Chapter 18

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Chapter 18
© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Chapter 18
Fiscal Policy and the
Stability Pact
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
The Fiscal Policy Instrument
• In a monetary union fiscal policy
– the only macroeconomic instrument at national level
– government borrows in slowdown and pays back on behalf of
citizens
– government acts as substitute to inter-country transfers in case
of asymmetric shock.
• Effectiveness depends on private expectations
• Slow implementation of fiscal policy
– Result: countercyclical actions can have countercyclical effects.
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
A Crucial Distinction: Automatic vs. Discretionary
• Automatic stabilisers:
– tax receipts decline when the economy slows down, and conversely
– welfare spending rises when the economy slows down, and
conversely
– no decision, so no lag: nicely countercyclical
– rule of thumb: deficit worsens by 0.5 per cent of GDP when GDP
growth declines by 1 per cent.
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Automatic Stabilisers
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
A Crucial Distinction: Automatic vs. Discretionary
• Discretionary actions: a voluntary decision to change tax
rates or spending.
• Cyclically adjusted budget shows what the balance would be
if the output gap is zero in a given year
• Difference between actual and cyclically adjusted budget =
footprint of automatic stabilisers
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Example: the Netherlands
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Output gap
Budget balance
Cyclically adjusted budget balance
4
2
0
-2
-4
-6
1991
1993
1995
1997
1999
2001
2003
2005
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Example: the Netherlands
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The output gap and
the overall budget
tend to move together
Output gap
Budget balance
Cyclically adjusted budget balance
4
2
0
-2
-4
-6
1991
1993
1995
1997
1999
2001
2003
2005
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Example: the Netherlands
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Output gap
Budget balance
Cyclically adjusted budget balance
4
The steady improvement of
the cyclically adjusted balance
is not directly reflected in the
actual budget outcomes
2
0
-2
-4
-6
1991
1993
1995
1997
1999
2001
2003
2005
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Fiscal Policy externalities
• Should the Fiscal Policy Instrument Be Subjected to Some
Form of Collective Control?
– Yes, if national fiscal policies are a source of several
externalities.
• Income spillover via trade:
– important and strengthened by monetary union
– lack of co-ordination means that with a symmetric shock too
much policy action can be used to counteract shock.
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Similar output gaps and business cycles
Output gaps
8
6
4
2
0
-2
-4
-6
1972
1975
1978
Switzerland
1981
1984
1987
Germany
1990
1993
1996
1999
France
2002
2005
Netherlands
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Fiscal Policy externalities (cont.)
• Borrowing cost externalities:
– one country’s deficit would induce higher interest rate for
everyone
• Long-term growth effects
– but euro area integrated in world financial markets
• Still, capital inflows can appreciate common currency and
affect competitiveness
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
The Most Serious Concern: The Deficit Bias
• The track record of EU countries is not good.
EU public debt (% of GDP)
80
70
60
50
40
30
20
1970
1974
1978
1982
1986
1990
1994
1998
© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
2002
2006
What is the Problem with the Deficit Bias?
• Most serious is the risk of default in one member country:
– capital outflows and a weak euro
– pressure on other governments to help out
– pressure on the eurosystem to help out.
• Answer to address risk:
– the ‘no-bailout’ clause in Maastricht Treaty
– Prevention procedure
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
In the End, Should Fiscal Policy Independence be
Limited?
• The arguments for:
– serious externalities
– a bad track record, anyway.
• The arguments against:
– the only remaining macroeconomic instrument
– national governments know the home scene better.
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
The Stability and Growth Pact (SGP)
• The SGP: meant to avoid excessive deficits upon entry into euro
area.
• Excessive Deficit Procedure (EDP) makes permanent the 3 per
cent deficit and 60 per cent debt ceilings and foresees fines.
• Final word remains with ECOFIN, and countries avoided fines so
far.
• SGP reformulated in 2005 to avoid rigidity of Pact.
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Exceptional circumstances
• New flexibility in the SGP
– Negative growth or accumulated loss of output over a period of low
growth exceptional
– Taking account of ‘all relevant factors’
– No specific definitions
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
How the Pact Works
• A limit on acceptable deficits: 3% of GDP
• A preventive arm
– Aims at avoiding reaching the limit in bad years
– Calls for surpluses in good years
• A corrective arm
– ‘early warning’ when deficit is believed to breach limit +
recommendations
– EDP procedure for excessive deficit: recommendations, to be
followed by corrective measures, and ultimately sanctions
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
The Fine Schedule
• The fine starts at 0.2 per cent of GDP and rises by 0.1 per
cent for each 1 per cent of excess deficit.
© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
How is the Fine Levied
• The sum is retained from payments from the EU to the country
(CAP, Structural and Cohesion Funds).
• The fine is imposed every year when the deficit exceeds 3 per
cent.
• The fine is initially considered as a deposit:
– if the deficit is corrected within two years, the deposit is returned
– if it is not corrected within two years, the deposit is considered as a
fine.
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Issues Raised by the Pact
• Does the Pact impose procyclical fiscal policies?:
– budgets deteriorate during economic slowdowns
– reducing the deficit in a slowdown may further deepen the
slowdown
– a fine both worsens the deficit and has a procyclical effect.
• The solution: a budget close to balance or in surplus in
normal years.
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Issues Raised by the Pact
• What room left for fiscal
policy?:
– if budget in balance in
normal years, plenty of
room left for automatic
stabilisers.
© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Issues Raised by the Pact
• What room left for fiscal policy?:
– if budget in balance in normal years, plenty of room left for
automatic stabilisers
– some limited room left for discretion action.
© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Issues Raised by the Pact
• In practice, the Pact encourages:
– aiming at surpluses (so public debts will disappear)
– giving up discretionary policy.
• The early years are hardest:
– takes time to bring budgets to surplus.
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Recent budget balances
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Limits of the Pact
• Economic flaws
– Annual deficits are endogenous
– Annual deficits tell little about fiscal discipline
– Evolution of debt is more important
• Political flaws
– Fiscal policy remain national sovereignty
– Large vs. small countries
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
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