EUROPEAN ECONOMICS:

FISCAL POLICY
CENTRALIZED FISCAL POLICY VS
DECENTRALIZED FISCAL POLICY
 If faced with an Asymmetric shock (as previously considered), then there are different effects depending
on whether Fiscal Policy is centralized in the union, or if it is decentralized.
 Centralized:
 Assume it is Germany that receives the positive effects and France that is hard done by.
 What happens is that in France, European spending increases due to higher unemployment and tax revenues
fall correspondingly.
 In Germany, however, European spending falls due to lower unemployment and tax revenues rise.
 Hence, there is simply a redistribution from Germany to France.
 In a Centralized system, countries are therefore insured against asymmetric shocks
 Decentralized:
 France still receives less tax revenue + spending has to increase and vice versa for Germany.
 However, in a perfect capital market, France raises the extra revenue to pay for the extra spending by
borrowing from Germany’s new found surplus.
 However, future generations of French people will have to pay back this debt to Germany, thus restricting
future fiscal policy.
 Hence, a decentralized system is only short – term insurance.
 It should be noted that the redistributive Fiscal Policies are only meant to be used for SHORT – TERM
shocks.
 The problem is that, although a centralized fiscal policy would be most desirable, it is not politically
tractable – the ‘Mezzagornio’ problem.
 Thus, fiscal policy should be allowed to be flexible in order to cope with asymmetric shocks; it should be
permissible to rack up a debt to pay for recovery.
 Or should it?
THE GOVERNMENT BUDGET
 For a more full discussion see Macro Fiscal Policy slides.
 Government Budget identity:
 G – T + rB = dB/dt + dM/dt
 If we express the budget identity as a ratio of GDP:
 db/dt = (g – t) + b.(r – x) – dm/dt
 This shows that, in balance (db/dt = 0), either the growth rate of GDP (x) > the nominal interest rate (r) –
which allows a primary budget deficit (g > t); or, if r > x (as was the case in the early 90’s in Europe), the
Government has to run a primary budget surplus (g < t).
 Important to note that (r – x) is variable over time.
 Also important to note that stabilising the debt/GDP ratio may not be a sufficient measure for stability –
the level at which it is stabilised may be too high.
 It is theoretically possible to use money creation (dm/dt) to service the debt, however it is forbidden to
do so under the Maastricht treaty – this is because all known hyperinflations were caused by
monetising the debt.
 If a country is simply unable to repay its debt however, it may have to either default or be bailed out.
 In a Currency union, defaulting would appreciate the currency for all and is unacceptable, therefore they
would need to be bailed out.
 Bailing out = Monetising the debt.
 Therefore, measures are needed to prevent a country from ever getting to the stage where it needs bailing
out  Fiscal Straight Jacket.
 In addition, Fiscal Policy isn’t a sustainable tool  when one has used it and run a deficit, one must then
spend the next couple of years running surpluses to ensure a stable debt level.
REASONS FOR FISCAL RULES
 As noted, two main schools of thought for why fiscal rules are
desirable:
 I – A ‘contagion’ spillover effect could occur if a single country
became caught in a debt crisis.
 Firstly, the country affected will raise union – wide interest rates
(because of the possibility of bail-out, the capital market can’t isolate
the interest rate rise to the single country) because of increased
borrowing.
 This rise in the union interest rate makes it harder for other countries
to service their debt AND puts pressure on the ECB to relax it’s
monetary policy to help out these countries because of their new found
higher interest rate.
 The union can’t let the country default as it could lead to a debt crisis
union-wide, and thus decides to ‘bail out’ the country.
 However, if the union could credibly commit to not bailing out a
country, this problem would not arise.
 II – Fiscal Policy is not as flexible as OCA theory would lead one to
believe, and not a sustainable tool.
MAASTRICHT TREATY + SGP
 The Maastricht Treaty:
 Set a limit of debt – GDP ratio of less than or equal to 60%.
 Set a limit of primary deficit as a ratio of GDP (g – t) as less than or
equal to 3%.
 These conditions were necessary for accession to the EMU, however
there also other conditions (no recent realignment – easy due to wide
bands – and criteria about inflation and interest rates).
 The Stability and Growth Pact:
 Carries off from the Maastricht treaty  people were worried that
countries would only just squeeze in under the criteria of the Maastricht
treaty, and a more binding agreement was desirable.
 Switches the focus to DEFICIT/GDP, rather than the debt/GDP.
 Sets a long term goal of Budgetary Balance (b = 0%)
 Keeps the same primary deficit/GDP ratio target as Maastricht, but
introduces punitive measures (fines) in case the target is breached
(allowing for exceptional circumstances).
PROBLEMS WITH RULES
 Problem with rules in general:
 I - lack of Enforceability (many countries employed creative accounting under Maastricht).
 II – Empirical evidence suggests that just being in a Monetary Union imposes fiscal discipline
due to the inability to monetize their own debts; this weakens the cause for further rules to be
imposed.
 III – Outside of the exogenous shock of the financial crisis/Greek clusterfuck, there was no real
evidence of any country being perceived by the markets to be in need of bail out/risky.
 Problems with the SGP/Maastricht Treaty in particular:
 I – Lead to pro-cyclical policies: the deficit/GDP ratio is given by [(G – T) /Y].
 In a recession, G rises, T falls and Y falls. The former 2 are the AUTOMATIC STABILISERS.
 However, under the fiscal rules, one would have to decrease G and raise T, which will cause further falls in Y.
 These pro-cyclical policies lead to ‘Euro – Sclerosis’ in the 90’s.
 It is possible to use a ‘Cyclically adjusted budget deficit’ – using the equilibrium output – however,
disagreements over what the ‘equilibrium output’ is.
 II – Went after the wrong measurement (SGP)
 Should focus on the DEBT/GDP ratio (long term goal), not the DEFICIT/GDP ratio.
 III – Not CREDIBLE:
 ECOFIN was meant to use ‘Excessive Deficit Procedures’ (fines) in the event of a breach – however, this was
more like a nuclear bomb; it was never meant to be used.
 When Germany + France fell under the EDP in 2003, ECOFIN voted against fines – let them off the hook.
 SGP made TOO MANY CRIMINALS.
 In addition, countries were not accountable to anyone – they are sovereign states, therefore they had to
voluntarily pay the money; they couldn’t be forced to.
 The SGP was a stupid answer to a sensible question, which still has no answer.