we have chosen relevant scientific articles
and books, treating, in particular, The Stability and Growth Pact and The Euro Plus Pact. In its
essence, the validity of this part of our empirical apparatus is strong as it is merely facts presented
in legal documents and as such cannot be contested. Additionally when we use scholars who have
16
Jespersen (2005); p. 37
17

13
interpreted these legal documents, it is made clear that this is an interpretation. This part of the
empirical data acts as the core foundation in the project as these legal documents are our object of
research.
The second set introduces economic key numbers and statistics on the Euro-zone as a whole
and specific countries with exceptional circumstances to make the case of economic inconsistency
within the EU. The empirical data in this area is provided primarily from OECD and Eurostat and
are as such valid. The point of concern in terms of validity in this perspective is our selection of the
specific countries, the statistics and key figures from these countries and most importantly our
interpretation of this data set. We have chosen to do the selection of this set of data from a
theoretical perspective. Firstly we have treated the variables the SGP focuses on, mainly public
sector deficit and public sector debt, as the most important variables in a monetarist perspective. In
addition to this we have paired these variables with those that, from a Keynesian perspective, have
been neglected completely in the SGP and partly in the EPP.
The choice of countries, and how we use them, is based on a problem oriented approach. This
means the choice of countries is based on finding answers to our research questions, rather than
specific choices for comparative analyses. This also means that our empirical approach gives only a
limited picture of the economics of any one country – the data is meant as a framework for
analysing the treaties, and only deals with the countries insofar as to shed light on these treaties.
These countries should then help us illuminate the potential problems of the SGP and EPP,
comparing different countries ad hoc when it is relevant to a specific value or goal of these pacts.
This means the countries we will be looking at will include diverse parameters.
Firstly there are the countries that were affected the most by the financial crisis: Greece,
Ireland, Portugal and Spain. Secondly there are the great economic powers of Europe: Germany,
UK and Italy. Thirdly there are the Social Democratic welfare countries, Sweden and Netherlands
being the best examples. Lastly there is the Euro-zone as a whole to give a picture of the average.
However, this is only one way to present them. Depending on the assumptions we make in the
analysis, and what we wish to explain, the criteria would instead be different. For example if we
wish to look at the relationship of exchange rate policy to explain competitiveness, then we might
look at Germany and Greece, as two examples of Euro-zone countries vis-à-vis Sweden and UK
who have a floating (or somewhat managed) exchange rate.

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This shows us that the large numbers of countries provide a strong framework for analysing
the goals of a treaty which is to encompass them all. If one (or more) countries do not fit the goals
of the treaty, then problems are bound arise.
1.7 Critique of Sources
This chapter will present our sources from a critical perspective. It will be divided into two parts,
one that will primarily discuss our theoretical sources, and one that will primarily discuss our
empirical sources.
Theoretical sources
Our theoretical presentation is overall divided into three parts. In the first we introduce the core
concepts of the theories, in the second, we present a theoretical critique of the SGP, while in the
third we present some of the core theoretical concepts and terms that we will use to analyse and
discuss the problems presented in this chapter. The theoretical parts of this project are all based on
some basic books on the subject by authors aiming to introduce the theories. These include scholars
De Grauwe, Artis and Nixon, as well as Jespersen and more. There are two main concerns with our
theoretical sources. The first is that the authors we use all share a common trait; they are more or
less devoted to the school of thought that they represent, or alternatively have clear views about our
subject; the SGP and the debate surrounding it. This means that all of our theoretical basis is
normative. This is partly unavoidable considering our subject, as the methodological basis of any
author of economy will always colour the way he or she does his or her research. However, we
could have based more of our theoretical framework on primary sources discussing economics on a
more complex, but fundamental level, not specifically regarding the EU. This would have
broadened our overall economic discussion. However, considering our restricted time frame and the
nature of our subject, we found it most wise to focus on scholars directly related to the subject, so
that we might bring the discussion of the SGP to its highest level. But, as stated, this may have
diluted some of the overall debate on economics in this report.
The second primary concern is that our theoretical sources are somewhat basic in nature. Both
The Economics of the European Union and Economics of Monetary Union, as well as some of

15
Jespersen's work, primarily aim to explain the basics of the economic theories regarding the
European Union and the SGP. We do not use primary sources of economic scholars explaining
these economic theories in detail, and this might impede the complexity of our economic discussion
in the overall perspective.
Empirical sources
Our empirical data mostly comes in two shapes; sources describing or discussing the pacts, and
statistical data. To begin with, we will discuss the first. Our empirical sources in this regard are,
overall, quite varied. We include both first-hand empirical data, such as official documents, as well
as second-hand empirical data such as scholarly articles, newspaper articles, reports and journals.
Our secondary sources generally come from a wide variety of normative bases as well. We include
both scholars of monetarist and Keynesian conviction, as well journals with more 'leftist' and 'right-
wing' approaches to economy.
When it comes to the statistical data, there is little to criticize regarding our selection of
sources – as they are mainly primary in nature. Criticism of our statistical data is mostly in the form
of how we selected the data we did, and how broad that selection was. These concerns are explained
more broadly in the Limitations and Empirical Data chapters.
1.8 Limitations
We have limited ourselves from looking at countries outside the EU. It would have been useful to
compare the EU with other economies such as the USA and China. Additionally, one cannot deny
the ever-growing interdependency caused by globalization. In this light we have limited ourselves
from looking at externalities, which imposes a weakness in the analysis, especially when you take
into consideration that the economic crisis, still in effect, is said to have been triggered by
investment banks in the USA. Drawing on the same reasoning as before, we have chosen to exclude
such factors, because the analysis would have been too difficult to undertake with so many
variables. On the other hand, because the EU has a floating exchange rate it makes sense to view the
region as a closed circuit, to a certain extent.
The political angle of our project is somewhat limited and there are a number of aspects which

16
could have been useful to include. We have chosen to question the lack of sanctions within the
pacts and furthermore the vague formulations of goals and tools held within. In this perspective we
have an overall critique of the SGP put forward by Marco Buti, which we pair with the political
debate in Denmark on the subject of the Euro Plus Pact. In doing so we are excluding all other
members of the pact and the domestic political debates within these. Arguably by choosing only to
look at Denmark, the analysis might not be representative for the EU as a whole, but it works well
for the purpose of our overall analysis. Another interesting angle to include could have been the
political influence on these, otherwise economic, agreements. In other words does the political
reality compromise the creation of these economic agreements? We do not investigate this angle
however, because of the aforementioned time-frame issue.
1.9 Bias
Firstly it should be noted that Keynesianism is ingrained in many of the assumptions we make – this
is partly because of the political leanings of our group, and partly a consequence of our studies at
RUC. This means our choice of methodology and the reflections we make are by their very nature
Keynesian.
Our choice of problem area arises from a preconception that the SGP was by its nature a
monetarist/neo-classical project, and our analysis will therefore inevitably incorporate a Keynesian
critique of this. However, firstly we attempt to be explicit about being Keynesian, and secondly we
attempt to be explicit regarding which assumptions are Keynesian and which are monetarist/neo-
classical and how these different models will give different results. Thus we attempt to be as sincere
and explicit about our bias, and its consequences, as possible.

