Chapter 18

Fiscal Policy and the Stability Pact Chapter 18 Fiscal Policy and the Stability Pact

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.

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.

GDP and budget balance

Automatic Stabilisers

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

Structural balance

Example: the Netherlands

Example: the Netherlands The output gap and the overall budget tend to move together

Example: the Netherlands The steady improvement of the cyclically adjusted balance is not directly reflected in the actual budget outcomes

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.

Similar output gaps and business cycles

Fiscal Policy externalities (cont.) Borrowing cost externalities: one country’s deficit would induce higher interest rate for everyone Long-term growth effects but euro area integrated in world financial markets Still, capital inflows can appreciate common currency and affect competitiveness

The Most Serious Concern: The Deficit Bias The track record of EU countries is not good.

CNN - 2011

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 Prevention procedure

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

The Stability and Growth Pact (SGP) 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)

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

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.

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.

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.

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.

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.

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.

Recent budget balances