Transcript Slide 1

Chapter 18
© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Chapter 18
Fiscal Policy and the
Stability Pact
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
The Fiscal Policy Instrument
• In a monetary union fiscal policy
– the only macroeconomic instrument at national level
– government borrows in slowdown and pays back on behalf of
citizens
– government acts as substitute to inter-country transfers in case
of asymmetric shock.
• Effectiveness depends on private expectations
• Slow implementation of fiscal policy
– Result: countercyclical actions can have procyclical effects.
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A Crucial Distinction: Automatic vs. Discretionary
• Automatic stabilisers:
– tax receipts decline when the economy slows down, and conversely
– welfare spending rises when the economy slows down, and
conversely
– no decision, so no lag: nicely countercyclical
– rule of thumb: deficit worsens by 0.5 per cent of GDP when GDP
growth declines by 1 per cent.
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GDP and budget balance
© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Automatic Stabilisers
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A Crucial Distinction: Automatic vs. Discretionary
• Discretionary actions: a voluntary decision to change tax
rates or spending.
• Cyclically adjusted budget (also called structural balance)
shows what the balance would be if the output gap is zero in
a given year
• Difference between actual and cyclically adjusted budget =
footprint of automatic stabilisers
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Structural balance
© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Example: the Netherlands
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Output gap
Budget balance
Cyclically adjusted budget balance
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2
0
-2
-4
-6
1991
1993
1995
1997
1999
2001
2003
2005
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Example: the Netherlands
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The output gap and
the overall budget
tend to move together
Output gap
Budget balance
Cyclically adjusted budget balance
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2
0
-2
-4
-6
1991
1993
1995
1997
1999
2001
2003
2005
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Example: the Netherlands
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Output gap
Budget balance
Cyclically adjusted budget balance
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The steady improvement of
the cyclically adjusted balance
is not directly reflected in the
actual budget outcomes
2
0
-2
-4
-6
1991
1993
1995
1997
1999
2001
2003
2005
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Fiscal Policy externalities
• Should the Fiscal Policy Instrument Be Subjected to Some
Form of Collective Control?
– Yes, if national fiscal policies are a source of several
externalities.
• Income spillover via trade:
– important and strengthened by monetary union
– lack of co-ordination means that with a symmetric shock too
much policy action can be used to counteract shock.
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Similar output gaps and business cycles
Output gaps
8
6
4
2
0
-2
-4
-6
1972
1975
1978
Switzerland
1981
1984
1987
Germany
1990
1993
1996
1999
France
2002
2005
Netherlands
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Fiscal Policy externalities (cont.)
• Borrowing cost externalities:
– one country’s deficit would induce higher interest rate for
everyone
• Long-term growth effects
• Growth data:
http://epp.eurostat.ec.europa.eu/tgm/table.do?tab=table&pl
ugin=1&language=en&pcode=tsieb020
– but euro area integrated in world financial markets
• Still, capital inflows can appreciate common currency and
affect competitiveness
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The Most Serious Concern: The Deficit Bias
• The track record of EU countries is not good.
EU public debt (% of GDP)
80
70
60
50
40
30
20
1970
1974
1978
1982
1986
1990
1994
1998
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2002
2006
The Most Serious Concern: The Deficit Bias
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European public debt 2010
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What is the Problem with the Deficit Bias?
• Most serious is the risk of default in one member country:
– capital outflows and a weak euro
– pressure on other governments to help out
– pressure on the Eurosystem to help out
• Answer to address risk:
– the ‘no-bailout’ clause in Maastricht Treaty (article 103),
stipulates explicitly that neither the Community nor any Member
State is liable for or can assume the commitments of any other
Member State.
– German finance minister, Peer Steinbrück, let the cat out of the
bag last February when he said: "The euro-region treaties do not
foresee any help for insolvent states, but in reality the others
would have to rescue those running into difficulty."
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In the End, Should Fiscal Policy Independence be
Limited?
• The arguments for:
– serious externalities
– increasing returns to scale (policies may be more effective when
carried out on a large scale)
• The arguments against:
– the only remaining macroeconomic instrument
– national governments know the home scene better (heterogeniety of
preferences and information asymmetries
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The Stability and Growth Pact (SGP)
http://ec.europa.eu/economy_finance/economic_governance/sgp/index_en.htm
• The SGP: meant to avoid excessive deficits upon entry into euro
area.
• Excessive Deficit Procedure (EDP) makes permanent the 3 per
cent deficit and 60 per cent debt ceilings and foresees fines.
• Final word remains with ECOFIN (the council of Finance Ministers
of the Eurozone), and countries avoided fines so far.
• SGP reformulated in 2005 to avoid rigidity of Pact (Pact may be
suspended in exceptional circumstances, such as a very severe
recession). New reformulations are on the agenda
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The Stability and Growth Pact (SGP)
http://ec.europa.eu/economy_finance/economic_governance/sgp/index_en.htm
The SGP: meant to avoid excessive deficits upon entry into euro
area.
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© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
How the Pact Works
• A limit on acceptable deficits: 3% of GDP
• A preventive arm
– Aims at avoiding reaching the limit in bad years
– Calls for surpluses in good years
• A corrective arm
– ‘early warning’ when deficit is believed to breach limit +
recommendations
– EDP procedure for excessive deficit: recommendations, to be
followed by corrective measures, and ultimately sanctions
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Excessive deficit procedure
http://ec.europa.eu/economy_finance/economic_governance/sgp/deficit/index_en.htm
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The Fine Schedule
• The fine starts at 0.2 per cent of GDP and rises by 0.1 per
cent for each 1 per cent of excess deficit.
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How is the Fine Levied
• 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 per
cent.
• The fine is initially considered as a deposit:
– if the deficit is corrected within two years, the deposit is returned
– if it is not corrected within two years, the deposit is considered as a
fine.
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Issues Raised by the Pact
• Does the Pact impose procyclical fiscal policies?:
– budgets deteriorate during economic slowdowns
– reducing the deficit in a slowdown 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.
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Issues Raised by the Pact
• What room left for fiscal
policy?:
– if budget in balance in
normal years, plenty of
room left for automatic
stabilisers.
© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Issues Raised by the Pact
• What room left for fiscal policy?:
– if budget in balance in normal years, plenty of room left for
automatic stabilisers
– some limited room left for discretion action.
© Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition
Issues Raised by the Pact
• In practice, the Pact encourages:
– aiming at surpluses (so public debts will disappear)
– giving up discretionary policy.
• The early years are hardest:
– takes time to bring budgets to surplus.
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Recent budget balances
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