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Chapter 2 – Theoretical Basis
In this section we will give a brief introduction to the two main schools of economics used in this
project. Therefore we have chosen to give this brief introduction. This however should only be seen
as a basic introduction, we are aware that there are many scholars in the periphery of the schools
which might not fit this simple explanation, but for the sake of arguments using the basic concepts
of the theories this will be sufficient, as, when needed, we will expand upon these.
2.1 Monetarism
Monetarism has its roots in the works of Milton Friedman and the Chicago School of Economics,
which from the 1950’s reinvented the classical economics. It is based on the ideas of the 19th
century of scholars such as John Locke and David Ricardo, hence the term neo-classical. Building
on these ideas, the neo-classical school focuses on the concepts of the ability of the market to
stabilize itself through the actions of individuals seeking to maximize their utility.18
Following this
train of thought, it is assumed that the market forces, working through flexible price and wage
adjustments will always approximate demand and supply, thereby reaching economic equilibrium.
This is so as individuals are always attempting to get the highest possible utility at the lowest
possible cost, and they make such decisions based on rational profit maximization and full
information. Through this automatic equilibrium, the basic assumption is that a deregulated market
with entirely free price and wage levels will ensure growth and stability. The concept of the market
being automatically adjusting to maximal distribution is known as the Invisible Hand. It is the free
price setting in combination with a strong competition which automatically secures employment
and stable prices. This is where the strong scepticism of political meddling in the market comes
from, as the political actors do not act rationally and therefore distort the natural equilibrium, and
hence should be kept to a minimum. Monetarists using these assumptions understood that the
supply of money has no effect on the real economy (the neutrality of money) but only affects the
price level, and therefore monetary policy should be left in the hands of an independent central
bank. If the central bank is not removed from the political process, there will always be a risk that
18
Web: Monetarism

18
political actors will abuse the monetary instruments for short sighted political gain.19
In summary, the neutrality of money, the flexibility of price and wages, the free market as
opposed to the government spending, and supply creating its own demand are the main tenants of
monetarism. Our main source of monetarism specifically regarding the EU is the book The
Economics of the European Union by Mike Artis & Frederick Nixson.
2.2 Keynesianism
The proponents of Keynesianism believe in activist government policies as a tool to control the
economy. Forged by John Maynard Keynes in the wake of The Great Depression, Keynesian
economics promotes government spending to stimulate aggregate demand. The core of the
Keynesian idea is that a combination of public spending and taxation are of primary importance in
managing demand in order to move to full employment, as this is desirable. Keynes' theory was
rooted in the depression of the 1930s. Keynes felt that the economic crisis showed a major flaw in
the free market paradigms. Keynes illustrated that the market forces were unable to create the
general equilibrium that ensured growth and stability on their own. It was a fantasy that the
assumptions of the neo-classical models would lead to such progress, and a helping hand was
needed – an active government economic policy was needed to ensure the well-being of the
economy and full employment, and thereby the well-being of all of the people. This government
policy can take the form of many different tools – but all with the goal of ensuring full employment
and stability. While there are different interpretations of Keynes, most can agree on several basic
rules. Unlike monetarists, Keynesianists believe money has a real effect on the economy by
stimulating aggregate demand – therefore fiscal deficit spending can be used to stimulate the
economy. Rigidities of prices and wages are a fundamental function of markets, and they adjust
only slowly to pressure, i.e. wages do not instantly drop as unemployment goes up.
Keynesianism was exposed to harsh criticism during the 1970s however, where an influx of
inflation caused major problems.20
In response, new takes on Keynesianism were developed. When
we talk about Keynesianism in this report, we talk about the concepts known as New Keynesianism
and Post-Keynesianism. For the discussion of Keynesiansim, Jespersen's Macroeconomic theory
19
Web: Monetarism
20
Web: Keynesian

19
will be the main source of Post-Keynesianism, and Paul De Grauwe's Economics of Monetary
Union will be the main source of New Keynesianism.
At the core of Post-Keynesianism is its methodology, a methodology vastly different than that
of monetarists. Post-Keynesianists take a more pragmatic approach to economics rather than a more
theoretical one. Instead of setting up advanced, refined models to predict the future, Post-
Keynesianism observes reality, and focuses on a few, observable causalities to arrive at its
conclusions.21
Thus, in Post-Keynesianism theory, emphasis is not on predicting the future per se,
but instead on using the observed causalities to identify robust tendencies that will grant some
insight into the workings of economic society. Fiscal policy therefore plays a major role in Post-
Keynesianism, particularly because of focuses on employment and its relationship with demand
stimulus.22
New-Keynesianism23
on the other hand can be seen as a sort of middle ground between
monetarists and Post-Keynesianists. While its proponents agree with monetarists in the long run,
they also focus their study on market failures, failures of coordination, and numerous other reasons
to explain recessions and as a critique of laissez-faire economists. The goal of any Keynesianist
therefore is to ensure approximate full employment, and the most useful tool for achieving this is
for the (responsible) politicians to use demand stimulus to make up for market failures and the
savings paradox.
21
22
23
Web: New Keynesian Economics

20
Chapter 3 – The Pacts
This chapter consists of three parts. In the first part we introduce the Stability and Growth Pact,
starting with a short historical introduction of the origins of the pact, which leads to the specifics of
the pact and finally we outline the changes made to the pact in 2005. The second part of the chapter
will introduce the contents of the Euro Plus Pact. Finally in the third section of the chapter, the
specific measurements and values set out in the Scoreboard for the Euro Plus Pact will be outlined.
3.1 The Stability and Growth Pact
The Stability and Growth Pact was initially initiated by the German government. The initiative, as it
was then called “Stability Pact for Europe”, expressed concerns regarding the stability of the
German government, before and during the negotiations of the Maastricht Treaty, as well as a
reflection of the ratification process in Germany and the position of the Bundesbank.24
One of the
goals was to reassure the German public that the EURO would be as strong a currency as the
Deutsche Mark.
From the outset, the proposal aimed to ensure budgetary discipline in the final stage, and in
doing so also strengthening the credibility of the European Monetary Union.25
Not only did the
original document contain guidelines for reduction of deficits and public sector debt, but also more
visionary features such as limiting public expenses and orientating government spending towards
public investment. The latter aimed at helping business and promote private investment. So
although the title of the original initiative did not express growth as an aim, this was to some extent
a feature. One, as we will see further on, has been expanded widely in later revisions.
The elements of the original document include requirements of stability in preparation of
national budgets. The medium term goals specified that public sector spending should be kept
below the growth in nominal GNP, a deficit goal of 1% of GDP was set as a safeguard for keeping
the deficit under 3% of GDP in economically unfavourable times. The 3% limit was only to be
exceeded in “extreme exceptional circumstances” with the agreement of a qualified majority of the
24
Web: Stability and Growth Pact Experiences and Future Aspects, The; p. 3
25
Ibid.; p. 4

21
participating member states.26
Examples of “exceptional circumstances” were given in the book
“The Stability and Growth Pact”:
“An annual decline in real output of more than 2 per cent of
GDP would be considered exceptional; a decline of 0.75 per
cent of GDP might be deemed exceptional if there is additional
supporting evidence.”27
Furthermore the maximum public debt level was set to 60%.28
The most explicit proposals however, were regarding the sanctions. The German government
wanted automatism in the sanction process and the freedom to enact the most stringent sanctions
right away. The Stability and Growth Pact was finally concluded, by the European Council, at the
Dublin Summit in December 1996. In 2005 the SGP was softened up. This happened after the
Commission took the Council to the European Court of Justice, for failing to take further actions
against Germany and France, who had persistently breached the set of rules in the SGP.29
The changes in the SGP included:
The excessive deficit procedure
Country specific medium term objectives
Greater reliability in statistics provided by member states
Involvement of national parliaments
Countries experiencing negative growth or a prolonged period of low growth avoid the excessive
deficit procedure. The original margin for this was a negative growth of 2% or more. Furthermore,
countries with a short term deficit or one close to the 3% margin, will be able to avoid the excessive
deficit procedure if they can refer a series of relevant factors. Factors such as potential growth, the
26
Ibid.; p. 4
27
Buti & Franco (2001); p. 54
28
Web: Stability and Growth Pact Experiences and Future Aspects, The; p. 4
29
Web: Stability and Growth Pact

