1. Chapter 10: Fiscal Policies in Monetary Unions
De Grauwe:
Economics of Monetary Union

2. Fiscal policies and the theory of optimum currency areas
Germany
France PF PG SG SF
D’G DF
D’F DG YG YF

3. 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
France accumulates budget deficits and debt
Germany reduces deficits and debt

4. 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

5. 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

6. 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

7. 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

8. The dynamics of debt accumulation
where g = G/Y, t = T/Y, x = Y/Y (the growth rate of GDP), and
When the interest rate on government debt exceeds the growth rate of GDP, the debt-to-GDP 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

9. The debt-to-GDP ratio stabilizes at a constant value if
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

10. 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

11. Government Budget Deficits in Belgium, The Netherlands, and Italy (1979 – 2005)

12. Gross Public Debt (% of GDP)

13. Government budget surplus, excluding interest payments (% of GDP)

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. Fiscal discipline in monetary unions
A monetary union may change the incentives of fiscal policy-makers, and, in so doing, may affect budgetary discipline
There are two opposing effects
Once in monetary union, individual governments face a larger ‘domestic’ capital market; their capacity to borrow increases; this will lead them to borrow more, and to have larger deficits

21. Countries which join the union reduce their ability to finance budget deficits by money creation
As a result, the governments of member states of a monetary union face a ‘harder’ budget constraint than sovereign nations
This will reduce budget deficits

22. Government budget deficits in Eurozone, US, UK, Japan

23. 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

24. 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

25. This tension exists at two levels:
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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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.

33. 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.

34. 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.

35. 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.

36. 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

37. 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