Fiscal Challanges on the Road to Euro: The Maastricht Fiscal Rule and the SGP from the Perspective of the New Member States György Szapáry Magyar Nemzeti Bank Seminar on „EMU and the New Member States: A Year After Accession” organized by the Bulgarian National Bank, Sofia, October 3-4, 2005

2 I. Outline The fiscal position of the New Member States vis-à-vis Maastricht Are Maastricht and the SGP inconsistent with the Optimal Currency Area (OCA) properties?

3 II. Central Banks and Fiscal Policy “Central Banks are often accused of being obsessed with inflation. This is untrue. If they are obsessed with anything, it is with fiscal policy.” Mervyn King Governor Bank of England

4 III. Fiscal Position of the NMS vis-à-vis Maastricht* Initial budgetary conditions: deficits and debt Yield convergence Implicit liabilities due to ageing *Based on a paper by Gábor Orbán and György Szapáry: “The Stability and Growth Pact From the Perspective of the New Member States”, Journal of Policy Modeling, Vol. 26 Issue 7 (2004), pp

5 Budgetary Balance as a Ratio of GDP: Distance from the 3% reference value in the run-up to the euro * Distance from the deficit reference value in 1994 for the EU-11, in 1996 for Greece and in 2004 for the other countries. A negative sign indicates that the deficit exceeds the 3% limit.  As regards initial distance from the reference value, the NMS on the whole are in a slightly better position than were today’s euro area member countries prior to euro adoption.

6 Debt GDP Ratios: in 2004 and in the run-up to the euro  The same is true for debt ratios.

7 Yield Convergence  With the exception of Poland and Hungary, most countries already more than satisfy the bond yield criterion. This was not the case 3 years prior to assessment in euro area countries. For the EU-11 the figure shows the distance from the March 1998 Maastricht interest rate criterion in March 1995, for Greece the distance from the March 2000 criterion in March 1997 and for the other countries the distance from the March 2005 criterion in March 2005.

8 Fiscal Gains from Yield Convergence as percent of GDP  Fiscal gains from yield convergence are small compared with euro area countries

9 Required Adjustment in Primary Balance  Necessary adjustment in primary balance important for high debt countries. A positive value means the reduction of the primary deficit is required.

10 Ageing is a threat in NMS

11 IV. Maastricht and SGP inconsistent with Optimal Currency Area? Preserve public credit: „As a very important source of strength and security, cherish public credit. One method of preserving it is to use it as sparingly as possible by cultivating peace (.. and) avoiding likewise the accumulation of debt, not only by shunning occasions of expense, but by vigorous exertions in time of peace to discharge the debt that wars have occasioned, not ungenerously throwing upon posterity the burden that we ourselves ought to bear.” George Washington, Farewell Address, 1796

12 Public Debt/GDP Before and After Maastricht,  Prior to Maastricht, the debt/GDP ratios increased in the EU countries. After Maastricht, they declined.

13 Interest Rate Expenditure/GDP,  Interest rate expenditures as a ratio of GDP rose prior to Maastricht, but declined thereafter.

14 Interest Rate Expenditure/GDP, 2003  However, in most countries, the interest burden is still high.

15 V. Fiscal Rule: Mundell vs Maastricht* Business cycle synchronization is one of the most important Mundell OCA criteria Meeting the Maastricht criteria is a condition for entering the euro area In a currency union, fiscal policy is the sole macroeconomic tool to smooth the business cycle when a country is hit by asymmetric shock Striking absence of direct overlap between Mundell and Maastricht: fiscal criteria and SGP mean that fiscal policy can not play the stabilizing role *Based on a paper by Zsolt Darvas, Andrew K. Rose and György Szapáry: „Fiscal Divergence and Business Cycle Synchronization: Irresponsibility is Idiosyncratic”, NBER Working Paper, No

16 V. Fiscal Rule: Mundell vs Maastricht (cont.) But is there an indirect connection between Mundell and Maastricht? Suppose fiscal policy itself is a source of shock, not a stabilizer. In that case Maastricht is indirectly consistent with Mundell Everything hinges on whether fiscal policy generates or responds to shocks. Intuition is that fiscal irresponsibility is idiosyncratic. That is what we have tested empirically

17 VI. Main results Using panels of 21 OECD countries and 115 countries of the world for the years , we found: Fiscal divergence reduces business cycle synchronization Smaller deficits/larger surpluses tend to be associated with more synchronized business cycles Large deficits are associated with more volatile business cycles

18 Business Cycle Correlation and Fiscal Divergence  Fiscal divergence reduces BSC Sensitivity checks –Estimation: OLS, IV –Fixed effects –Different samples: 40 yrs, 10yrs, without EMU –Other controls (trade, gravity regressors, level of deficit) –Different measures of BCS and FD (total and primary deficit)

19 Average Budget Positions and Business Cycle Synchronization  Smaller deficits/larger surpluses tend to be associated with more synchronized business cycles.

20 Government Budgets and Business Cycle Volatility  Larger deficits are associated with more volatile business cycles

21 VII. Conclusion Maastricht imposes fiscal convergence to low levels, thus helps reduce debt Strong evidence that fiscal convergence is associated with business cycle synchronization Moreover, evidence that –reduced deficits (or higher surpluses) increase business cycle comovements, and –large deficits are associated with volatile cycles Reason: high deficits increase the likelihood that fiscal policy itself is a source of asymmetric shock: that is, irresponsibility is idiosyncratic Therefore, Maastricht helps synchronization

22 To Sum Up Maastricht fiscal rule has helped to reduce debt and debt service burden and also helps to satisfy OCA criteria. Many cheers!