The fiscal convergence criteria of the Maastricht treaty have proved controversial, in part because of their deflationary impact on economies that are already suffering from high unemployment, and also because of the strict monetary discipline needed to meet the inflation and exchange rate criteria in the treaty. In Discussion Paper No. 1351, Research Fellow Andrew Hughes Hallett and Peter McAdam set out to calculate the fiscal corrections necessary for the four largest European economies to meet by 1999, the 3% deficit to GNP ratio and for those ratios to be maintained thereafter. They use a conventional multi-country econometric model to make empirical estimates of the fiscal contractions necessary and of how these contractions must change over time for countries to reach, and then maintain, the required target ratios.

The authors argue that because the criteria are defined as ratios, a change in the policy mix is required – fiscal contractions alone are not enough. The interaction between fiscal and other policies is therefore the crucial factor. The change in policy mix might involve monetary relaxation, currency depreciation, or perhaps most effectively, wage restraint to boost competitiveness. Certainly some action is needed to maintain (or boost) the ratio’s denominator (GDP), since fiscal cuts alone will reduce both numerator and denominator, leaving the ratio unchanged. There is, however, a debt criterion, and it is most unlikely that the deficit and debt criteria can be achieved simultaneously. It is very hard to reach the deficit criterion and remain there without accompanying policies designed to sustain output. Otherwise fiscal cuts will continue to deflate the economy, and hence inflate the deficit ratio, in an attempt to reach the required debt ratio. To offset this there must be reform of the tax regime as well. These results point to growth and the design of the tax regime as being the key features of the fiscal side of a successful monetary union.