22
business cycle, policies supporting R&D and medium term budgetary efforts.30
As a monetarist
project the SGP only focused on the public sector, without giving much attention to the private
sector debt, an aspect that will be critically assessed throughout this project.
3.2 The Euro Plus Pact
The Euro Plus Pact (EPP) was concluded the 25th
of March 2011. The pact was agreed upon by the
Euro-zone heads of state and an additional six member states including Denmark. All EU member
states are invited to join on a voluntary basis. The aim of the pact is to lead EU member states out
of the financial crisis and to secure stability and growth in the EU on the medium and long term.
The EPP is a comprehensive financial agreement consistent with existing financial instruments,
such as the SGP and Europe 2020.31
The main goals of the EPP are to:
Foster competitiveness
Foster employment
Contribute further to the sustainability of public finances
Reinforce financial stability
These areas fall under national competences and it is up to the participating member states
themselves to decide how they want to achieve the goals, although specific attention will be given
to a set of possible measures.32
Competitiveness will be assessed on “wage and productivity developments and
competitiveness adjustment needs.” To measure these factors Unit Labour Cost (ULC) will be
monitored over a period of time, by comparing with other Euro-zone countries and relevant trading
partners. ULC will be monitored for each country separately, for the economy of the country as a
whole and in each of the major economic sectors of the country. The specifics of the reforms in the
30
Ibid.
31
Web: EPP p. 13-14
32
Ibid.; p. 15

23
individual countries are up to the member states themselves to decide. Special attention however,
will be given to reforms ensuring that cost developments are in line with productivity. In this vein
focus is on wage setting arrangements and keeping public sector wages at a level which supports
efforts of keeping wage costs at a competitive level in the private sector. Furthermore, efforts to
increase productivity by investing in education and infrastructure, removal of restrictions which
hamper competitiveness, etc., will be given attention.33
Employment is an important factor in the competitiveness of the Euro area and progress in this
area will be assessed on long term and youth unemployment rates and labour participation rates.
Although the participating member states are responsible for policy actions taken to ensure progress
in this area, specific reforms will be given particular attention. Reforms which promote
“flexicurity,” reduce undeclared work, increase labour participation, promote life-long learning and
tax-reforms lowering the taxes on work in order to ensure a high level of employment.34
Sustainability of public finances to guarantee the full implementation of the SGP will focus on
“Sustainability of pensions, health care and social benefits” and “National fiscal rules.” Proposals
for reforms in this regard include aligning the pension system to the national demographic situation,
limiting early retirement schemes and using targeted incentives to employ older workers. Regarding
the national fiscal rules, the participating member states are committed to adopting the EU fiscal
rules set out in the SGP into national legislation.35
Reinforcing fiscal stability and the strength of the financial sector is of grave importance to
the overall stability of the Euro-zone. In this vein a wide reform of the EU framework for financial
sector supervision has been launched. Furthermore the participating member states have committed
themselves to incorporating national legislation in full respect of the Community Aquis. Strict bank
stress tests will be conducted on a regular basis and will be coordinated at EU level. The level of
private debt for banks, households and non-financial firms will be closely monitored. In addition
special attention will be paid to tax policy coordination. Member states are committed to participate
in structured discussions on tax policy issues.36
33
Ibid.; p. 16-17
34
Ibid. p. 17
35
Ibid. p. 18-19
36
Ibid. p.19-20

24
3.3 The Scoreboard
In relation to the new Euro Plus Pact (EPP), a scoreboard37
has been proposed to help assess macro
economic imbalances in the EU. The aim of the Scoreboard is to help the EU and its member-states
identify major imbalances in time, before harsh economic adjustments are forced to take place. The
scoreboard is based on 4 criteria:
The chosen indicators should reveal imbalances that suggest a weakening of
competitiveness
The scoreboard should be a limited number of indicators
The scoreboard should be simple and transparent
The indicators should keep in mind accessibility, actuality and quality of the available data
Based on these criteria a number of indicators were proposed:38,39
- Balances of Payments, as a % of GDP over a 3-year period. Major imbalances, such as 4% deficit
of GDP in the current account are to be suggestive of an imbalance and might imply a weakness in
competitiveness and inversely an equally large surplus might imply a weakness in domestic
demand.
- Net change in national control of assets. This is related BoP, as it shows the long run ownership of
foreign assets contra foreign ownership of domestic assets, with a value of 35% of GDP. A deficit
here means a country will be burdened by payment of interests.
- Export market share, as measured in a 5 year period with changes of -6%, which is also to be
suggestive as a measure of a country's competitiveness.
37
Web: Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL
38
Web: Indikatorer og scoreboard om overvågningen af makroøkonomiske ubalance
39
This scoreboard is not necessarily representative of the final, as it is currently only a proposal, and is
still in ongoing debate. The article in question does however mention that both Denmark and the other member
states seem agreeable to the overall measures and indicators

25
- Unit Labour Cost, as a measurement of changes over a 3-year period with a value of 9% for Euro-
zone countries and 12% for non-Euro-zone member-states. Increasing ULC is seen as wages
increasing faster than production, the reason for differentiation between Euro-zone members and
non-members is because the Euro-zone members have a common currency, meaning the exchange
rate cannot function as a shock absorber of diverging levels of competitiveness, which it can in the
case of non-members.
- Real effective Exchange rate, as changes over a 3-year period surpassing ±5% for Euro-zone
countries and 11% for non-Euro-zone members.
- Private and Public Debt. Private debt is to have a loft of 160% of GDP as increases above this can
have a weakening effect on the demand and stability of financial sector and make it vulnerable to
shocks in asset valuation, inflation and interest rate. Public debt is still to follow the old and
separate system of the Stability and Growth Pact, but is to be included as an indicator to help give a
more complete picture of the size of a countries debt.
- Size and terms of private sector loans and development of real estate prices. A loft on growth of
15% in the total credit to the private sector and a 6% increases in the price of total value of real
estate is proposed because these tend to suggest an increase in value which is incompatible with any
real value increase. This is considered as a good measure because these values tend to follow the
cyclical development quite closely, and as the recent crisis showed the increasing profits of banks
and value of real estate was mostly speculation (a bubble) rather than representative of “true”
growth.
Lastly the Commission is expected to make a list of supplementary indicators which are to be
adjusted on a yearly basis along with the economic analysis upon which the Commission is to base
its actions. If these indicators and measures are accepted by the member countries, and the member
states fail to adhere to the recommendation by the Commission, any member who is found to be in
breach of these thresholds by the Commission is to be subject to a corrective action plan, as
proposed by the council with the possibility of a fine of up to 0,1 % of GDP.40
40
While the member states seem agreeable to the measures and indicators, even with small
disagreements on what the correct values and thresholds are to be set as, there is however considerable debate on

