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CLASS ANNOUNCEMENTS
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No class on Friday, April 23
Fiscal Policy and the Stability and
Growth Pact
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Monetary union – loss of monetary policy BUT
fiscal policy still remains
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National fiscal policies affect other countries
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A country has 2 macroeconomic instruments:
1.
2.
Monetary policy – lost in a monetary union
Fiscal policy – retained even in a monetary union
Fiscal Policy and the Stability and
Growth Pact (cont.)
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In the Euro area fiscal policy therefore becomes
very important!
In case of asymmetric shocks fiscal policy is the
only available macroeconomic instrument
But fiscal policy is more difficult to activate and
less reliable than monetary policy
Fiscal Policy and the Stability and
Growth Pact (cont.)
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Fiscal policy – changes in spending and/or taxes
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Fiscal policy is also very slow to implement
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Ex. In monetary policy – central bank can change
interest rates very quickly;
Fiscal Policy and the Stability and
Growth Pact (cont.)
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In fiscal policy – establishing the budget is a very
long process
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Government must agree on budget
Ministers will negotiate
Parliament must approve budget
Spending must be enacted by bureaucracy
Taxes take time to increase
Sometimes during this process the situation fiscal
policy is trying to solve dissapears
Fiscal Policy and the Stability and
Growth Pact (cont.)
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Another way of looking at fiscal policy:
government borrows and pays back on behalf of its
citizens
During a slowdown – government budget deficit
financed by public borrowing
During an upswing – government budget surplus –
government pays back its debt
Fiscal Policy and the Stability and
Growth Pact (cont.)
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Individual firms and citizens could lead to the
same effect, in principle, by borrowing in bad
years and paying back in good years
The government simply acts as a bank vis-a-vis its
citizens
This makes sense because when the economy
slows down lending becomes generally riskier and
banks become cautious
Fiscal Policy and the Stability and
Growth Pact (cont.)
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Many citizens and firms cannot borrow in bad
times
When governments are considered a good risk (as
is the case in Europe) they can borrow at a
relatively low cost
Fiscal Policy and the Stability and
Growth Pact (cont.)
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Europe also fares poorly in inter-country transfer
(remember OCA theory!)
This is the equivalent of a transfer
When a country faces a negative asymmetric
shock its government can borrow from countries
that are not affected by the shock
Fiscal Policy and the Stability and
Growth Pact (cont.)
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Instead of receiving a loan or grant from other
EMU governments the affected country can
borrow on international private markets
This way fiscal policy makes up for the absence of
a “federal” transfer in a monetary union
Fiscal Policy and the Stability and
Growth Pact (cont.)
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Basically – if government borrows to reduce taxes
now it will raise taxes later to pay back its debt
In an asymmetric shock the country facing the
negative demand shift can borrow from countries
not affected by the shock – equivalent of a transfer
Fiscal Policy Externalities
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Spillovers and Co-ordination

Fiscal policy actions in one country may spillover to
other countries through different channels
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İncome and spending
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Inflation
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Borrowing costs
Fiscal Policy Externalities (cont.)
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Such spillovers are called externalities
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They can help or hurt other countries
Countries need to consider other countries when
implementing fiscal policy and the effect other countries
policies will have
Countries should coordinate their policies
Will the EMU countries want to give up more of their
sovereignty to coordinate fiscal policy after loss of
monetary policy?
Fiscal Policy Externalities (cont.)
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Formally, fiscal policy remains a national
prerogative
However, deepening economic integration among
EMU countries may call for some coordination
Fiscal policy coordination that requires binding
agreements would limit each country’s sovereignty
at a time when fiscal policy becomes an important
tool
The question to ask:

Does sharing the same currency increase spillovers to
the point where some new limits on sovereignty are
warranted and justified?
Fiscal Policy Externalities (cont.)
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Cyclical Income Spillovers:
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Business cycles – transmitted through exports and
imports
Ex. Germany enters an expansion phase
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Germany gets more imports
Partner countries have more exports and more incomes
(GRAPH)
Spillover is stronger the more countries trade with
one another and the larger the coutnry taking
action
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This is why Germany is so important
Fiscal Policy Externalities (cont.)
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What does this mean for fiscal policy?
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Ex. 2 monetary union member countries undergoing
synchronized cycles suffering from a recession
Each country will want to adopt an expansionary fiscal
policy but ignoring the other country’s actions may
mean the combined action may be too strong
If each government relies on the other to do the work –
too little may be done
If the cycles are asynchronized – expansionary fiscal
policy in one country may boost spending in the
booming country; a contradictory fiscal policy move in
the booming country may deepen the recession of the
other country
Fiscal Policy Externalities (cont.)
