1 fiscal policy in european monetary union 1. topics 1. introduction 2. the need for a fiscal...

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Fiscal Policy in European Monetary Union

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Topics

• 1. Introduction

• 2. The need for a fiscal framework in a monetary union

• 3. Rationale of the SGP

• 4. Advantages and disadvantages of the SGP

• 5. Proposals for reform

• 6. Conclusions

1. Introduction

• 1st January 1999: European Monetary Union (introduction of the Euro currency) and the European Central Bank.

• Initially 11 countries joined in 1999.

• The UK, Sweden and Denmark could join but decided not to.

• Currently there are 17 member countries.

1. Introduction

• The European Monetary Union performed very well from 1999-2008.

• Average inflation rates in Germany for the Euro-zone were lower than the 2 per cent benchmark of the ECB.

• Average inflation rates for the Euro-zone were lower than the 2 per cent benchmark.

• Massive increase in intra-Eurozone trade.

1. Introduction

• International crisis in 2008

• Debt crisis in EMU

• Countries: Greece, Ireland, Portugal

• Countries: Italy, Spain, Belgium, France (?)

• Why?

• EMU – European Central Bank (ECB)

• EMU – European Central Fiscal Authority?

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2. Why is there a need for a fiscal framework in a monetary union?

Assume a monetary union with no fiscal

framework:

• Two main problems:

• i) Free Rider Problem: It occurs when one country loosens its fiscal policy expecting other member countries to offset this by tightening their policies.

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2.Why is there a need for a fiscal framework in a monetary union?

• ii) Spill-over Effects: It occurs when countries formulate their own fiscal policies failing to take into account the impact on other member states’ fiscal policies.

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• The creation of a monetary union may stimulate national governments to pursue expansionary fiscal policies. If governments want to borrow more than the domestic market can supply they must borrow in a foreign currency. This exposed governments to foreign exchange risk and therefore reduces borrowing. But within EMU the ‘domestic’ capital market becomes much bigger.


• However, the creditworthiness of heavy borrowers determines the interest rate they pay on their debts. However, financial markets may believe that EMU provides an implicit guarantee of its members’ debts, so that any default risk premium on the debt of the heavy borrowers will disappear.


• When a country faces problems with servicing its national debt, it seeks help from its central bank.

• The government issues bonds, that are purchased by the Central Bank. The Central Bank prints more money to buy these bonds.

• As a result the value of the domestic currency decreases, which helps restore competitiveness losses.


• However, in the medium run imported inflation becomes a problem.

• In particular, if higher inflation persists then authorities run the danger of people becoming accustomed to higher inflation and this embedded in people’s expectations.

• In this case expectations generated inflation could potentially become a serious problem.


• When a country is in a monetary union, like EMU, with a central bank responsible for the union as a whole, like the ECB, a national government not able to service its debt, like Greece, Ireland and Portugal, can not engage in the previous process.

• Thus, they need the Union’s help. This should involve the transfer of resources from rich parts to poor parts of the Union (Mundell, R.)


• Therefore, excessive borrowing by EMU member countries will harm the union as a whole. Because of these externalities it would be in the interest of the fiscally prudent countries that a control mechanism be in place restricting the size of budget deficits.

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Therefore a fiscal framework refers to the sustainability of public finances of all member states. A country unable to finance its debt in a monetary union has the following options:

• Default on its debts (debts).

• Receive direct transfers from other countries

• Central Bank to reduce interest rates to reduce the cost of debt financing.

• “Create Euro-zone bonds”?.

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• However, there is a limit to all these policies:

• 1st: The risk of contagion increases, and there is a possibility of a debt crisis

• 2nd: Political problems

• 3rd: The ECB would simply refuse to endanger the stability of the single currency.

• 4th: Euro-bonds

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• Countries inside EMU would suffer more for three reasons:1. Since government debt is denominated in the

same currency, the risk of contagion increases.

2. An interest rate cut for debt financing reasons could stimulate excess inflation.

3. The credibility of the Euro area would suffer.

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• Debt crises more likely in the euro area as 17 countries and only one Central Bank

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• In the case of EMU, the Treaty explicitly rules out bail outs of one Member State by another or by the ECB (Articles 101 and 103).

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Central Fiscal Authority

• Arguments in favour:

• Eliminate the free rider problem and ensure that the spill-over effects are fully taken into account.

• Enables the pulling of risk, surpluses in one country can be used to offset other countries’ deficits.

• Respond more quickly to economic circumstances when there is disagreement about the appropriate course of action (lags of adjustment).

