Fiscal policy in EMU
Description
Rules, discretion and political incentives
Taxation
Target audience: Specialised/Technical
Taxation
Target audience: Specialised/Technical
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| Publié par | EUROPEAN-COMMISSION-DIRECTORATE-GENERAL-FOR-ECONOMIC-AND-FINANCIAL-AFFAIRS |
| Nombre de lectures | 53 |
| Langue | English |
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EUROPEAN ECONOMY EUROPEAN COMMISSION DIRECTORATE-GENERAL FOR ECONOMIC AND FINANCIAL AFFAIRS ECONOMIC PAPERS ISSN 1725-3187 http://europa.eu.int/comm/economy_finance N° 206 July 2004 Fiscal policy in EMU: Rules, discretion and political incentives by Marco Buti and Paul van den Noord (*) Directorate-General for Economic and Financial Affairs
Economic Papersare written by the Staff of the Directorate-General for Economic and Financial Affairs, or by experts working in association with them. The "Papers" are intended to increase awareness of the technical work being done by the staff and to seek comments and suggestions for further analyses. Views expressed represent exclusively the positions of the author and do not necessarily correspond to those of the European Commission. Comments and enquiries should be addressed to the: European Commission Directorate-General for Economic and Financial Affairs Publications BU1 - -1/180 B - 1049 Brussels, Belgium (*)(*)European Commission and OECD, respectively. An earlier draft of this paper was presented at the conference on "Rethinking Economic and Social Policies", Madrid, November 26-27, 2003. We are grateful to an anonymous referee for useful comments and suggestions and to the two discussants, Antonio Fátas and Ludger Schuhknecht, and other participants at this conference for a stimulating discussion. We would also like to thank Alessandro Turrini for his valuable comments on an earlier draft. The opinions expressed in this paper belong to the authors only and should not be attributed to the institutions they are affiliated with. The usual disclaimer applies. Correspondence: Marco.Buti@cec.eu.int; @oecOORDgd.oraPluEDNNV.NA ECFIN/003748/04-EN ISBN -892495-79-1 9 KC-AI-04-206-EN-C ©European Communities, 2004
Abstract
The fiscal philosophy of EMU's budgetary rules is to bring deficits close to balance and then let automatic stabilisers play freely. Given the large tax and benefit systems in Europe, relying mainly on automatic stabilisation would allow a relatively high degree of cyclical smoothing while avoiding the typical pitfalls of fiscal activism. While this is, in most circumstances, good economic policy, it is evidently not regarded as good politics. The current difficulties of EMU's fiscal policy framework have little to do with its alleged fault lines and much to do with the resurgence of electoral budget cycles amid a weak system of incentives to abide by the agreed rules.
JEL CLASSIFICATION : E61, H3, H6
1. Introduction Europes Economic and Monetary Union (EMU) is based on an original arrangement of public finance relations between member countries: fiscal policy remains decentralised, but is subject to rules which are meant to combine discipline and flexibility. The Stability and Growth Pact (SGP), which complements and tightens the fiscal provisions laid down in the Maastricht Treaty, is the backbone of fiscal discipline in EMU.
The SGP is widely viewed as the most stringent commitment technology ever adopted by sovereign governments on a voluntary basis in the attempt to establish and maintain sound public finances. The fiscal rules of EMU are based on a simple predicament: government should reduce budget deficits to close to balance and then let automatic stabilisers play freely. The SGP, if applied according to its letter and spirit, will have important implications for the behaviour of budgetary authorities in both the short term (cyclical stabilisation, policy co-ordination) and long term (sustainability of public finances).
The experience of the early years of EMU has, however, been disappointing. While several euro area countries continued the fiscal retrenchment, even moving into surplus, the three largest members Germany, France and Italy and Portugal remain trapped in high deficits. It is fair to assume that these countries (and some others as well) would have faired worse had there not been the SGP. The SGP has institutionalised the reporting of multi-annual fiscal trajectories and enhanced transparency, awareness of longer-term fiscal issues and peer pressure. Even so, the failure of fiscal co-ordination in EMU is blatant. The eventual demise of the Commission recommendations for correcting the excessive deficits by France and Germany in Autumn 2003 calls into question the political willingness of countries to adhere to the prior-agreed fiscal rules.
A large number of observers ascribe such failure to alleged inconsistencies of the Pact: the SGP is not abided by because its "numerology" makes no sense. We do not buy that line of argument. EMU's fiscal rules have been applied flexibly and the skeleton of the Pact has been increasingly covered with sensible economic flesh. Putting the emphasis on automatic stabilisers rather than discretionary fiscal policy is sound policy advice. If the ensuing cyclical smoothing would be considered too small, instead of relapsing into fiscal activism, it would be helpful if governments sought ways to improve the effectiveness of the automatic
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stabilisers. As it stands, automatic stabilisers are often the by-product of tax and benefit systems designed in the pursuit of allocation and redistribution objectives. Broadening the set of policy objectives pursued by tax and benefit systems to include macroeconomic stabilisation objectives may be welfare-enhancing.