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Borrowing Cost Spillovers:
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Fiscal expansion – increases public borrowing OR
reduces public saving
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The Government is the country’s biggest borrower –
large budget deficits – push interest rates up
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However, EMU countries share the same interest rate
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One country’s deficits (especially if the country is large and
the deficits sizeable) may impose higher interest rates
throughout the Euro area
High interest rates – deter investment and affect long
term growth
Eurozone Government Bond
Spread
Excessive Deficits and the NoBailout Clause
Excessive Deficits and the NoBailout Clause (cont.)
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Debt build-up – partly related to the oil shocks of
1970s and 1980s
What happens when a public debt becomes
unsustainable?
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Financially hard-pressed governments may ask the
central bank to finance their deficits – this would lead
to inflation
If the Eurosystem did this – inflation in Euroland
would increase
The Maastricht Treaty forbids the Eurosystem
(ECB and NCBs) from providing direct support to
governments
Excessive Deficits and the NoBailout Clause (cont.)
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Spillover 1:
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If 1 country had heavy borrowing – could trouble
international financial markets
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If markets believe debt is unsustainable
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The whole Euro area comes under suspicion
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Capital outflow from Euro area would occur
Excessive Deficits and the NoBailout Clause (cont.)
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Spillover 2:
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If a government cannot pay its debt – this would lead
to a default which would mean:
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Massive capital outflow
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Collapse of the exchange rate and the stock markets
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Deep recession
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Rising unemployment
In a monetary union this may affect all member
countries
Excessive Deficits and the NoBailout Clause (cont.)
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The Maastricht Treaty has a no-bailout clause
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In spite of the no-bailout clause in case of an emergency
some arrangement could be found to bail out a bankrupt
government
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No official credit can be extended to a distressed member
government
Ex. The ECB could “informally” relax its monetary policy to
make general credit more abundant at a lower cost
It should be remembered that defaults do not occur out of
the blue – it takes years to accumulate large debts

Preventative measures could be taken during this time
Collective Discipline
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Why do governments accumulate such high
deficits?
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To win elections (paying money back takes a long time
– usually the spenders are out of office by then)
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Public spending favors narrow interest groups (civil
servants, military, public road contractors, etc.) while
debt service is diffused and borne by the majority
(Theory of Collective Action)
Collective Discipline could be used as a substitute
to refuse spending for these purposes
Public Debts in Europe in 2009
(%GDP)
Austria
63,3
France
75,9
Belgium 90,1
Germany
69,5
Bulgaria 13
Greece
102,1
Cyprus
Hungary
76,7
Czech
28
Rep.
Denmark 21,6
Ireland
32,9
Italy
118,9
Estonia
4,2
Latvia
12,8
Finland
32,8
Lithuania
19
52,6
Luxembourg
Malta
Netherlands
Poland
Portugal
Romania
Slovakia
Slovenia
Spain
Sweden
UK
EU27
Eurozone
8,6
68,7
44,1
49,7
74
17,4
31,6
25,7
39,3
37,2
60,2
66,9
73,3
Fiscal Policy
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Existence of spillovers – 1 argument for sharing
policy
Broader question: At which level of government
(regional, national, supranational) should
policies be conducted?
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Theory of fiscal federalism
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Principle of subsidiarity
Theory of Fiscal Federalism
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Theory asks how in one country fiscal
responsibilities should be assigned between the
various levels (national, regional, municipal)
Asks the question of which responsibilities should
stay in national hands and which responsibilities
should be transferred to Brussels
Theory of Fiscal Federalism (cont.)
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1.
2.
2 arguments for sharing responsibility:
Spillovers lead to inefficient outcomes when each
country is free to act as it wishes
Some policies are more efficient when carried out
on a large scale
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Ex. Use of money, defence
Theory of Fiscal Federalism (cont.)
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One solution is coordination which preserves
sovereignty but needs repeated negotiations
Another solution is giving up sovereignty to a
supranational institution
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In Europe the European Commission (internal market
and trade negotiations) and the ECB (monetary policy)
have already taken on some important tasks
Excessive Deficits and the NoBailout Clause (cont.)
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1.
2 arguments for keeping sovereignty:
Preferences are heterogenous and a supranational
institution will create dissatisfaction
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2.