26
Chapter 4 – The Debate of the Pact
This chapter will serve as an introduction to the complex debate surrounding the Stability and
Growth Pact. The aim of this project is to delve deeper into this to debate. Thus, this chapter will
serve mainly to introduce elements in the debate that are not brought forth by us, but which have
been discussed prior to the writing of this report. The chapter will start with a brief overview of
some of the main criticisms of the SGP, which will serve to give a basic understanding of the SGP's
supposed problems. Next we will identify the overall approach of Keynesianism and monetarism to
the SGP. We do this to give an overview of the theories' standpoints – standpoints which we will
expand upon in later chapters.
4.1 Main criticism of the SGP
One important thing to remember in order to understand the criticism of the SGP is that although it
revolves around the concept of 'fiscal discipline' – the restrictions on budget deficits for example - it
is not the very idea of fiscal discipline that many criticise, but the way it has been implemented in
the varying versions of the SGP. As scholars Alves and Alfonso put it:
”[The deficit-restriction] has been the object of deep discussion
and criticism in political and academic circles. This does not
generally involve questioning the need for fiscal discipline […]
Instead, the discussion has been centred around the way in
which this discipline should be implemented and controlled.”41
Thus, while many scholars support the idea of fiscal control, and view it as a necessity for a
cooperating monetary union, the tools that the SGP have relied on were seen as possibly detrimental
to growth and economic stability. The three main reasons were:
1) That the pact had too much focus on restrictive rules
2) That these rules seemed to focus on the objective of low inflation, without taking into
the functioning of corrective actions and the process and tools of that are to be used in case of a breach. This will be
elaborated on in a later chapter.
41
Web: “New” Stability and Growth Pact: More Flexible, Less Stupid?, The; p. 5

27
consideration alternative options
3) That these rules presupposed negative consequences from budget deficits, not taking into account
possibilities of expansionist economic policies42
When delving deeper into the pact, many criticized the SGP from a more pragmatic angle.
Questions were raised as to the precise solutions to instability the pact used, and what basis these
had been selected on – for example, the 3% budget deficit restriction. Furthermore, how were the
values in the pact calculated? Which methods would be used to establish a state's public deficit –
would things like public investments be taken into account or not?43
One of the fears of people criticizing the SGP, was that the lack of flexibility would prove not
only ineffective, but even harmful, to economic stability in the Euro-zone. If countries had to
adhere to strict fiscal rules during a crisis, and thus have their ability to react with economic policies
restricted, a crisis could worsen as a result.44
Some scholars, including Paul De Grauwe, also
criticise the very basis for the SGP, in this case the SGP-III. The SGP-III, Grauwe said, was
founded on the idea that public debt was increasing and that this was a problem that needed to be
solved. But public debt had been steadily declining until 2007, when the crisis struck and
governments had to bail out banks and a struggling private sector, all the while dealing with
reduced tax revenues. Thus, the ”public debt crisis” only exists in so far as it is related to the
financial crisis. The debt-crisis might then be: 1) not a result of irresponsible governing and 2)
perhaps entirely unavoidable.45
A study by Andrew Hughes Hallet, John Lewis and Jürgen von
Hagen lends credibility to this argument. According to this study, “[...] Most Euro-zone countries
have avoided the 3% budget deficit limit of the Stability and Growth Pact (SGP) due mainly to
economic growth.” In other words; expansion, not restriction, has been responsible for the “stars”
in Euro-zone economies.46
Another important point of critique relating to the SGP is political or “practical.” This critique
claims that the SGP is simply too difficult to enforce. Evidence of the lack of enforcement is most
outspoken in the case of France and Germany, who exceeded the limit of the budget deficits but,
42
43
44
45
Web: Why a Tougher Stability and Growth Pact is a Bad Idea
46
Web: Study Finds Lack of Market Flexibility Has Undermined Stability and Growth Pact

28
despite threats from ECOFIN, were never penalized.47 This institutional criticism of the SGP is
expanded with a criticism of the ECB's role in managing the fiscal policy of the member states:
“The ECB has long claimed that its only purpose is to pursue
price stability, e.g. control inflation. Nevertheless, [...] the ECB
reacted too little, too late when economic growth slowed in the
early 2000s. [...] The result was that it became exceedingly
difficult, if not impossible, for some member states to satisfy the
SGP’s requirements.”48
Thus, another perspective of the criticism is that institutions such as the ECB react with their policy
regulations with “bad timing,” causing more harm than good. The last central point of overall
criticism of the pact is that while it is not sufficient to solve the problems of the Euro-zone and
stabilize its economies, it is still “better than nothing.” Martin Heipertz concludes in his report on
The Stability and Growth Pact that the incentives the pact gives to states to follow it are too limited.
Additionally, that pact focuses too much on restrictive short-term goals instead of preventing long-
term instability, and that it, by not being based on voter-participation and not generating enough
results, fails both an “input” and “output” legitimacy-test. Still, Heipertz concludes: “It [the SGP] is
surely not the optimal solution. However, the second best is still better than nothing.” From
Heipertz' point of view, countries that systematically fail to adhere to the pact will be politically
forced to formulate alternatives, which can provide the basis for a stronger pact.49 In light of the
recent developments regarding the EPP, Heipertz may have formulated a correct thesis on the last
bit; that the failure of one pact paves the way for another by way of necessity.
4.2 New-Keynesianism and the SGP
According to Paul De Grauwe, the two primary focuses of a stability pact in a monetary union
should be50
1) Making sure there is flexibility to make up for the lack of an exchange rate tool, so
that countries can combat asymmetric shocks, and 2) Defending against spill-over effects from
47
Web: It is broken. Can it be Fixed?; p. 12
48
Web: It is Broken. Can it be Fixed?; p. 13
49
Web: Stability and Growth Pact, The – Not the Best but Better than Nothing; Chapter 4 – Conclusion
50
De Grauwe (2009); p. 244

29
budget deficits and public debt in the member-states. However, it seems that the SGP has focused
almost solely on the latter of these two concerns. Even worse; countries which have seen a
moderate decline in GDP during the recession would have too small a decline in GDP (between 0%
and 2%) to be protected against the deficit penalty. If the Euro-zone followed the rules of the SGP
strictly, these countries would be subject to fines because of their budget deficit, prompting them to
further tighten the reins on their fiscal policies. Considering the need for fiscal flexibility in a crisis,
this part of the SGP can be directly harmful for the economies of the member-states, causing even
worse spill-over effects.51
In 2002, major economic downturns for, among others, France and
Germany, had the result that the Commission recommended actions against the two states;
imposing the SGP's budgetary balance even in times of declining growth or stagnation. Refusing to
do this, it came down to a political brawl between France and Germany, and the Commission.
Predictably, the nation states won this battle, even though the Commission might have been “right”
according to the rules laid down in the SGP. This, of course, invalidated the pact. As De Grauwe
puts it: “For all practical purposes the Pact had become a dead letter.”52
Ergo, this presents
another danger of requiring tight budgets in a monetary union; in situations where countries cannot
comply with the rules, the rules risk being effectively annulled. Since both Keynesians and
monetarists agree that some form of conformity on fiscal policy is required in a monetary union,
this must be perceived as negative in any case. Most Keynesians agree that the objectives of the
SGP were good – budget control and sustainable debt levels – however, De Grauwe uses the classic
Keynesian argument that in times of recession, because of the savings paradox, it is useful for
governments to be able to stimulate demand even if it incurs some debt doing so.53
4.3 Monetarism and the SGP
The SGP was, from a monetarist point of view, supposed to bolster the agreements already present
in the treaties of fiscal discipline in Europe. Criticism has been levelled against the SGP for being
too constrained, in particular for not letting automatic stabilizers operate. According to the
51
De Grauwe (2009); p. 244-245
52
De Grauwe (2009); p. 245-246
53
De Grauwe (2009); p. 246