Unfortunately, even if automatic stabilisers can be made more effective in a technical sense, theirde factoeffectiveness is undermined if political economy motives prevented them from working symmetrically over the cycle. If fiscal windfalls in good times are wholly or partly handed out to the electorate, fiscal policy will fail to smooth the business cycle and precious opportunities to build up a war chest against the looming ageing challenge will be missed. With the creation of EMU the carrot of EMU entry has been eaten while there are hardly any sticks left to force governments to live up to the rules, except for the Excessive Deficit Procedure (EDP) which, although essential, kicks in when harm is already done. The preventive part of the SGP has proven very weak.
Here are the roots of the current difficulties of the SGP which has little to do with its intrinsic "quality" and much to do with a weak system of incentives for resisting a politically motivated fiscal behaviour.
The present paper provides a broad review of these issues, based on findings in the literature and our own recent analytical work. Section 2 presents a birds eye view of the history of the downfall of fiscal discretion in favour of fiscal rules and how this has shaped fiscal co-ordination in EMU. Section 3 develops a broader view on automatic stabilisers, including supply side aspects that affect their stabilisation properties in the face of asymmetric shocks. The latter cannot be dealt with by a one-size-fits-all monetary policy, so automatic stabilisers are essential and we draw conclusions on how automatic stabilisers could be strengthened in this regard. Section 4 examines to what extent political incentives have affected fiscal behaviour in EMU to date and how these incentives could be stemmed in the future. Section 5 concludes.
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2. The rise and fall of fiscal activism
2.1 Fiscal policy in macroeconomics: a bird’s-eye view
Economics is a science that moves in cycles. There is probably no better example of this than fiscal policy which has been falling into disfavour and re-emerging from its ashes almost every decade since the Second World War.1
Fiscal policy gained prominence after the 1950s and 60s as a tool for demand management as it was seen as more effective than monetary policy. According to the standard Keynesian textbook model, in a closed economy, its effectiveness depends on the relative slope of the IS and LM curves. The extreme case is that of the so-called liquidity trap where any additional supply of money fails to put downward pressure on interest rates and monetary policy becomes completely ineffective. Hence fiscal policy remains the only instrument to prop up economic activity. The traditional Keynesian model largely ignored the opposite case, that of fiscal policy ineffectiveness. While crowding-out effects were early recognised, full ineffectiveness was seen, until the mid-1970s, as a mere theoreticalcuriosum.
The literature in the early 1970s highlighted the different effects in the short run and the long run of fiscal policy. The seminal contribution of Blinder and Solow (1973) shows that pure fiscal policy (i.e. a bond-financed increase in the budget deficit) can be more effective in the long run than money-financed fiscal policy. The reason is that the interest payments on public debt add to the expansionary boost of the initial deficit rise and result in a higher long-term multiplier. However, the authors point out that, if both tax rates and government spending were exogenously fixed (i.e. in modern jargon, if the government behaviour is non-Ricardian), a bond-financed fiscal policy can lead to instability, a result that, re-framed within a different theoretical context, has given rise to a vast literature (see below).
In an open economy, the classic Mundell-Fleming model shows that the effectiveness of fiscal policy depends on the exchange rate regime. In the limited case of a small economy with perfect capital mobility, fiscal policy is shown to be completely ineffective in a flexible exchange rate regime while its effectiveness is maximal under fixed exchange rates.
The Mundell-Fleming framework enables the neat analysis of the effects of national fiscal policies within a multi-country currency area. A monetary union can be thought of as 1 This section draws heavily on Buti (2003).
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combining fixed exchange rates within the area and flexible exchange rates vis-à-vis the rest of the world. This implies that national fiscal policy may be of the beggar-thy-neighbour type: if directed to the purchase of goods and services produced domestically, government spending can be very effective at the national level, but, by leading to an appreciation of the common exchange rate, it also crowds out exports of other countries in the currency area to the rest of the world. If the currency area is small in the world market, in order to keep the money market in balance, the rise in output in the country enacting the fiscal expansion has to go hand in hand with an output decline in the rest of the currency area. As in the case of the original Mundell-Fleming model, such stark results may not hold if the currency union is large and hence it can influence world interest rates.
Since the mid-1970s, however, the role of fiscal policy as a stabilisation tool started to be increasingly questioned.
