1. Chapter 18

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

3. 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.

4. 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.

5. GDP and budget balance

6. Automatic Stabilisers

7. 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

8. Structural balance

9. Example: the Netherlands

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

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

12. 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.

13. Similar output gaps and business cycles

14. 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

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

16. CNN

17. 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

18. 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

19. 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)

20. 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

21. 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.

22. 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.

23. 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.

24. 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.

25. 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.

26. 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.

27. Recent budget balances