Chapter 10:
Fiscal Policies in Monetary Unions
De Grauwe:
Economics of Monetary Union
Fiscal policies and the theory of
optimum currency areas
Germany
France
PF
PG
SG
SF
D’G
DF
D’F
DG
YF
YG
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
– If capital markets are integrated French
government borrowing eased by increased
German supply of savings
– Future generations of Frenchmen pay for the
hardship of today’s Frenchmen
– Issue of sustainability
• Note that the insurance system (whether
centralized or decentralized) should only be
used to take care of temporary shocks
• 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
• 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
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
The dynamics of debt accumulation
b  ( g  t )  (r  x)b  m
• where g = G/Y, t = T/Y, x = Y/Y (the growth rate of
  M / Y
GDP), and m
• When the interest rate on government debt
exceeds the growth rate of GDP, the debt-toGDP 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
• The debt-to-GDP ratio stabilizes at a constant
value if (r  x)b  (t  g )  m
• If nominal interest rate > the nominal growth
rate of the economy:
– Either the primary budget shows a sufficiently high
surplus (t > 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
• 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
Government Budget Deficits in Belgium,
The Netherlands, and Italy (1979 – 2005)
16
Belgium
Italy
Netherlands
14
12
10
8
6
4
2
0
-2
-4
1980
1983
1986
1989
1992
1995
1998
2001
2004
Gross Public Debt (% of GDP)
160
140
120
100
80
60
40
Belgium
Italy
Netherlands
20
0
1980
1983
1986
1989
1992
1995
1998
2001
2004
Government budget surplus, excluding
interest payments (% of GDP)
8
6
4
2
0
-2
Belgium
-4
Italy
Netherlands
-6
-8
1980
1983
1986
1989
1992
1995
1998
2001
2004
• 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
Stability and Growth Pact
• Main principles
– Countries have to achieve balanced budgets over
the business cycle
– Countries with a budget deficit > 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
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
• 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
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
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
Government budget deficits in
Eurozone, US, UK, Japan
12
10
8
6
4
EUR-12
US
2
JP
UK
0
-2
-4
-6
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
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
• 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
• 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
• 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
• 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
• 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
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
• 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
– 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
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.
De bt to GDP ra tio unde r S GP
120
B
D
EL
100
E
F
IRL
I
60
NL
A
P
40
FIN
2050
2047
2044
2041
2038
2035
2032
2029
2026
2023
2020
2017
2014
2011
2008
0
2005
20
2002
D eb t/G D P
80
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.
– 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.
– 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.
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
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