If one introduces the intertemporal budget constraints for households and the government, fiscal policy may not be effective in affecting national saving and consumption. As Barro shows in his seminal paper (Barro, 1974), since public debt has to be re-paid at some point in the future, forward-looking consumers anticipate the higher taxes and offset the expansionary fiscal stance by increasing private savings (dubbed Ricardian equivalence). In parallel, the New Classical Macroeconomics called into question the effectiveness of monetary policy which could only influence output to the extent that it deceives economic agents via surprise inflation.
Although the complete ineffectiveness of fiscal policy holds only under very restrictive assumptions, the intellectual seeds for the demise of macroeconomic policy as a stabilisation tool were sown. Real business cycle theory closed the loop: if the business cycle is an equilibrium response to supply side shocks, fiscal policy is unnecessary and may even be damaging being itself a source of shocks.
Whereas, in this view, fiscal policy cannot and should not attempt to stabilise real variables, it affects nominal variables. The unpleasant monetarist arithmetic of Sargent and Wallace (1981) uncovered the fiscal roots of inflation. Persistent fiscal imbalances put pressure on the central bank to finance the government budget deficits. Using current terminology, if economic agents are not Ricardian (i.e.there is a violation of the solvency constraint), tight
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money now gives rise to higher inflation in the future. Under rational expectations, tight money now would actually give rise to higher inflation now!
As recalled by Blinder (2002), the precursor of Sargent-Wallaces unpleasant arithmetic was the seminal model by Blinder and Solow (1973) referred to above which, under static expectations and fixed prices, showed that the economy can be unstable in the event of a bond-financed fiscal expansion. Bond financing can be viewed as adherence to monetarism, because the central bank sticks to its money supply target regardless of the deficit. If the expansionary fiscal policy leads to spiralling public debt and there is fiscal leadership (that is, in the game of chicken, fiscal authorities do not change their budgetary plans), monetary authorities will eventually have to step in and monetise the debt.
Fifteen years later, the unpleasant arithmetic has been taken beyond its original monetarist roots. The Fiscal Theory of the Price Level (FTPL) argues that a commitment of the central bank not to monetise public debt may not be sufficient. Despite this commitment, inflation may still rise if the fiscal authority credibly maintains a spending policy that would imply a violation of its intertemporal budget constraint. If so, not the central bank, but households optimisation moves the price level, breaking Ricardian equivalence.
However, even those refusing full Ricardian equivalence, recognised that an active fiscal policy to fine tune the cycle was doomed to fail, given the political and institutional constraints on fiscal policy making. In the end, a fiscal policy focussing on intertemporal sustainability and some form of tax smoothing (Barro, 1979) gathered a large consensus amongst academic economists: New Classical macroeconomists and real business cycle theorists emphasised the benefits of avoiding an excessive volatility of tax rates associated with a strict balanced budget rule; moderate (and New) Keynesians put the emphasis on the smoothing effectiveness of automatic stabilisers which are immune to the typical pitfalls of discretionary fiscal policy (model uncertainty, risks of pro-cyclical behaviour due to implementation delays, irreversibility of spending decisions, etc.).
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2.2 Does a monetary union require fiscal constraints? Theoretical underpinning of the “Brussels-Frankfurt consensus
The EMU is unique: it is a currency area of sovereign countries retaining a large degree of fiscal autonomy, with a single monetary authority managing monetary policy for the whole zone.
EMU is built on strong fiscal discipline foundations. The budgetary autonomy of EMUs members is subject to the numerical constraints of the Maastricht Treaty and the SGP. The Treaty sets rules on budget deficits and debt as a requirement for joining the single currency. It prescribes that budget deficits should not exceed 3% of GDP, unless exceptional circumstances occur, and, even in this case the excess should remain limited and temporary. Public debt should not exceed 60% of GDP or, if this is the case, it should be maintained on a downward trend.
While the numerical parameters of the Maastricht Treaty were seen as a screening device to select the members of the euro area, the goal of the SGP was to make fiscal discipline a permanent feature of EMU. The SGP, which was adopted by the European Council in Amsterdam in June 1997, requires that national budgets should be close to balance or in surplus in normal times so as to create sufficient room for manoeuvre in bad times to let automatic stabilisers play fully without exceeding the 3% of GDP deficit ceiling.
EMU is commonly seen as a regime of monetary leadership where fiscal policy is to support the central bank in its task to keep inflation in check. The European Council Resolution which accompanies the Pact underlines the importance of safeguarding sound government finances as a means to strengthening the conditions for price stability and for strong sustainable growth conducive to employment creation. It is also necessary to ensure that national budgetary policies support stability oriented monetary policies.