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• Arguments against:

• Political problems-Taxation-Redistribution

• The use of the tax system depends on political preferences i.e. a center-left government would, at least in principle, tax more rich people in favour of the poor. It is therefore impossible to reach an agreement on this issue (especially when there are 17 governments).

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• National Automatic Stabilizers

• Member states are more familiar with their economies (regional problems).

• Member states can spread the risk over time by varying the deficit.

• Country specific shocks (oil shocks)-Structural Reforms.

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Conclusions

• Therefore wide-area (many countries) Fiscal Rules should aim to reduce or to eliminate the negative externalities of unsustainable policies (free rider problem and spill-over effects) while preserving a high degree of national autonomy and discretion =>

STABILITY AND GROWTH PACT

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STABILITY AND GROWTH PACT

• Public Sector Deficit < 3 % of GDP

• National Debt < 60 % of GDP

• Countries with a public debt > 50 % of GDP should necessarily satisfy (i)

• In the medium term growth in public sector spending < the growth in gross national product.

• Sanctions if countries failed to meet these conditions = 0.25 % of GDP for each percentage point away of the deficit limit.

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3. Rationale of the SGP

• Fiscal policy is decentralised in the EU with no central determination of fiscal policy.

• Decisions on tax and public spending are a matter for national governments.

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• Members of the EMU area have a legal commitment to avoid excessive deficits.

• The Council of the EU Economic and Finance Ministers can impose sanctions to any EMU country.

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• This is not the case if the deficit has been caused by exceptional and temporary circumstances.

• In the euro area fiscal coordination takes place within framework of the SGP.

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• Preventing countries with high deficits and high debts from resorting to borrowing in order to meet the Maastricht Criteria (It applies to the 1996-1999 period).

• Alleviate German fears concerning the post-1999 era given the large number of countries that finally participated in the EMU (Initially 11 today 17 countries).

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• Shifts the emphasis from debts to deficits.

• To tie the hands of any potential recalcitrant member states. If you allow deficits to increase, interest rates would increase as well, threatening the credibility of the euro.

• Therefore the Stability and Growth Pact creates a supranational budget mechanism (but not an institution).

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–Disagreements between France – Germany

• France: Argued/argues in favour of the creation of a Stability Council with political status to balance the dominance of the European Central Bank and the Stability and growth pact.

• Germany: Rejects the French proposals.

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• The debate that ensued after the decision to endorse the SGP focused on its restrictive nature (France).

• In the case of an asymmetric shock countries would be under unbearable pressure (e.g. oil shock, changes in the labour market, current account deficits).

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4a. Advantages of the SGP

Stabilisation properties:

• i) Fiscal Automatic Stabilizers:

Taxation-Unemployment Benefits.

• ii) Low inflation, low interest rates.

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4b. Disadvantages of the SGP

• SGP combined with low Economic Growth could lead to a recession or a deflation.

• Suppose EMU countries have a balanced budget in the medium term. Then they can let their deficits increase up to 3%. This does not require expansionary fiscal policies, as in a recession automatic stabilizers will drive up deficits. How large is then the cyclical sensitivity of national budgets?

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• In most EU countries the cyclical component rarely exceeded the 3% of GDP limit. So if countries stick to the 3% limit in the medium run the SGP offers substantial room for automatic stabilisers to function.

• What about the dampening effects of automatic stabilisers on output?

• They differ substantially from country to country.


• According to EU estimates the average stabilising impact after a shock is 28 %, ranging from 41 % in Finland to 15% (?).

• It is also quite low (18 %) in the cases of Portugal and Spain.


• Lags of adjustment, Discretion may lead to indiscipline.

• Focusing on annual budget deficits imposes that too much of the adjustment to contingencies (like the current one) to be bottled in the year they occur.

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• 3 percent deficit criterion: arbitrary?

• 3 percent deficit criterion: to all countries.

• Sanctions: To an irresponsible government they are OK, but to a responsible one?

• Pressure on the EU budget-Political obstacles-Democratic deficit.

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• France and Germany violated SGP in 2002-4.

• France, Spain, Ireland, Portugal and Greece violation in 2008.

• 9 countries violated the 3% deficit criterion in 2009. This reflects a de-facto upward revision of the 3% deficit criterion.

• 2010 almost all EMU countries violated the SGP.

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• Which countries do you punish?• Why not punish countries with high debt

(Greece, Italy, Belgium, Ireland, Portugal)?

• Why to punish a country that fails one criterion and not a country that lags behind as a whole?

• What about asymmetry in EMU?

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5. Proposals for Reform

• Strict Rule Enforcers: Northern countries e.g. the Netherlands, Finland, Austria, Estonia + Germany + European Central Bank.

