International Monetary Economics
Mar 2 2004
Lesson 8
By
John Kennes
Fiscal Policy and the Stability
Pact
Feb 26 2004
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In a monetary union, the fiscal instrument assumes greater
importance:
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The only macroeconomic policy instrument left at the national level
Its effectiveness is increased (see Mundell-fleming model).
A substitute to transfers
Many questions regarding its effectiveness and use.
Limits on effectiveness
Feb 26 2004
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The crucial role of private expectations
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Slow implementation
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A deficit today but a debt tomorrow: who will pay?
A tax cut, but how permanent
Agreement within government
Agreement within parliment
Spending carried out by bureaucracy
Taxes not retroactive
Result: countercyclical moves can become procyclical actions
A Crucial Distinction: Automatic
vs Discretionary
Feb 26 2004
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Automatic stabilizers:
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Tax receipts decline when the economy slows down, and conversely
Welfare spendng rises when the economy slows down, and conversely
No decision, so no lag: nicely countercyclical
Rule of thumb: deficit worsens by 0.5% of GDP when GDP growth declines
by 1%.
Automatic Stabilizers
Feb 26 2004
Discretionary
Feb 26 2004
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Discretionary actions: a voluntary decision to change tax rates or
spending.
Technically: a chnage in the structural budget balance
The Structural Budget Balance: A
Formal Presentation
Feb 26 2004
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G=G(y) and T=T(y) with G’<0 and T’>0.
Actual budegt balance: B(y)=G(y)-T(y) with B’>0
Cyclical adjusted balance: B(yp)=T(yp)-G(yp)
So, roughly: B(y)=B(yp)+B’(yp)(y-yp)Discretionary actions: a voluntary
decision to change tax rates or spending.
A Crucial Distinction: Automatic
vs Discretionary
Feb 26 2004
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Discretionary actions: A voluntary decision to change tax rates or
spending.
Technically: a change in the structural budget balance
But no automatic correction of deficits, so a problem of discipline.
Should the Instrument Be Subjected
to Some Form of Collective Control?
Feb 26 2004
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Yes, if national fiscal policies are a source of several externalities
Income externalities via trade:
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Important and strengthened by monetary union
Income Spillovers 1972-2004
Feb 26 2004
Should the Instrument Be Subjected
to Some Form of Collective Control?
Feb 26 2004
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Yes, if national fiscal policies are a source of several externalities
Income externalities via trade:
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Important and strengthened by monetary union
A case for some coordination
Borrowing cost externalities
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One common interest rate
But euro area integrated in world financial markets
The Most Serious Concern: The
Deficit Bias
Feb 26 2004
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The track record of EU countries is not good
What is the Problem with the Deficit
Bias?
Feb 26 2004
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Fiscal indiscipline in parts of the euro area might concern
financial markets and
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Raise borrowing costs: unlikely, markets can distinguish among countries
More serious is the risk of default in one member country
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Capital outflows and a weak euro
Pressure on other governments to help out
Pressure on the eurosystem to help out
The Answer to Default Risk: The No
Bailout Clause
Feb 26 2004
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The no-bailout clause
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Overdraft facilities or any other type of credit facility with the ECB or with
the central banks of the Member States (herinafter referred to as ”national
central banks”) in favour of Community institutions or bodies, central
governments, regional, local or other public authorities, other bodies
governed by public law, or public undertakings of Member States shall be
prohibited, as shall the purchase directly from them by the ECB or national
central banks of debt instruments. (Art. 101)
The Answer to Default Risk: The No
Bailout Clause
Feb 26 2004
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The no-bailout clause
Still, fears remain:
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Informal pressure
Impact on the euro
Prevention is better, especially given a tradition of indiscipline
In the End, Should Fiscal Policy
Independence be Limited?
Feb 26 2004
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The arguments for:
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A serious externalties
A bad track record, anyway.
The arguments against
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The only remaining macroeconomic instrument
National governments know better the home scene
The General Principles
Feb 26 2004
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Two general arguments for collective actions:
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Two general arguments against collective action
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Externalities
Increasing returns
Heterogeneity of preferences
Information asymmetries
And a caveat
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Government may pursue own interests.