30
monetarists, however, this is untrue.54
Rather, problems with the SGP have been due to the national
governments – in particular their failure to “undertake sufficient consolidation in “good times.””55
In other words, countries may have complied with the rules in the SGP and the maximum budget
deficit restriction, but at the same time neglected to prepare for economic difficulties while
circumstances were beneficial and the economic surplus was there to help preparations. Another
problem in this vein is related to the collaborative ignorance displayed by the Euro-zone members
with regards to the SGP. Lack of peer-pressure towards economically irresponsible member-states
resulted in a complete lack of sanctions. Most notably, countries that presented “overly optimistic”
predictions of financial growth were not criticized and their behaviour was not questioned.56
When
pressure was put on countries, it did not have the desired effect, or was inaccurate. In addition, the
commission warned national governments without effect. For example, the commission
recommended 'early warnings' to the Portuguese and German governments in 2002. The Council
however, did not find it prudent to release these warnings, since the Council argued the
Commission's worries had already been taken into account by the “accused” governments. Later,
however, an audit showed that Portugal and Germany had indeed exceeded the 3% budget deficit.57
“The monetarist conclusion” to the SGP and its successes and failures thus becomes a
relatively simple matter. The SGP and the monetary union functions in theory, but in practice they
have been undermined by non-compliant governments, institutional inefficiency and the lack of
ability to sanction “offending member-states.”58
54
Artis & Nixon (2007); p. 307
55
Artis & Nixon (2007); p. 308
56
Artis & Nixon (2007); p. 308
57
Artis & Nixon (2007); p. 309
58
Artis & Nixon (2007); p. 311

31
Chapter 5 – The Mechanisms of a Monetary Union
The aim of this chapter is to give a theoretical basis for the discussion of the monetary union. Firstly
the reader will be introduced to the theory of optimum currency area, which lies at the heart of the
monetary union. This will be followed by a more pragmatic discussion of the concepts of the
optimum currency area as well as additional arguments for a monetary union.
5.1 Optimum Currency Area
In order for a monetary union to work, the participating member states have to give up national
monetary instruments to a central administration. This means that national central banks will either
cease to exist or have no real power. Not all nation states are alike and the authority to control
exchange rates can, in many cases, prove to be a valued policy instrument. This transfer of national
monetary competences to a common central bank is one of the costs of a common currency. In the
60’s Mundell, McKinnon and Kenen founded theoretical thoughts on this subject.59
In the following
we will present the basics of this “theory of optimum currency areas” as it will prove to be at the
core of several arguments throughout this report.
At the core of the theory of optimum currency areas lies the analysis of demand shifts or
asymmetric demand shocks, as they will be referred to in the following. We have chosen to take our
basis in De Grauwe’s60
explanation of this theory, making the argument from a monetary union set
up between two countries, as it explains the mechanisms of the optimum currency area without
over-complicating it. Obviously a monetary union between 17 countries with different national
constellations, as is the case with the EMU, is far more complicated. But for the sake of our
argument this basic explanation will be sufficient.
In this explanation we will use the example of a monetary union set up between two countries,
Italy (IT) and Portugal (PT). The two countries IT and PT set up a common currency which is
managed by a central bank. We devise a thought-experiment; that the consumers within the
monetary union shifts their preference in favour of products produced in IT, at the cost of a
decreased demand for products produced in PT. This results in an asymmetric demand shock. The
59
De Grauwe (2009); p. 5
60

32
increased demand for products made in IT will increase the price level and thereby the incentives
for the producers in IT to increase their output, which in turn lowers the unemployment in the
country i.e. greater output, require a greater workforce. In contrast the output in PT is likely to
decrease, which leads to increased unemployment. There are two factors which can help to adjust
this imbalance between IT and PT: wage flexibility and mobility of labour.61
If there is sufficient wage flexibility, wages in PT will decrease and adjust to the lessened
demand, in turn making Portuguese products cheaper to produce and thereby more competitive. The
opposite will happen in IT where wages are likely to go up making Italian products less
competitive. This has stabilizing effect on the demand i.e. increasing demand for Portuguese
products and decreasing the demand for Italian products.62
The second adjustment mechanism, labour mobility, relies on the assumption that the
unemployed workers in PT, will move to IT where there is an increased demand for labour. In
doing so the price level in PT will not decline due to greater unemployment and the wages in IT
will not increase due to the decrease in unemployment.63
If one or both of these mechanisms are in place, the adjustment problem will be solved. If this
is not the case however, if prices in PT do not decline and the Portuguese workers are unwilling to
move to Italy, the increased demand for Italian products will force the wages and thereby prices up,
leading to an increased competitiveness in products produced in PT. In other words, if wage
flexibility and labour mobility are too rigid, equilibrium will only be reached through inflation in
Italy.
If the two countries had not been in a monetary union and kept their monetary policy
instruments intact, they could have done several things to adjust to the asymmetric demand shock.
De Grauwe distinguishes between two types of exchange rate regimes, flexible exchange rate
regimes and regimes where countries peg their currency to another currency. If PT and IT had
chosen a flexible exchange rate system, PT could have lowered their interest rate increasing
aggregate demand and IT could have done the opposite raising their interest rate and decreasing the
demand. This could lead to a depreciation of the PT currency and an appreciation of the IT
61
62
63

33
currency, making Portuguese products less expensive in Italy and thereby increasing demand. If
they in the other case had chosen to peg their currencies, PT could have devalued their currency
against the Italian making their products more competitive, which again would lead to increased
demand.64
To sum up, when countries in a monetary union are hit by asymmetric demand shocks there
are two adjustment tools to reach equilibrium: wage flexibility and labour mobility. If these are not
sufficiently present, a shock can lead to inflation. When in a flexible exchange rate system,
countries can adjust their interest rate to boost demand. If they, however, are in a regime where they
have pegged their currencies they can choose devaluation to boost demand and reach equilibrium.
5.2 Monetarism and the Monetary Union
From a neo-classical or monetarist perspective, a central element in the success of the monetary
union was limiting national government's continued public deficit. The increase in public debt led to
“an increase in equilibrium real interest rates, crowding out of private investment, and, therefore,
to lower capital stock.”65
In other words; governments had failed to control economy via fiscal
policy, thus, they had to be constrained. This need is further solidified by the fact that negative
economical situations in one country undoubtedly will have “spill-over” effects on other countries,
particularly within the Euro-zone. In the mind of a monetarist, this reinforces the argument for a
need for common restrictive policies to ensure one country's debt problems do not become the debt
problem of the collective union.66
Another argument for the monetary union and the constraints on
national fiscal policy it came with, was the fact that factors such as an integrated market, free
movement of good and workers, as well as flexibility within a market, were key to protect
economies against economic shocks. Research showed that in these areas Europe scored much
worse than USA. The argument then became that an EMU in itself would contribute to the
aforementioned factors; that it would positively affect the integration of the European market,
which would in turn help defend European economies from economic shocks. Along with
promoting and strengthening free movement of goods and people, this could empower the European
64
65
Artis & Nixon (2007); p. 281
66
Artis & Nixon (2007); p. 282

