Fiscal Policy and EMU

Abstract

This article considers the role of fiscal policy within a European Monetary Union. There are two quite different issues. The first is the medium-term problem of deficits and debt. The Maastricht fiscal convergence criteria are usually seen as an imperfect response to the need to contain potentially 'irresponsible' fiscal authorities. It is argued here that they should be seen as reflecting a coordinated response to the generalised objective of fiscal consolidation and restraint in Europe: similar rules are likely to be a feature of Stage 3. There is a danger that governments are underestimating the difficulties of fiscal consolidation in a large area such as Europe. In practice, success would require a sustained rise in private sector investment and growth (or reduced private savings). The monetary coordination to go with generalised fiscal restraint appears to be lacking and we suggest a preemptive cut in interest rates. A more complete view of the causes of rising debt stocks in Europe is needed, and we suggest that a reframing of the problem of deficits and debt in terms of the needed (counterpart) private sector responses would be helpful in highlighting the coordination problems and avoiding adverse dynamic reactions. The medium-term problems interract unfavourably with the second set of issues-the need for fiscal policy to be used more actively for short-term stabilisation in a future common currency area. Fiscal offsets are an appropriate response to domestic demand shocks, but not to others, such as those requiring a change in the real exchange rate. Contrary to the 'fiscal federalist' position, such stabilisation need not involve centralisation. But there are serious difficulties. Without care, needed stabilisation will be prevented by the Maastricht criteria or the rules likely to follow them. And without coordination, independent stabilisation of common shocks will tend towards too little fiscal activism rather than too much.

Economic Policy Coordination in the European Union

“…A Member State running a deficit will no longer face a higher real exchange rate vis-à-vis the rest of the currency zone, while the burden of crowding out will be shifted onto the currency zone as a whole in the form of a higher unified interest rate. Thus, Member States can externalise the costs of excessive deficits and the need to exercise fiscal restraint is, by implication, diminished (Aizenman, 1994;Allsopp and Vines, 1996;Beetsma and Bovenberg, 1999). If all Member States are free to act on this incentive -and this is clearly the case in a decentralised fiscal regime -then a retaliatory and discordant mix of fiscal policies will lead to a deterioration in the aggregate fiscal position (Agell et al, 1996;Collignon, 2001).…”

The Future of Macroeconomic Policy in the European Union

“…Whatever may be thought of the Pact itself, it is hard to deny, in the European context, that some medium-term fiscal rules were needed. Nevertheless, the change from the past is very great: whether one looks at actual or structurally-adjusted deficits, there was only a single year in the period 1980-95 when Europe as a whole would have met the Maastricht 3% limit (and that was the boom year 1989), let alone the much more stringent limits imposed by the SGP (Allsopp and Vines 1996).…”

‘Close‐to‐Balance or in Surplus’: A Policy‐Maker's Guide to the Implementation of the Stability and Growth Pact

“…If so, the loss of monetary independence compounded by constrained fiscal policies may lead to a suboptimal degree of stabilization especially in the event of country-specific shocks. During the initial years of EMU, before budgetary targets have been achieved, cyclical stabilization may be restricted because of the closeness of initial deficits to the 3 per cent ceiling (Allsopp and Vines, 1996;Eichengreen and Wyplosz, 1998). Indeed, as already pointed out by Buti et al (1997, p. 362), 'in the event of a severe recession during the early years of EMU, since several countries will still have deficits in the 2% to 3% of GDP range, they risk moving into excessive deficit, unless they take a pro-cyclical budgetary stance'.…”