Ex: common law concerning family life –
preferences in these types of areas differ across
countries
Information asymmetries – policies need to be
understood at the local level
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Ex: decisions regarding where to build roads, etc. –
requires knowledge of that particular geographic area
– information asymmetries may occur (more
knowledge regarding such issues is available more so
at the local level than the global level)
The Principle of Subsidiarity
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Principle embraced in the Maastricht Treaty
Basically means that decisions should be made as
close to the people as possible and that the EU
should not take action unless doing so is more
effective than action taken at national, regional or
local level
The broad definition of subsidiarity is that
decisions should be taken at the lowest level
possible
The Principle of Subsidiarity (cont.)
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European Commission’s definition:
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“The subsidiarity principle is intended to ensure that
decisions are taken as closely as possible to the citizen
and that constant checks are made as to whether action
at the Community level is justified in the light of the
possibilities available at national, regional or local
level.”

The problem is that the dividing lines between the EU
and the national level are unclear and ever changing.
This makes the subsidiarity principle an ambigious
principle.
Micro vs Macroeconomic Aspects
of Fiscal Policy
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It is very important to separate two aspects of
fiscal policy:
1.
Structural aspect (or microeconomic aspect)
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Concerns the size of the budget, what public money
is spent on, how taxes are raised, etc.
2.
Macroeconomic aspect
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The income stabilization role of fiscal policy
We are focusing on the macroeconomic aspect of
fiscal policy
Implications for Fiscal Policy
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The Case for Collective Restraint:
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Spillovers such as income flows, borrowing costs, and
the risk of debt default can have serious effects across
the Euro area
Some countries may lack the political institutions
necessary for fiscal discipline necessitating the use of
an external agent such as Brussels for restraint
The limits of collective restraint can range from
coordination and peer pressure to mandatory limits
on deficits and debts
Implications for Fiscal Policy
(cont.)
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The Case Against Collective Restraint:
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Important heterogeneities and information asymmetries
exist between nations
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This can lead to asymmetric shocks
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A common fiscal policy in addition to a common
monetary policy would leave nations without any
counter-cyclical macroeconomic tool
Implications for Fiscal Policy
(cont.)
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It is far from clear that the macroeconomic
component of fiscal policy should be subject to
external limits
A common fiscal policy is ruled out but some
degree of coordination may be considered
This is an ongoing debate in the EU
Implications for Fiscal Policy
(cont.)
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The subsidiarity principle implies that as long as
the case is not strong fiscal policy should remain a
national issue
On the other hand the spillover that could result
from excessive deficits is important – this forms
the basis for the Stability and Growth Pact
Stability and Growth Pact
The Stability and Growth Pact
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Admission to the monetary union:
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Budget deficit of less than 3% of GDP
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Public debt of less than 60% of GDP
There was some worry that after a country joined
the EMU that a breach of either of these criteria
could happen
The Stability and Growth Pact
(cont.)
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Maastricht Treaty’s Article 104:
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“Member states shall avoid excessive government
deficits”
The practical details of the procedure are fulfilled
by the Stability and Growth Pact
The initiative was taken by Germany in 1995
The Stability and Growth Pact
(cont.)
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Germany was worried that fiscal indiscipline could
lead to inflation and insisted on a clear and
automatic procedure
Germany made full use of the Maastricht Treaty to
achieve its aims
The other countries were less enthusiastic but
agreed because of Germany’s importance for EMU
The Stability and Growth Pact
(cont.)
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The SGP consists of 4 elements:
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A definition of what constitutes an ‘excessive deficit’
A preventive arm, designed to encourage governments
to avoid excessive deficits
A corrective arm, which prescribes how governments
should react to a breach of the deficit limit
Sanctions
The SGP applies to all EU member countries but only
the Eurozone countries are subject to the corrective
arm
The Stability and Growth Pact
(cont.)
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The Pact:
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Deficits are excessive when they are above 3% of GDP
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Recognizes that serious recessions beyond government
control can lead to deepening deficits
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Trying to close down deficits during a recession may lead to
contradictory policies which may deepen recession
Exceptional circumstances when the provisions are
automatically suspended:
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If the country’s GDP declines by at least 2% in the year in
question
When output declines by less than 0.75%
The Stability and Growth Pact
(cont.)
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When a country is found exceeding the limit –
commission issues a report and decides whether
the country is in excessive deficit
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Commission issues a report and decides whether the
country is in excessive deficit
If it finds against the country – recommendations and
deadline (may or may not be made public)
A country may run deficits in excess of 3% GDP
for 2 successive years without incurring sanctions
The Stability and Growth Pact
(cont.)