How to Restrain Fiscal Policies
Feb 26 2004
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Distinction No. 1:
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Micro/structural aspects (tax and spending levels and structure)
Macro aspects (the balance between tax revenues and spending)
Distinction No. 2:
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Coordination: voluntary and flexible efforts at taking into accounts each
other’s action
Binding commitments or rules
The Stability and Growth Pact
Feb 26 2004
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Formally, the implementation of the Excessive Deficit Procedure
(EDP) mandated by the Maastricht Treaty
The EDP aims at preventing a relapse into fiscal indiscipline
following entry into euro area
The EDP makes permanent the 3% deficit and 60% debt ceilings
and foresees fines.
The Pact codifies and formalizes the EDP
How the Pact Works
Feb 26 2004
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Emphasis on the 3% deficit ceiling
Recognition that the balance budget worsens with recessions:
Exceptional circumstances when GDP falls by 2% or more:
automatic suspension of the EDP
When GDP falls by more than 0.75% country may apply for
suspension
Precise procedure that goes from warnings to fining
The Procedure
Feb 26 2004
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When the 3% deficit ceiling is not respected:
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The Commission submits a report to ECOFIN
ECOFIN decides whether the deficit is excessive
If so, ECOFIN issues recommendations with an associated deadline
The country must then take corrective action
Failure to do so and return the deficit below 3% triggers a recommendation
by the Commision
ECOFIN decides whether to impose a fine
The whole procedure takes about 2 years.
The Fine Schedule
Feb 26 2004
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The fine starts at 0.2% of GDP and rises by 0.1% of excessive
deficit
How is the Fine Levied
Feb 26 2004
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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%
The fine is initially considered as a deposit:
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If the deficit is corrected within 2 years, the deposit is returned
If it is not corrected within two years, the deposit is considered a fine.
The Broad Economic Policy
Guidelines
Feb 26 2004
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Emphasis on precuationary measures to avoid warnings and fines
The stability programmes are embedded in the wider BERG, a
peer monitoring process that includes the Lisbon strategy.
Each year, each country presents its planned budget for the next
three years, along with its growth assumptions.
The Commission evaluates whether the submission is compatible
with the Pact.
Issues Raised by the Pact (1)
Feb 26 2004
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The BEPG shift the focus to ex ante commitments:
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Decisions are taken by ECOFIN, a political grouping:
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Led to the Irish warning (2001).
France and Germany treated leniently in 2003-4
Imposition of a fine can trigger deep resentment:
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are fines credible?
If not, what is left?
Issues Raised by the Pact (2)
Feb 26 2004
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Does the Pact impose procyclical fiscal policies?
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Budgets deterioriate during economic slowdowns
Reducing the deficit in a slow down 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.
Issues Raised by the Pact (3)
Feb 26 2004
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What room left for fiscal policy:
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If budget in balance in normal years, plenty of room left for automatic
stabilizers.
Issues Raised by the Pact (3)
Feb 26 2004
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What room left for fiscal policy:
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If budget in balance in normal years, plenty of room left for automatic
stabilizers.
Some limited room left for discretionary action
Issues Raised by the Pact (3)
Feb 26 2004
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What room left for fiscal policy:
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In practice, the Pact encourages:
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If budget in balance in normal years, plenty of room left for automatic
stabilizers.
Some limited room left for discretionary action
Aiming at surpluses
Giving up discretionary policy
The earliest years are hardest
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Takes time to bring budgets to surplus
The Early Years (Before Slowdown)
Feb 26 2004
Austria
Belgium
Finland
France
Germany
Greece
Ireland
Italy
Luxembourg
Netherlands
Portugal
2001
1998
Spain
-6
-4
-2
0
2
4
6
8
Further Controversies
Feb 26 2004
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Discipline imposed from outside
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Arbitrary limits
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Why 3 %?
What about the debt ceiling of 60%?
Asymmetry
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A further erosion of sovereignty
The Pact binds in bad years only
A budget forever close to balance or in surplus would drive
debt/GDP ratio to 0.