Chapter 10: Fiscal Policies in Monetary Unions

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Chapter 10Fiscal Policies in Monetary Unions

• De Grauwe
• Economics of Monetary Union

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Fiscal policies and the theory of optimum
currency areas
Germany
France
PF
PG
SG
SF
DG
DF
DF
DG
YG
YF
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Two cases

• France and Germany form monetary and budgetary
  union
• If asymmetric shock occurs
• The centralized European budget automatically
  redistributes income from Germany to France
• There is risk sharing
• France and Germany form a monetary union without
  budgetary union
• If asymmetric shock occurs
• France accumulates budget deficits and debt
• Germany reduces deficits and debt

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• If capital markets are integrated French
  government borrowing eased by increased German
  supply of savings
• Future generations of Frenchmen pay for the
  hardship of todays Frenchmen
• Issue of sustainability
• Note that the insurance system (whether
  centralized or decentralized) should only be used
  to take care of temporary shocks

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• The theory of optimum currency areas leads to the
  following implications
• It is desirable to centralize a significant part
  of the national budgets to the European level
• Risk sharing reduces social costs of a monetary
  union
• If such a centralization of the national
  government budgets in a monetary union is not
  possible then, national fiscal policies should be
  used in a flexible way and national budgetary
  authorities should enjoy autonomy

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• The view expressed in the OCA-theory has not
  prevailed
• Instead rigid rules have been imposed
• These find origin in the view that the systematic
  use of fiscal policies can lead to unsustainable
  debts and deficits

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Sustainability of government budget deficits

• A budget deficit leads to an increase in
  government debt which will have to be serviced in
  the future
• Government budget constraint
• G - T rB dB/dt dM/dt
• G is the level of government spending (excluding
  interest payments on the government debt), T is
  the tax revenue, r is the interest rate on the
  government debt, B, and M is the level of
  high-powered money (monetary base)
• (G - T) is the primary budget deficit, rB is the
  interest payment on the government debt
• The budget deficit can be financed by issuing
  debt (dB/dt) or by issuing high-powered money
  dM/dt

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The dynamics of debt accumulation

• where g G/Y, t T/Y, x Y/Y (the growth rate
  of GDP), and
• When the interest rate on government debt exceeds
  the growth rate of GDP, the debt-to-GDP ratio
  will increase without bounds
• The dynamics of debt accumulation can only be
  stopped if the primary budget deficit (as a
  percentage of GDP) turns into a surplus
• Alternatively, it can be stopped by seigniorage

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• The debt-to-GDP ratio stabilizes at a constant
  value if
• If nominal interest rate gt the nominal growth
  rate of the economy
• Either the primary budget shows a sufficiently
  high surplus (t gt g)
• Or money creation is sufficiently high in order
  to stabilize the debt - GDP ratio
• The latter option has been chosen by many Latin
  American countries during the 1980s, and more
  recently by some Eastern European countries. It
  has also led to hyperinflation in these countries
  

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• Important conclusion is that, if a country has
  accumulated sizeable deficits in the past, it
  will now have to run large primary budget
  surpluses in order to prevent the debt - GDP
  ratio from increasing automatically
• This means that the country will have to reduce
  spending and/or increase taxes

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Government Budget Deficits in Belgium, The
Netherlands, and Italy (1979 2005)
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Gross Public Debt ( of GDP)
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Government budget surplus, excluding interest
payments ( of GDP)
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• The experience of these countries shows that
  large government budget deficits quickly lead to
  an unsustainable debt dynamics
• Fiscal policies are not the flexible instrument
• There is a lot of inertia
• The systematic use of this instrument quickly
  leads to problems of sustainability, which forces
  countries to run budget surpluses for a number of
  years

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Stability and Growth Pact

• Main principles
• Countries have to achieve balanced budgets over
  the business cycle
• Countries with a budget deficit gt 3 of GDP will
  be subject to fines. These fines can reach up to
  0.5 of GDP
• These fines will not be applied if the countries
  in question experience exceptional circumstances,
  e.g. a natural disaster or a decline of their GDP
  of more than 2 during one year
• In cases where the drop in GDP is between 0.75
  and 2 the application of the fine will be
  subject to the approval of the EU finance
  ministers

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The argument for rules on government budget
deficits

• A country with an unsustainable increasing
  government debt creates negative spillover
  effects for the rest of the monetary union
• First, such country will have increasing recourse
  to the capital markets of the union
• The union interest rate increases
• This higher union interest rate increases the
  burden of the government debts of the other
  countries
• These will be forced to follow more restrictive
  fiscal policies

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• A second spillover
• The upward movement of the union interest rate is
  likely to put pressure on the ECB to relax its
  monetary policy stance

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Criticism is based on efficient markets

• If the capital markets work efficiently, there
  will be no spillover
• There will be different interest rates in the
  union, reflecting different risk premia on the
  government debt of the union members
• It does not make sense to talk about the union
  interest rate

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Is this criticism valid?

