LUISS Master in European Studies 200809 European Macroeconomics 4

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LUISSMaster in European Studies
2008-09European Macroeconomics4

• Francesco Farina
• University of Siena

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FISCAL POLICY Public deficit / GDP and public
debt / GDP
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In the EMU, after a 2 fall in GDP automatic
stabilizers create a 1 deficit but the GDP
recovery is only 0,5. They can only absorb a
shock by a quarter. Higher absorption only in UK
and two Scandinavian countries (non cyclically
correlated with EMU ).
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FIG. 9.1 sums up the European Commission (EC)
critiques to European governments In the two
decades that preceded the monetary union, fiscal
policy was characterized by1) a falling deficit
ratio with a negative output gap, whereas it
increases with positive output gaps (1976-81 and
1989-91). 2) a constantly growing average debt to
GDP ratio since the start of EMS. In the EC
judgement, the high P.Def./GDP ratios caused the
high P.Debt / GDP ratios.
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• The EC has blamed governments for not having set
  aside additional fiscal revenues stemming from
  expansionary business cycles, in order to prevent
  the progressive accumulation of debt during the
  subsequent downwards.
• The IPBC implies that governments should control
  the overall public deficit (the primary deficit
  plus interest payments). Yet, only the first
  component is under direct control of governments.
  In fact, interest rates are determined by
  monetary policy and international financial
  markets, and represent an exogenous impact on
  public finances.

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• The deficit/GDP ratio rises as an effect of both
  deficit components, and the debt ratio is also
  affected by the issue of new bonds to cover the
  secondary component of the deficit (the spending
  on interest payments on outstanding debt) and by
  the growth dynamics (a fast income growth brings
  down the deficit and debt ratios).
• All in all, since the beginning of the 90s
  until 1995, the rise in debt does not seem to be
  due to a less rigorous management of fiscal
  policy, but rather to bad economic conditions.

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• Sluggish growth and the recession of the early
  nineties induced many governments to follow an
  active fiscal policy, and give some
  discretionary boosts to the economy. This caused
  public deficits (and debt) to grow.
• Moreover, the expansion of public spending in
  the EMS can be in part interpreted in this way
  fiscal policy substituted a monetary policy
  that was rather restrictive.

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• The next figure displays the overall situation
  of taxation and public spending between the years
  1993 and 2000. The 45 degree line separates the
  area in two above the line, the primary
  structural deficit increases below the line it
  falls. The downward sloping line shows the
  contribution of spending and taxes to the
  deficit. Below the line, a rising primary surplus
  is mainly due to spending cuts above the line,
  higher taxation improves the deficit ratio. These
  data confirm the success of fiscal consolidation
  for the average of all EMU countries.

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By how much did governments reduce the structural
fiscal deficit/GDP ratios in 1993-2000?Were
restrictive fiscal impulses obtained by exp.
cuts or tax increases?
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• Questions Upward diagonal Does the
  discretionary fiscal intervention by governments
  increase or reduce the primary structural
  deficit? Downward diagonal Does the fiscal
  impulse mainly consist in higher T or lower p.
  exp.?
• ANSWERS
• All countries, except Greece and Portugal, saw
  the primary structural balance improve.
• A majority of countries below the downward
  diagonal. Five countries Belgium, Italy,
  Finland, the Netherlands and Spain have cut
  spending more than they reduced taxation.
• Ireland is an outlyer.

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Fiscal policy automatic stabilizers fiscal
impulses

• Governments conduct discretionary fiscal
  expansions in order to sustain output. To measure
  these fiscal impulses, we cancel out the output
  increase (Yt Yt-1) due to the reaction to the
  business cycle due to the operation of the
  automatic stabilizers.
• TAB. 9.3 shows how periods of fiscal restriction
  and expansion have alternated.
• Yet, a non-balanced budget could force a
  government to a fiscal restraint during a
  downward, by cutting the operation of automatic
  stabilizers.

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• Deficit and debt ratios rise when fiscal policy
  sustains output in the years after the 1991-93
  crises. In contrast, they fall in the years
  before the admission to the eurozone when
  macroeconomic stabilization was put aside for
  consolidating debt instead.
• In order to ensure participation in the EMU, most
  governments had to follow highly restrictive
  policies. The 2001 recession shows that after EMU
  entry, both ratios start to rise again. Why?
  Consolidation fatigue or the Twin Towers
  negative shock?