• Marginal Reformers: European Commission Proposals: Do not take account of Military Expenditure when applying the 3% deficit criterion. Take into account the structural deficit only.

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• Radical Reformers: Politicians in “problem countries” e. g. Ireland,

Greece, Portugal, Spain, Italy. Although they recognize the need for a framework this is not the one applied by the SGP.

Academic Economists: Proposals: Abandon the SGP or reverse upwards its

criteria, e.g. instead of 3%, apply a 6 or 7% deficit criterion in the case of a recession. Thus, take into account when applying the SGP of the business cycle.

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An upward revision - flexibility to member state governments when preparing their budgets.

• Debts rather than deficits: The SGP should focus only on debts, since they are more important for fiscal sustainability.

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• Allowance for public investment: The capital budget of member states should be

excluded from the deficit of the member states, permitting borrowing for net public investment.

• A “permanent balance” rule: The share of government taxes in GDP is kept

constant at a value no less than the permanent public spending share in GDP.

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• Institutional Proposals:

Fiscal Policy Committees in each member state

New monitoring institutions

Trade-able deficit permits

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6. Conclusions - General

• The SGP should/would remain the framework within which member states formulate their fiscal policies (Not in its current form obviously).

• There need not/cannot be a meticulous/rigid application of the SGP.

• No sanctions have been imposed on any countries that failed to meet the criteria in the short run.

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There is the need for the introduction of some sort of flexibility (like today). Flexibility should imply:

i) Structural changes

ii) Take account of business cycle (i.e. do not apply strictly the SGP criteria in the case of a recession).

Above all there is a need for a new fiscal authority to enforce the application of the pact.

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• However, the SGP has failed to provide an effective incentive mechanism conducive to the reduction of budget deficits in the long run.

• The fact that Northern EMU countries have experienced current account surpluses by exporting to South EMU countries leads to regional imbalances within EMU which is clearly unsustainable.

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• If regional imbalances emerge in any monetary-currency union then resources have to be transferred from the rich parts to the poor parts of the union (Mundell).

• However, this presupposes the existence of available union funds. This explains the creation of the European Financial Stability Facility (EFSF), and the European Stability Mechanism in 2013.

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• However, there are disagreements between France and Germany concerning the scale of the funds provided by the EFSF (currently E440 bn) and the nature of the EFSF.

• France would prefer the EFSF to be assisted by EMU institutions such as the ECB whereas Germany wants the EFSF to remain just a fund. Partly, this explains the exposure of French banks to Italian debt.

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• If the EFSF were to be supported by the ECB this would imply that the ECB would become a bank of last resort, effectively bailing out the countries whose bonds were to be purchased.

• If the EFSF were not to be supported by the ECB but by national sources of finance it is questionable whether it could support either Spain or Italy (obviously not France). In this case, the sustainability of EMU is questioned.

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• The potential lack of funds in this case combined with the inability of Italy to service its debt could cause contagion to France.

• In this case French banks would have to make considerable writing downs in their assets. In the case that their capital requirements can not withstand these losses the French state has to do what Ireland and the UK did which is to nationalise part of these institutions.

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• In this case French national debt/GDP would be significantly increase and markets could become sceptical with regards to the ability of France to service its debt.

• These expectations can become self-fulfilling or alternatively rating agencies could downgrade the country and France were to lose its AAA status.

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• In this case, the immediate issuance of Euro-bonds or the massive purchase of unprecedented levels of French bonds by the ECB would be the only solution averting the collapse of the Euro-zone.

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6. Conclusions - Comments

• EMU as a whole has a lower debt/GDP than the USA.

• Why are we then talking about a debt crisis in EMU?

• The USA has four main advantages over EMU.

• First, the reserve currency status of its currency, second its federal budget, third the Federal Reserve and fourth it has no objective with regards to the value of the dollar.

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• First, reserve currency status of the dollar (Data).

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• Secondly, the federal budget in the USA accounts for funds ranging between 22-30 percent of USA GDP.

• In the dollar currency area therefore funds could be utilised immediately to cover debts in California.

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• Third, the federal reserve in the USA can act, and has acted since 2007 as the lender of last resort. The ECB has not (at least not yet) acted as a lender of last resort. This is why markets are sceptical with whether Euro-zone would actually manage to resolve the crisis.

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• Even if the ECB acts as the lender of last resort this does not guarantee the viability of EMU, as it would not automatically resolve the debt problem in various EMU countries.

• It would only provide an answer in the short run.

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• Between 2002-9 the US dollar was devalued by 70% in relation to the Euro and 50% according to a weighted average of major trading countries’ currencies.

• Why?

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1 fiscal policy in european monetary union 1. topics 1. introduction 2. the need for a fiscal...

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