This was Sweden’s experience with the combination of a currency peg and deteriorating public finances in 1991-1992. But now there is another danger. Given that the target of imminent euro adoption is gone, and the large euro area nations do not provide real leadership on fiscal soundness, there is less incentive for some of the new member states to stick to the consolidation of their public finances. This is especially obvious for Hungary, where the deficit was 7.5 per cent in 2005 and is, according to present plans, expected to increase to around 10% this year. For Poland and the Czech Republic the deficits will stay at the present level of around 3% in the coming two years. Whether in the old or new member states, there is an additional problem, as we are entering a period of intensifying structural changes. Old industrial patterns in Europe are being changed when confronted with both the boost to productivity from IT and globalisation and enlargement, all of which supports this process. These trends will eventually help productivity and growth in Europe to start catching up with the US again. But in the short term the structural changes will lead to higher frictional unemployment as old industries are more rapidly replaced by new ones. In addition, the recent downturn never led to a dramatic increase in unemployment or a dramatic decrease in employment in the euro area; hence, the upturn is probably also less likely to lead to rapid job creation.
Why are budgetary rules needed at EU level? This interaction is fairly well understood, if not always acted upon, at national level. But at the EU level there is an extra dimension. Many countries’ fiscal policies are now matched by a single monetary policy. One possible risk is that the ECB would in the end have to bail out a fiscally undisciplined country from an unsustainable debt. However, many EU member states’ unwillingness to meet the Stability and Growth Pact has shown that problems can arise before matters have gone as far as to a full-blown debt crisis. The problem might be a bias towards fiscal laxity that has to be counterbalanced by tighter monetary policy - hence a bad policy mix. With a single monetary policy the effect of fiscal stimulus in one country will be diluted in the whole area and will therefore by definition meet with less of a monetary policy response than it would if monetary policy had been national. Furthermore the nature of the political set-up makes it more difficult for the ECB to comment on individual national budgets. This means that there will be a strong temptation to “free-ride” by expanding the budget at the expense of fellow euro area nations. But the dilemma goes further – given that it is rational for others to expand their budgets it becomes rational for your own country to do so too – even if your instinct is not to “free-ride”.