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• During recessions output stabilization (let
  automatic stabilizers to freely operate despite
  the high structural deficits) or debt
  decumulation (by conducting pro-cyclical f.p.)?
• In many countries, the strong slowdown of demand
  is responsible for slow economic growth.
• In the three major European economies, the
  deficit ratio increased in this way above the 3
  limit.
• Public debt in some countries (Italy, Belgium and
  Greece) is still near or above 100 of GDP.

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• g 5 3 / 60 (the percentages imposed on
  fiscal policy by Maastricht Treaty are a 3
  deficit /GDP ratio - (G-T)/Y iB/Y - and a b
  constant at 60). So the two fiscal constraints
  (3 and 60) are compatible with a growth of
  nominal income equal to 5. In 1991, nominal
  economic growth in Germany was equal to 5 (2,5
  in real terms). The current growth rate of
  nominal income in the EMU has fallen by about
  40, however. It now is more or less 3.

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• The fall in average growth reported in Europe
  casts some doubts on the consistency of the 3
  constraint. If we follow the reasoning of the RBC
  model, the loss of one percentage point in
  average labour productivity growth in the EU
  (from 2,3 between 1975-90 to 1,3 in the
  nineties) is not due to cyclical factors but is
  due to a structural fall of economic growth from
  2,5 to 1,5. On average, real economic growth is
  only 1,4 per year, and varies for Continental
  Europe in a range from 0,5 to 2.
• With g3, a correction of the public deficit /
  GDP limit from 3 to 1,8 would be necessary.

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• THE STABILITY AND GROWTH PACT
• The SGP introduces a system of fiscal
  discipline that is certainly more advanced
  compared to the Maastricht Treaty. By prohibiting
  the money financing of public deficits, Art. 194
  of the TEU and Art. 21.1 of the ECB Statute left
  to national fiscal authorities the responsibility
  of fiscal policy. The TEU claims that a balanced
  fiscal position is a necessary condition for the
  good functioning of a monetary union. If the
  budget deficit tends towards the 3 limit, a
  procedure is started that, in case of a breach of
  the rules of the SGP ends with a penalty.

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• The articles of the Pact allow for deficits
  higher than 3 under three particular conditions.
  The deficit should be
• 1. exceptional the reason for the breach has to
  be a serious recession, defined as a sudden fall
  of real output equal at least to -0,75
• 2. transitory the deficit returns within the 3
  limits after one year
• 3. close the deficit ratio should not move to
  far away from 3.

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• The New SGP (2005)
• 1. The close to balance or in surplus rule
  imposes the obligation to reach the normal
  fiscal position of balance in the medium term.
  When a shock occurs, a country will be able to
  exploit the budgetary room for letting automatic
  stabilizers work up to the 3 limit. In order to
  keep budgets anchored to balance in the medium
  term, member countries should give up using
  discretionary stabilization policies.
• 2. the appropriate method for assessing the
  fiscal position of a country is the public budget
  balance corrected for the cycle (structural
  budget balance)

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• 3. the new SGP revised in March 2005,
  introduced some changes to make the SGP
  constraints less stringent. More discretion is
  allowed in the evaluation of the three conditions
  for an excessive deficit. A) exceptional
  conditions can not only be interpreted in terms
  of negative growth, but also of prolonged slow
  growth below potential. B) a low debt to GDP
  ratio raises the deficit limit to 3,5. A higher
  deficit may be tolerated for two consecutive
  years. Some spending items (e.g. investment exp.)
  that promote economic growth may be deducted from
  the calculation.

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• The EC has a monitoring role on deficit and debt
  ratios but also the power to propose to sanction
  a EMU country for excessive deficit.
• Yet, the power division between European
  Commission and Ecofin on the implementation of
  sanctions shows a precarious compromise between
  political choice and economic constraints. This
  is a weakness of the enforcement mechanism, which
  reduces the credibility of the SGP in financial
  markets. Political power matters. When France and
  Germany were in the same conditions in 2003 that
  caused to Portugal a pecuniary (unenforced)
  sanction in 2002, the proposal of the EC was not
  approved.

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• The theoretical explanation for the SGP
• High deficits would disrupt the capacity of the
  ECB to control the interest rate in the eurozone.
• The ECB may grant credit to a country in
  difficulty. If a government is obliged to
  refinance its own debt at increasingly high rates
  and there are doubts regarding its fiscal
  solvency, the ECB is by its Statute not allowed
  to save the government (no-bail-out clause). A
  weak instrument, as the ECB could anyway finance
  the indisciplined government in the secondary
  market.