• There is interdependence in the risk of bonds
  issued by different governments because within
  EMU, governments are likely to bail out a
  defaulting member state
• Thus, financial markets may find it difficult to
  price these risks correctly
• The no-bailout clause introduced in the
  Maastricht Treaty may not be credible
• Mutual control to avoid costly bailouts is
  necessary

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Fiscal discipline in monetary unions

• A monetary union may change the incentives of
  fiscal policy-makers, and, in so doing, may
  affect budgetary discipline
• There are two opposing effects
• Once in monetary union, individual governments
  face a larger domestic capital market their
  capacity to borrow increases this will lead them
  to borrow more, and to have larger deficits

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• Countries which join the union reduce their
  ability to finance budget deficits by money
  creation
• As a result, the governments of member states of
  a monetary union face a harder budget
  constraint than sovereign nations
• This will reduce budget deficits

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Government budget deficits in Eurozone, US, UK,
Japan
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The Stability and Growth Pact an evaluation

• Two conflicting concerns
• The first one has to do with flexibility and is
  stressed in the theory of optimum currency areas
  in the absence of the exchange rate instrument
  and a centralized European budget, national
  government budgets are the only available
  instruments for nation-states to confront
  asymmetric shocks
• A second concern relates to the spillover effects
  of unsustainable national debts and deficits

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• The Pact has been guided more by the fear of
  unsustainable debts and deficits than by the need
  for flexibility
• As a result, the Pact is quite unbalanced in
  stressing the need for strict rules at the
  expense of flexibility
• This creates a risk that the capacity of national
  budgets to function as automatic stabilizers
  during recessions will be hampered, thereby
  intensifying recessions

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• Lack of budgetary flexibility to face recessions
  creates a potential for tensions between national
  governments and European institutions
• This tension exists at two levels
• As countries are hindered in their desire to use
  the automatic stabilizers in their budgets during
  recessions, they increase their pressure on the
  ECB to relax monetary policies
• When countries are hit by economic hardship, EU
  institutions are perceived as preventing the
  alleviation of the hardship of those hit by the
  recession intensifying Euro-scepticism

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• The flaws of the Stability and Growth Pact we
  just described led to serious problems in 2002 4
  
• Major Eurozone countries were hit by an economic
  downturn. This led to an increase of the budget
  deficits of France, Germany, Italy, and Portugal
• In the name of the Pact, the European Commission
  insisted that these countries should return to
  budget balance even in the midst of a declining
  business cycle

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• A number of countries, in particular France and
  Germany, refused to submit their economy to such
  deflationary policies
• The result was an inevitable clash with the
  European Commission which, as the guardian of the
  Pact, felt obliged to start procedures against
  these countries

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• The Commission had to yield to the unwillingness
  of these countries to subject their policies and
  their commitments towards the increasing number
  of unemployed to the rule of the mythical number
  3
• In November 2003 the Council of Ministers
  abrogated the procedure that the European
  Commission had started. For all practical
  purposes the Pact had become a dead letter

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How to reform the Stability and Growth Pact?

• More flexibility is required. This flexibility
  should be achieved at two levels
• The judgment of whether budget deficits are
  excessive should be based on the debt levels of
  individual countries
• The analysis of the budgetary situation should be
  based on the structural budget deficits

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• Finally, the requirement that countries should
  have balanced budgets on average implies that the
  debt to GDP ratio is pushed to zero
• There is no valid economic argument to force
  countries to bring their debt ratio to zero
• Requirement to bring the debt ratio to zero gives
  strong political incentives to reduce government
  investment
• Governments are required to finance all new
  investments by current taxation

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• A large part of the benefits of these investments
  will be reaped by future governments
• This gives an incentive to governments today to
  reduce these investments and only spend on items
  that benefit the present voters
• Thus the GSP is likely to lead to lower
  government investments and thus lower growth

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Hypothetical evolution of the debt ratios within
Euroland assuming that the member countries abide
by the pact, and assuming that nominal GDP
increases by 5 a year.
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The Reform Proposals

• On March 22-23, 2005, the European Council agreed
  to a reform of the Stability Pact
• The main elements in this reform are the
  following
• First, countries with a low debt ratio (and a
  high growth potential) are allowed to maintain a
  deficit of 1 over the business cycle. The other
  countries have to maintain a balanced budget over
  the business cycle. The 3 budget deficit
  ceiling, however, is maintained for all
  countries.

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• Second, while in the old Stability Pact countries
  could exceed the 3 deficit ceiling when GDP
  declined by 2 or more, this condition will be
  relaxed in the new Stability Pact. It will be
  enough to have a negative growth rate or a
  protracted period of very low growth relative to
  potential growth to be allowed to (temporarily)
  exceed the 3 limit.

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• Third, countries will be able to invoke more
  special circumstances for exceeding the 3
  ceiling. For example, investment programs,
  pension reforms that increase the debt today
  while improving the future sustainability of
  government finances will be accepted as special
  circumstances allowing for a temporary breach of
  the 3 rule.
• Finally, countries which exceed the 3 ceiling
  but have low debt levels will be allowed to
  stretch the adjustment over a longer period than
  countries with a high debt level.

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Evaluation

• The proposals go in the right direction of
  targeting the debt levels and allowing more
  flexibility
• However, by keeping the 3 rule but allowing for
  many exceptions, the proposals have laid a
  minefield for future discussions and conflicts

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Conclusion

• Two views about how national fiscal policies
  should be conducted in a monetary union
• National fiscal authorities should maintain a
  sufficient amount of flexibility and autonomy
  (theory of optimum currency areas)
• The conduct of fiscal policies in the monetary
  union has to be disciplined by explicit rules on
  the size of the national budget deficits
  (Stability and Growth Pact)
• Strong criticism against the Stability and Growth
  Pact for its excessive rigidity
• This has led to a reform of the SGP which
  provides for more flexibility