34
economy, making it less vulnerable and more able to adjust. This, in turn, reduced the need for
active fiscal policy. Furthermore, the monetarists claim, empirical evidence gathered within the last
decade seems to show that an increase in public debt results in an increased interest rate.67
One of the benefits of the Monetary Union is that it strips the national governments from its
ability to print money – thus rendering it insusceptible to inflation-bias:
“For example, once social partners have concluded wage
agreements, higher than anticipated inflation will reduce ex post
real wages and thus increase output and employment. Such
incentives to inflate will, however, be understood ex ante by a
rational public who adjust their inflation expectations
accordingly.”68
In other words, a government that attempts to increase production and employment via inflation will
be predicted by the rational public which will “adjust their actions accordingly.” When stripped of
its ability to inflate via money-printing, a government can no longer cause this or similar situations.
This is obviously beneficial to the economy, if the claim of a rational public is true. The other basic
power of governments – the power of taxation – is also affected by a tight, monetary union. As
flexibility and freedom of movement grows, countries will compete for workers and products via
their tax-rates, forcing governments to lower their taxes – or at least forcing them not to increase
them. This reduced control of tax-rates for governments is not an argument against the monetary
union though; rather it is perceived as yet another argument for more fiscal discipline and public
deficit control. Put differently, the lowered income from taxes resulting from increased competition
among the member-states must be balanced by more fiscal discipline.69
67
Artis & Nixon (2007); p. 282-283
68
Artis & Nixon (2007); p. 285
69
Artis & Nixon (2007); p. 287

35
Chapter 6 – The Public and Private Sector
In this chapter we introduce the core issues of the SGP concerning its lack of focus on the private
sector, as well as the secondary concerns of a 3% public sector deficit and a government debt not
exceeding 60% of GDP. As mentioned earlier, these values were seen as a central condition for
growth and stability within the union. This chapter starts by introducing the concept of the public
sector budget and introduces the relevant data in order to compare the economies of Europe. We
analyse the preconditions that lie behind the budgetary criterion and then contextualise these with
our empirical data as well as our theoretical understanding. We continue by analysing the
shortcomings of the SGP and its narrow focus on the public sector budget excluding the private
sector. We conclude by looking at the recent real estate bubble as our macroeconomic theory
indicates that an understanding of this is crucial, in order to understand the boom-and-bust cycle
and crisis in general.
6.1 Public Sector Deficit
Simply put, the public sector budget is made up by receipts and expenses, which then are
subtracted, making up a country’s public sector budget deficit. A more thorough explanation is
given here below.
Expenses Receipts
Wages to employees
Purchase of goods
Real investments
Social benefits/pensions
Subsidies loans
Income taxes
VAT and excise duties
user charges
The public sector's revenue and expenses can not be viewed independently. For instance, if a
government approves new expenditures, it must simultaneously find a way to finance this new

36
expenditure.70
For example, if a government decides to lay off people in the public sector and these
do not find employment in the private sector, then they still become an expense due to receiving
welfare benefits (unemployment). So this argument preconditions that a job in the public sector has
its equivalence in the private sector in order to create real savings.
A significant part of the SGP has been on financial discipline, or, in other words, a balanced
budget, where revenues meet expenses. As mentioned earlier the criteria for this is an annual budget
deficit no higher than 3% of GDP. Introducing figure 6.0 we see how countries have managed to
meet these criteria:
Figure 6.0: Government Deficit71
Until the crisis, we see that the Euro area as a whole has kept its deficit approximately at the desired
level of deficit. However countries such as Greece and Portugal have had problems meeting this
criteria and the international crisis has only worsened this. At the moment all countries as a result of
the crisis are breaching or coming close to breaching the 3% criteria.
70
71
Appendix 1

37
6.2 Public Debt
Another criteria in the SGP is a national debt lower than 60% of GDP or approaching this value.
We see on figure 6.1, that the Euro area as a whole has kept its government debt at constant level
around 70%, whereas Greece and Italy have been running with a government debt around and
above 100% of GDP.
Figure 6.1: Government Debt72
6.3 Fiscal Policy Instruments
Fiscal policy is the government's use of expenditure and revenue, with an aim to influence the
economy. However not all expenditures and revenues can be used as fiscal policy instruments. We
have to distinguish between
“1) discretionary interventions initiated by politicians, and 2)
business cycle dependent expenditures and revenues, the so-
72
Appendix 2

38
called automatic budget-changes or automatic stabilizers, which
are beyond the direct control of the government.”73
Decisions concerning discretionary items can be made up in specific expenses such as investments
in infrastructure. The point to be made here is that discretionary expenditures can be set according
to political belief and desires. In opposition to this, we find the business cycle dependent
expenditures and revenues. It is impossible, in advance, to set the cost of for instance
unemployment benefit, social benefits and early retirement pensions, as these payments are
dependent on the actual business cycle.74
It is not possible for the politicians to set the margin of
these expenditures. However, politicians are able to raise for instance the requirements for gaining
social benefits or raising the minimum retirement age.
Within the EU, the member states have different levels of welfare systems and in this context
different unemployment benefit schemes or automatic stabilizers. These automatic stabilizers have
been set in place to reduce the sensitivity of the economy when a “slump” occurs. In general a
“slump” is a result of a decline in demand. The decline in demand automatically lowers the output
i.e. a percent of the workforce relevant to the decline in output will become unemployed. When
unemployment benefits are in place, the unemployed will receive income in form of unemployment
subsidies, thus keeping their purchasing power at a respectable level and thereby in turn keeping
their demand at a respectable level. In other words the unemployment benefits to some extent
counteract the expected decrease in demand. One downside of these automatic stabilizers is that
when the economy is exposed to a continuous “slump” and unemployment rises, the public sector
spending can spin out of control. The main factors which contribute to this are reduced tax income
from work and increased expenses in form of unemployment benefits.75
As the member states have
different levels of automatic stabilizers, the effect an economic “slump” will have on the member
states will differ i.e. countries with extended unemployment benefits will suffer bigger losses on the
public sector budgets, than those with more restricted unemployment benefits. This in turn means
that member states with an extended welfare system are more prone to exceed the 3% budget deficit
cap set out in the SGP, which could lead to a set of restrictions and economic penalties as set out in
73
74
75
Jespersen (2009); p. 166-167