What has been dubbed the Brussels-Frankfurt consensus (Sapir et al., 2003) sees sound public finances as necessary both to prevent imbalances in the policy mix, which negatively affect the variability of output and inflation, and also to contribute to national savings thus helping foster private investment and ultimately growth. The beneficial effect is magnified as low deficits and debt, by entailing a low interest burden, create the room for higher public investment, productive public spending and a low tax burden. Prudent fiscal policies avoid policy-induced
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shocks and their unfavourable impact on economic fluctuations while ensuring a larger room for manoeuvre to address other disturbances which increase cyclical instability.
The design of the fiscal policy architecture of EMU has been influenced by the debate in the 1970s and 1980s. A rule-based fiscal policy came to be regarded as a way to ensure monetary leadership. In order to avoid Sargent-Wallaces unpleasant arithmetic, a particular emphasis was put on the need to ensure budgetary discipline. As a central banker though not of one of the countries belonging to the euro area put it, (c)entral banks are often accused of being obsessed with inflation. This is untrue. If they are obsessed with anything, it is with fiscal policy (King, 1995: 171).
The potential influences of fiscal behaviour on monetary policy have certainly been a major factor behind the Maastricht fiscal constraints and the SGP. However, the policy spillovers in a currency area are multiple and play in different directions: fiscal policy affects monetary policy, but the reverse is also true.
In a monetary union, independent fiscal authorities only partly internalise the constraints on monetary policy arising from their choices. In a two-period model of a monetary union, Beetsma and Uhlig (1999) show that myopic governments who know that they may be replaced at the beginning of the second period issue more debt than a social planner would do.2This would constrain monetary policy in the second period. This effect is magnified in a monetary union because the adverse impact on the common monetary policy is diluted. As a result, the incentive to restrain public debt accumulation is reduced and we end up with an overburdened monetary policy. Hence, a pact limiting public debt accumulation increases welfare in a monetary union.
The desirability of imposing fiscal constraints crucially depends on the ability of the single monetary authority to commit to its future policies. If the central bank is strong, fiscal constraints are damaging because they limit the room for manoeuvre by fiscal authorities in responding to shocks. If shocks are highly correlated across countries and the central bank is strongly committed to price stability, then a fiscally constrained monetary union is superior over a regime with multiple currencies. Instead, under idiosyncratic shocks, moving to a fiscally-constrained monetary union would be welfare-reducing: if the set of policy instruments open to fiscal authorities is sufficiently restricted, then monetary union may not 2 See also Uhlig (2003).
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increase welfare. Despite having commitment power, the central bank lacks the tools to stabilise in the presence of country specific shocks that are not perfectly correlated. (Cooper and Kempf, 2000: 27).
However, the effectiveness of the central banks commitment depends on the behaviour of budgetary authorities. An extreme case of commitment impossibility is developed by the FTPL which highlights that, if fiscal policy does not ensure solvency at every price level, monetary policy will lose grip on the determination of the price level. In order to ensure stability, fiscal policy has to react sufficiently strongly to a rise in the interest rate in the event of inflationary pressures by increasing the primary surplus. In other words, monetary policy aimed at keeping inflation in check - as the ECB is mandated to do - has to go hand in hand with a fiscal policy obeying a solvency constraint3.
Although FTPL implies that fiscal discipline is necessary for a smooth functioning of EMU, once it is applied to the EMU institutional set up, however, different conclusions are drawn. While Sims (1999) considers EMUs fiscal rules insufficient to rule out FTPL's doom scenario, Canzoneri and Diba (2001) conclude that such rules appear far too strict from the point of view of guaranteeing fiscal solvency. The latter authors, in particular, call for a shift in attention from actual to cyclically-adjusted budget balances in assessing the compliance of EMU members with budgetary prudence so as not to hamper fiscal stabilisation.
In a game theoretic framework, Dixit and Lambertini (see Dixit and Lambertini (2001), and Dixit (2001)) assume that monetary and fiscal authorities minimise a quadratic loss function in inflation and output, but final targets and the weight attributed to them vary (typically the central bank is assumed to be more inflation-conservative). These authors conclude that fiscal discretion destroys monetary commitment and, as such, may justify rules imposed on budgetary behaviour. If final targets differ (e.g. the central bank is an inflation hawk and the fiscal authority aims at pushing output beyond its structural level), a race between monetary and fiscal policy would lead to equilibrium levels of output and inflation far away from the preferred choices4.
3For a forceful criticism, see Buiter (1999). For a reply, see The FTPL has caused a heated controversy. Woodford (2001). 4precursor of these recent models is Blinder (1982) who shows that, if monetary and fiscal A authorities have different objectives, separation of monetary and fiscal policies will give rise to an unbalanced policy mix with excessively tight money and lax fiscal policy.
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