Government Investment and the European Stability and Growth Pact

Since 1999, 13 countries have abandoned their national currency and joined the European Monetary Union, adopting the euro. This new currency regime posed unprecedented challenges in designing institutions that would ensure its success and stability. Particularly important to this endeavor was defining the interaction between fiscal policy and monetary policy. In the case of national currencies, large and persistent fiscal deficits frequently lead to higher levels of inflation (Sargent and Wallace, 1981; and Sargent, 1986). This possibility became an even greater concern when many countries decided to share a single currency. Under the new regime, each country would fully reap any benefits of deficit spending but could potentially force others to face the undesirable consequences of undermining the independence of the newly created European Central Bank or generating instability in the Eurobond market (Chari and Kehoe, 2004). This concern was addressed in the Maastricht Treaty of 1992, which paved the way for the monetary union, and especially in the European Stability and Growth Pact (SGP), which was adopted in 1997. The pact made permanent some of the conditions that the Maastricht Treaty required of entrants at the creation of the single currency.