39
the excessive deficit procedure.
As mentioned earlier, governments have different methods available to bring down their
deficits. They can either raise the receipt side or reduce their expenses. Governments can choose to
reduce the public sector, thereby making savings through reduced wage costs. In order for this to be
a successful manoeuvre you would have to ensure that the private sector is able to absorb this
increase in labour supply. Another way to bring down the deficit is by reducing the level of real
investments in infrastructure (roads, railways etc.). However, this will also lead to a fall in demand,
which again will affect the private sector and its ability to employ. Governments could also choose
to reduce its social benefits. This however would lead to a fall in private consumption, which in turn
would lead to a fall in aggregate demand, causing further unemployment. And lastly another way to
go is to simply increase its revenues through higher taxes. This would however again cause a fall in
consumption, and again fall in demand. These arguments for savings could however be countered
by arguments in favour of budget deficits not being a decisive factor and instead focus on
increasing aggregate demand. This could be done by economic stimulus via an expansionary fiscal
policy, for example by implementing discretionary measures such as major public investment
programs. Of course, this would in the very-short run lead to further budget deficit, but will also
help ensure both a higher growth and lower expenses on other accounts such as unemployment
benefits. Professor at Columbia University, Joseph Stiglitz, agrees that sometimes savings are
necessary. However too many European countries are leading tight fiscal policies, which only
worsens the economic downturn.76
Instead, he argues, investments should be made in order to
ensure growth. This would stimulate the private sector, ensure employment and is in his view the
best way to bring down the budget deficit in the long run.77
This debate over fiscal responsibility then becomes a debate about which assumptions are the
true conditions of macroeconomic behaviour. If the assumptions are neo-classical or monetarist,
then savings in the public sector will reduce investment crowding, thereby having a positive effect
on both growth and public budgets. This line of thought is what is behind the 3% and 60% criterion
of the SGP.78
In response to this we find the Keynesian argument, which argues that a budget deficit
76
Article: Økonomiens superstjerner i København
77
Ibid.
78
Artis & Nixon (2007); p. 283-285

40
is not necessarily a negative factor. A Keynesian would argue that discretionary measures are
necessary in order to help the economy move towards full employment, thereby solving the above-
mentioned problems.
6.4 Budgetary Convergence
Many economists have criticised the 3% and 60% norms as being too arbitrary. The formula
determining the budget deficit needed to stabilize the government debt is a follows:79
d = g · b
b is the steady state level at which the government debt is to be stabilized (as a percentage of GDP
(60%)), g is the growth rate of nominal GDP, and d is the government deficit (as a percentage of
GDP).80
From the formula we see that in order to reach the desired level of government debt at 60
percent of GDP, budget deficit must be brought to 3% of GDP if and only if the nominal growth of
GDP is 5% (0.03 = 0.05 · 0.6). It is unclear as to why the debt should be stabilized at 60%. If for
example other numbers such as 70% or 50% were chosen, then the deficit should be 3.5% and 2.5%
respectively. These numbers are very important as they constitute the meaning of budget discipline
and a ±0.5% deviation would have a major impact on states and their room for fiscal policy.
However these values were set at Maastricht, where the average debt-GDP ratio was 60%. Secondly
they were conditioned on the nominal growth rate of GDP, which at that time was relatively high. It
is however interesting to see what would happen if growth were to slow down to for instance 2.0%.
Then the budget deficit should not exceed 1.2%, which shows the fragile mathematical equation
upon which these criteria were formed.
Growth Rate Government Debt Budget Deficit
0,05 0,6 0,03
0,04 0,6 0,02
0,03 0,6 0,02
0,02 0,6 0,01
0,01 0,6 0,01
79
De Grauwe (2009); p. 148
80
De Grauwe (2009); p. 148

41
This mathematical way of arguing furthermore shows us, that if the budget deficit is made
dependent on the annual growth, then a slowdown in growth should lead to fiscal tightening in
order to compensate for a lack in growth. And this way of arguing has also been criticised from
different sides. Especially Keynesians see these debt and deficit values as a straitjacket which does
not allow for much fiscal freedom within the member states. They argue that fiscal tightening
during an economic downturn is not desirable, as expansionary fiscal policy is seen as the best way
in order to help create demand.
One of the major problems with the 3% and 60% is that they precondition a 5% annual growth
rate. This is based on the assumption that a state of equilibrium between these values is possible.
And from a strictly mathematical view this is true. However the problem arises when one of these
start changing rapidly. For instance in welfare states, where business cycle dependent expenditures
such as unemployment benefits are relatively high, an economic downturn would have a significant
impact on the budget deficit. Keynesians argue that in times of economic downturn, governments
must step in and stimulate the economy and raise aggregate demand. However, this is impossible
according to the mathematical reasoning which lies behind the SGP, as a fall in growth should lead
to fiscal tightening.
6.5 Private Sector Debt
Much of the recent criticism against the SGP has been that it ignores private debt. This criticism has
been strengthened due to the financial crisis. Therefore this sub-chapter aims to first give a
theoretical insight into the effects of private debt, and secondly to establish what the main
divergences are, and how big these are, in the EU. There is an economic equilibrium relating to
current account balance, budget balance and private sector balance. To clarify, this means that when
a country runs a current account deficit, the private sector and the public sector cannot de-leverage
at the same time:
Private Balance + Budget Balance = Current Account Balance

42
From this we denote Private Balance = Private Saving – Investment.81
An unsound development in
the private sector debt could potentially harm domestic demand, growth and cause financial
instability.82
It has been argued that this unsound development in the private sector was the decisive
factor causing the recent crisis, and not profligacy of national governments. Paul De Grauwe
argues, and our empirical data shows, that prior to the crisis, government debt to GDP ratio in the
Euro-zone was actually declining.83
The private debt however has risen across the economy. From
consumers using credit cards, through industrial companies borrowing for expansion, and financial
companies using debt to buy risky assets. In theory there is no maximum level for this debt relative
to GDP, but Ireland and Iceland found the limit in practice when their debt level reached 700% and
1200% respectively.84
This burden proved too much and threw them into financial crisis.
“Throughout the 1980s and 1990s a rise in debt levels
accompanied what economists called the “great moderation”,
when growth was steady and unemployment and inflation
remained low. No longer did Western banks have to raise rates
to halt consumer booms... asset prices were rising even faster, so
balance-sheets looked healthy.”85
However, in early 2007 and onwards there were signs that economies were reaching the limit of
their ability to absorb more borrowing. The growth-boosting potential of debt seemed to peter out.86
In the wake of the financial crisis it has become harder to distinguish between debt in the private
and public sector as they relate to each other:
“If the private sector suffers, the public sector may be forced to
step in and guarantee the debt … Otherwise the economy may
81
Web: Deciphering the G10 Sovereign Debt Crisis: A Macroeconomic Perspective
82
Web: Indikatorer of scoreboard om overvågningen af makroøkonomiske ubalancer
83
Web: Fighting the wrong enemy
84
Web: Indebtedness after the financial crisis – World debt
85
Web: Repent at leisure
86
Ibid.

43
suffer a deep recession which will cut the tax revenues
governments need to service their own debt.”87
As a result of this, government debt in many countries exploded in 2007. Therefore, it became a
necessity to save the private sector; in particular the financial sector. As noted earlier, the SGP
focuses mainly on government debt and deficit discipline. However, as Paul De Grauwe points out,
it seems to fight the wrong enemy.
If we look at government debt in the United Kingdom we see that the UK has kept its government
debt below the desired 60% of GDP (Figure 6.2). The total debt however has exploded to 466%,
where government debt “only” contributes with 59%. One can see that UK borrowing primarily was
driven by growth of the financial sector.
Figure 6.2: Total Debt to GDP (UK)88
87
Ibid.
88
Appendix 3

44
If we then take a look at Spain we see a similar pattern unfold. Spain's debt has grown rapidly since 2000 in
spite of significant government reduction (figure 6.3). We see here as in the UK that it is primarily the
private sector which accumulates significant debt.
Figure 6.3: Total Debt to GDP (Spain)89
And finally turning to Germany in figure 6.4 we notice that Germany experienced increased growth after
reunification but this has stabilized after 2000. It also worth noticing that of all these countries it is
Germany who has the highest government debt (73%) making it the only country in violation with the 60%
rule. It seems somewhat peculiar in this regard that Germany is regarded as one of the strong-performers
of the SGP.
89
Appendix 4