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• A fiscal expansion in one or more countries of
  the EMU would raise the interest rate for the
  currency zone as a whole. In fact, large issues
  of government bonds would boost the demand for
  liquidity and thus generate upward tensions on
  the interest rate in European financial markets.
• This argument has been downplayed. First,
  econometric studies do not find large effects of
  higher deficits (a 1 increase in the deficit of
  a European country of average dimension has an
  impact on interest rates of around 10 basis
  points).

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• Second, a government in difficulty would pay a
  default premium on the issued bonds, especially
  if this country has a high public debt.
• Yet, due to the higher interdependence between
  capital markets, in a period of excess demand for
  liquidity, the euro interest rate could raise
  very much.
• Hence, with increasing interest rates,
  governments that resort too much to EMU financial
  markets might cause a negative externality on the
  eurozone interest rate.

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• Financial market would start to expect the
  monetization of public debt by the ECB. As a
  consequence, financial agents would reduce their
  positions in euro.
• Another controversial aspect of the SGP is its
  limited focus on the public deficit. Sanctions
  apply only if the deficit ratio passes 3. There
  are no additional restrictions on countries whose
  debt to GDP ratio is higher than 60.
• In order to stabilize the debt to GDP ratio,
  the overall deficit ratio should not be larger
  than the product of economic growth and the debt
  to GDP ratio.

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• In a monetary union, domestic inflation and
  output are not only determined by domestic
  factors but also by economic activity in the
  other countries of the eurozone via two
  transmission channels
• 1. trade interdependence a change in the level
  of output and inflation in one country produces a
  multiplier effect in other countries via trade
  flows
• 2. financial interdependence a change in output,
  inflation and fiscal policy in one country
  affects output, inflation and fiscal policy in
  all other countries through the effect on the
  average interest and inflation rates of the
  monetary union, and on the euro exchange rate.

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• The NKE inclines to think of a positive income
  multiplier (provided that there is unemployment
  in a flexible L mkt). The RBC models support
  non-Keynesian effects of macroeconomic
  stabilization policies.
• The SGP is in line with the NCE. The modest
  positive effect of public spending in deficit via
  the trade channel is fully compensated by the
  crowding out of aggregate demand via the
  financial channel. Still, the extreme position of
  RBC theory that an expansionary fiscal impulse
  has a negative impact on income is refuted.

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• According to the Tax Smoothing principle, using
  automatic stabilizers is sufficient to make
  fiscal stabilization policy effective. Then, the
  SGP rationale is that giving up discretionary
  policy manoeuvres has no effects.
• In case of a supply shock, inflation and income
  move in opposite directions. It is more probable
  that coordination makes the two authorities
  behave like substitutes when monetary policy is
  restrictive (expansionary), fiscal policy is
  expansionary (restrictive). In contrast, after a
  demand shock, both inflation and output move in
  the same direction. Both policies are likely to
  be complements.

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• Besides, stabilization by the two authorities
  depends on the domestic macroeconomic conditions
  (e.g., the degree of flexibility of L mkt, the
  intra EMU inflation differentials, etc.).
• By imposing the SGP, the European Commission
  endorses the Tax Smoothing principle. NKE models
  do not adopt the Ricardian Equivalence
  hypothesis as consumers face liquidity
  constraints. Simulations with dynamic versions of
  the NKE model confirm that discretionary fiscal
  policy increase inflation but also reduce the
  volatility of output.

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• In order not to violate the SGP, during the
  first years of the new millennium Germany, France
  and Italy should have adopted a pro-cyclical
  budget and cut short the work of automatic
  stabilizers.
• This would have created an additional primary
  surplus and avoided breaching the 3 limit.
• The difficulty in respecting this constraint
  increases when international interest rates are
  rising.
• If the ECB raises the interest rate the public
  balances of EMU countries are burdened by
  additional interest payments. In a recession, a
  breach of the 3 barrier will only be avoided by
  sterilizing the automatic stabilizers.
• This affects mainly those countries with a high
  stock of public debt.