45
Figure 6.4: Total Debt to GDP (Germany)90
From these countries we see that it has not been a growth in government debt that constituted the
most significant problem, but debt accumulated in the private sector. One of the main problems
related to this is the fact that the SGP does not mention private sector debt with a single word,
thereby rendering it irrelevant in relations to measurement of member-states performance. This has
been based on an assumption: that private and public sector debt could be meaningfully separated.
However as mentioned before, the financial crisis proved this assumption to be wrong.
Governments were forced to increase their public deficit and guarantee the debt, in order to save the
private sector from a regular meltdown. From this perspective it seems quite odd that the SGP
focuses so narrowly on the public sector and its deficit, when the small imbalances of Germany and
even the considerable public debt of Italy has not caused problems of anywhere near the magnitude
of for instance Ireland. It seems quite arbitrary that no measurements or rules apply for the private
sector and its debt.
As mentioned earlier, the SGP was founded on a monetarist discourse, which stipulates that
government and its debt and deficit are the main factors which hinder growth and stability. Limiting
government and its intervention in the economy would leave the market forces free to pursue profit
maximising and secure growth and thereby stability, which would be to the benefit of all. However,
this is a theoretical approach. Reality shows us that market forces alone will not provide stability.
Neither will the SGP be the “iron-clad” guarantee against collapse, such as was theorised. The
90
Appendix 5

46
collapse of the financial sector showed the instability of the private sector. Several financial
institutions had become “too big to fail”91
and had to be bailed out by governments in order to
prevent a threatening depression. This shows us that it is not sufficient to look only at the public
sector as this only shows us a partial view of the economy as a whole. It is questionable to speak of
fiscal discipline in the public sector without looking at the private sector, as reality has shown that a
separation of these two is only true in theory. The debt which accumulated in the private sector was
transferred, becoming public debt and making the difference between the public and private sector
debt blurry.
6.6 Real Estate Bubble
Another contributor to the recent financial crisis was the collapse of real estate bubbles. A real
estate bubble is characterized by
“rapid increases in the valuations of real property such as
housing until they reach unsustainable levels relative to incomes
and other economic indicators, followed by decreases that can
result in many owners holding negative equity (a mortgage debt
higher than the value of the property).”92
The Economist asks the question of whether housing is the most dangerous asset in the world,
because the purchasing of a house usually involves taking on lots of debt. The bursting of a real
estate bubble hits banks disproportionally hard and research in financial crisis show a consistent
link between house-price cycles and banking busts. Falling house prices lead to an increase in banks
non-performing loans, and as their collateral shrink, so does their capacity to lend.
The recent boom in house prices were driven by two common factors: low interest rates
encouraged home buyers to borrow more money and the households lost faith in equities, making
properties look more attractive. One of the major problems has been that
91
Web: Greenspan Says U.S. Should consider Breaking Up Large Banks
92
Web: Real estate bubble

47
“rising house prices have boosted consumer spending by making
people feel wealthier, offsetting the effect of falling share prices.
Consumers have also been able to borrow more against the
higher value of their homes, turning capital gains into cash
which they can spend on a new car or a holiday.”93
Rising house prices help boost spending, however when these prices fall, so does consumption,
causing pain for the economy. Even a modest weakening of house prices would hurt consumer
spending, because home-owners have been cashing out their capital gains at a record pace.
Furthermore a decline in property prices will leave some households with homes worth less than the
amount they have borrowed. This could lead them into insolvency. An example: in the wake of the
Danish real estate bubble burst in 2007 it was estimated that, in 2009, around 120.000 home owners
were considered insolvent.94
Looking at figure 6.5 we see that housing prices have risen
significantly since 1996 reaching a high around 2007, where the financial crisis began. After this
prices started declining, however at different rates. Ireland, however, has experienced a regular
meltdown falling from around 400% to around 250%.
Figure 6.5: House-price Index95
93
Web: House of cards
94
Web: 120.000 boligejere teknisk insolvente
95
Web: Clicks and Mortar

48
The effect of this massive growth in housing prices is that there is a boost in wealth, or at least how
rich people believe themselves to be. On the one hand this stimulates consumption and thereby
creates demand. But on the other hand when prices go down, people feel poorer and spend less,
thereby decreasing aggregate demand. The problem is that when bubbles burst, the value of
property falls, but the level of debt does not. The burden of repaying this debt is likely to depress
aggregate demand, thereby causing economic slump. This shows us that the instability of housing
prices has the effect of deepening a recession and overheating the economy in good times. The
monetarist view, at least in its more basic form, will of course be that the market forces are best left
to handle this on their own. The Keynesian view on the other hand is that the government should,
through regulation, fiscal and monetary policy, ensure that the stability of house prices does not get
out of control. However, this is not entirely unproblematic. Many of the SGP members are also
members of the Euro, and therefore rely on the European Central Bank for control of their interest
rates, and further interest rate has other effects on the economy than merely housing prices. Fiscal
policy on the other hand would mainly take the form of either raising estate taxes or implementing
transaction costs on the value growth of houses. However raising taxes for a large segment of the
population, or increasing transactions for sales, has despite the positive view of many economists,
proven to be extremely difficult to implement politically.
6.7 Analytical Summary Part I
In this chapter we have identified two core problems with the SGP. The main problem being that the
pact completely ignores the significance of the private sector and the secondary problem being the
3- and 60% thresholds. The latter are chosen from a mathematical theoretical perspective that only
makes sense when connected to a specific growth rate. This is, in our minds, not a sensible way to
conduct economic policy. This is evidenced by the fact that the 3% criteria was chosen due to a
period-specific growth rate, and the 60% criteria was chosen because it was the average public
sector debt in the Euro-zone at the time. But, even making these rates flexible would not have been
enough. This is because these criteria completely ignore the fundamental problem that caused the

49
financial crisis; the growing debt-issues in the private sector. Thus, not only must the rates become
flexible in order to make economic sense; the SGP should also have taken heed of the private sector
and its problems, notably private sector debt. The public and private sector cannot be kept apart in
theory or in practice, as their economic fortunes are intertwined. One extreme example is the bank
bail-outs which blurred the borders between state and the private sector. Financial institutions –
banks – are integrated in the modern economy in a way that makes them key to the stability of it. It
is unwise to ignore them and their effect in a Stability and Growth Pact. Thus, a solid pact should
include details about how to secure the financial institutions that are among the most important
factors in our economy. However, even a pact that answers these concerns might be problematic.
This is so because of the restrictive nature of a focus on the public sector that does away with a very
important tool for financial policy; the expansive financial policy. As we have shown earlier, this
can cripple economies already in trouble due to the economic crisis. If the only tool available during
a financial crisis in which demand is low is to restrict the public budget, thus averting one-self from
aggregating demand, a vicious circle where demand plummets can potentially occur. One can only
speculate how bad a situation the EU might have been in, were it not for the last-minute save from
the central governments in the form of aforementioned bank bail-outs. Something ill-advisable
following a monetarist line of thought became a necessity to undo the damage caused by the crisis.
Furthermore, countries who have automatic stabilizers in place to protect them against these
situations - i.e. a fall in demand when a “slump” in the economy occurs - will be in even greater
jeopardy if the “slump” is long lasting, because unemployment benefits will start to hollow out the
government treasury. Thus, member states with extended welfare systems and hereby extended
unemployment benefits will be more prone to exceed the 3% budget deficit.

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