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• A fiscal constraint determined also by the debt
  ratio?
• Lets link the deficit constraint (already
  reached by all countries, although some violated
  it recently) to a debt constraint (still far from
  being fulfilled in some countries) d 0,03 x
  (b 0,6), where x can for example be equal to
  0,10.
• A country with a high debt ratio (bgt60)
  should respect a stricter limit on the deficit
  than the 3 rule e.g. b80 d 0,01. In
  contrast, a virtuous country, thanks to its
  better fiscal solvency, could run higher
  deficits e.g. b40 d 0,05.

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• Has the SGP been deflationary during the EMU?
• The SGP seems not to have affected economic
  stabilization discretionary fiscal policy less
  pro-cyclical in the post-Maastricht era (lower
  coefficient of the OG after 1992).
• The coefficient has reduced as during
  expansionary business cycles fiscal surpluses
  have been devoted to public debt reduction, and
  during recessions, in order to avoid a dramatic
  fiscal restriction, many governments have reduced
  the sensitivity of automatic stabilizers to the
  output gap.

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• Why did public deficit/GDP and debts/GDP
  increase at the EMU inception?
• 1. In 1999 and 2000, the economic boom might
  have been an opportunity to reduce public debt
  and/or put aside the additional tax revenues for
  future bad years. This opportunity was not
  seized, as governments resorted to discretionary
  policies in addition to the automatic
  stabilizers, thus eroding primary surpluses.

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• The origin of the worsening primary structural
  deficit is due to the adoption of a neutral
  fiscal policy (i.e., no Tax Smoothing). It is
  true than in 2002, due to the increase of public
  spending aimed at stabilising the negative demand
  shock produced by the Twin Towers attacks, the
  primary structural deficit ratio decreased in the
  eurozone only by 0,3. But it is likely that the
  main impulse behind the increase in the deficit
  ratio came from slow economic growth in the
  presence of high interest rates.

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Fiscal policy at the inception of the Eurozone
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• After the excessive rise in 1999-2000, too
  modest interest rate cuts by the ECB.
• The left graph would seem to confirm, at first
  glance, the thesis of the European Commission no
  Tax Smoothing, as governments left public debt to
  grow. Yet, the right graph shows how in both
  recession periods following an increase in
  interest rates - debt dynamics resumed.
• EMU 2000-04 due to the recession, to curb
  rising deficit and debt ratios is difficult.
• First, the slow growth of output pushed up the
  total deficit/GDP ratio. Second, the
  consolidation of public debt entered into a
  conflict with output stabilization.

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• The progressively falling surplus at the start
  of the millennium suggests that stabilization has
  not been sacrificed for consolidation. This might
  have produced a further increase in the debt
  ratio in some countries (a typical example is
  Italy).
• An alternative interpretation to the theses of
  a more anti-cyclical discretionary policy in
  the after-Maastricht period and of consolidation
  fatigue. We already saw that it is doubtful
  that a) the Maastricht constraints and the SGP
  represented an obstacle for the implementation of
  a stabilizing fiscal policy, and b) consolidation
  efforts diminished.

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• Results of the empirical analysis carried out
  for the pre-Maastricht, pre-EMU and EMU period
  show that the lower pro-cyclicality since
  Maastricht comes from a minor effort to stabilize
  when the output gap is positive.
• It is also the consequence of using fiscal
  resources for the consolidation of the debt with
  the aim to comply with the 3 and 60 limits.
• After the Twin Tower shock and the fall in
  aggregate demand, the trade-off between
  stabilization and consolidation has caused a fast
  deterioration in the deficit/GDP ratio.

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• To abide by Tax Smoothing, countries renounced
  to economic stabilization and pursued restrictive
  fiscal policies that turned off the impact of
  automatic stabilizers.
• The high debt countries financed high
  secondary deficits with new debt issues, so that
  debt consolidation came to a halt . The
  consolidation fatigue is not just the effect of
  reneging on the SGP, but reflects a trade-off
  between further consolidating debt and
  stabilizing income in a recession.
• The social cost of increasing tax pressure, or a
  further cut in social spending items (health and
  pensions), might be very high.

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• The paradox of national fiscal policies is that
  EMU governments have at the same time to account
  for their actions to European institutions
  (Commission and Ecofin) and stand up to the
  judgment of citizens. From a social choice point
  of view, this seems rather hard. Governments give
  in to stiff opposition against welfare reform and
  a reduction in social spending, and consequently
  choose to break the fiscal rules. They would
  rather run the risk of incurring in the sanctions
  of the Commission and the Ecofin in case of a
  violation of the SGP.