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Due to the EU experiences of 2001-2003:
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Shallower but longer-lasting slowdowns can gradually
deepend the deficit
With its revised version the SGP introduces two
elements of flexibility:
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It admits taht a negative growth rate or an accumulated loss
of output during a protracted period of very low growth may
be considered as exceptional
It suggests taking into account of ‘all other relevant factors’
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In contrast with the 3% limits and the -2 and -0,75% definitional of
exceptional circumstances, these new elements are vaguealy
specified.
Sanctions
If a country fails to bring down the deficit below
3% by the deadline – it is sanctioned
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Size of deficit
(%GDP)
3%
4%
5%
6% +
Amount of fine (%
GDP)
0,2%
0,3%
0,4%
0,5%
Deposits are imposed each year until the deficit is
corrected
●If there is no correction within 2 years – deposits
become a fine – otherwise they are returned
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Several Aspects of the Pact
Does not remove fiscal policy sovereignty
1.
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2.
3.
4.
Governments are in full control – but they bear the
consequences of their actions
Intent is pre-emptive due to the time between the deficit
deemed excessive and the time a deposit is imposed and
another 2 years before the deposit becomes a fine
The declaration of the country in violation is meant to
elicit prompt corrective action
All decisions are in the hands of the Council ( a political
body that can exploit the “ifs” in the pact)
Stability Programmes
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Part of wider peer-monitoring arrangement – calls
for every country to submit its budgetary positions
for the following 3 years to the Council and the
Commission annually
Objective is not just deficits below 3% but a
budget balance or surplus – leaving room for
policy action in case of a modern slowdown
The Commission and the Council examine
national budget plans and draws conclusions
Stability Programmes (cont.)
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A warning could be issued and made public
Warnings however are peer pressure and only
violations of the Pact can carry fines
Even though the Broad Economic Policy
Guidelines, such as the Stability and Growth Pact,
concern all EMU members regardless of their
membership to the EMU, only monetary union
members can be sanctioned
Problems with the SGP
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Early experience with the SGP has revealed some
problems
Questions arise as to whether or not SGP leaves
enough room for counter-cyclical fiscal policies
Early experiences of the SGP
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Over the first 10 years of the monetary union, the
Excessive Deficit Procedure (EDP) has been
triggered 15 times:
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İncluding 7 cases concerning Eurozone members
which are subject to sanctions
Yet sanctions have never been imposed
Problems With SGP (cont.)
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Ireland:
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1st country to be formally “warned” under the SGP
rule
Odd case with an odd official statement:
“In 2000, due to a strongly growing economy the
surplus is estimated to hae been 4.5% for GDP, …the
period of 2001-2003 projects high surpluses of 4.2%
GDP on average and a further decline in debt ratio…
the public finances are sound…the Council considered
budgetary plans for 2001 inappropriately expansionary
and issued a recommendation to Ireland to end this
inconsistency” – Council Recommendation, 15 June
2001
The Irish economy was actually booming in 2000-2001
and the Irish government and citizens were not happy
with “Brussels” invading their national sovereignty
Problems With SGP (cont.)
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France and Germany:
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2002-2003 have not been good for most European
countries
The economy slowed down significantly
The EMU’s 2 biggest countries, France and Germany,
have faced deficits in excess of 3%
Since budgets did not improve enough during the
earlier years there was not enough room to use fiscal
policy as a counter-cyclical tool
Both countries were issued warnings in 2002 and
recommendations in 2003
They were not fined however
SGP Fines
Problems With SGP (cont.)
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The sanctions and recommendations of the Pact
are openly questioned:
Former President of the Commission, Romano
Prodi, referred to the pact as “stupid” and the
Economist adopted the nickname of the “Stupidity
Pact”
SGP Reforms
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Pact reformed in 2005 after widespread criticism
over weak treatment of France and Germany
More emphasis on:
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Nation-specific situations
Advice on addressing problems
More time permitted to address problems
Allowance for evolving situations (ex.
Recommendations may not be met because situation
further deteriorated)
In summary: move toward peer support and peer
pressure
Limits of the Pact
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SGP serves 2 main purposes:
1.
2.
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It counteracts the deficit bias
It greatly reduces the odds of a debt default within
the monetary union which could result in painful
spillover effects
The imposition of fiscal discipline from the
outside has the advantage of protecting
governments from interest groups however using
“Brussels” as a scapegoat too often can
undermine the general support for European
integration
Limits of the Pact (cont.)
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The imposition of fines could especially have the
effect of undermining support for European
integration
The 3% limit is artificial – if there are economic
difficulties it is difficult to justify this number
For example: why not 3.5%
As long as Europe remains less than an OCA
leaving member countries without the fiscal policy
instrument is not desirable
Possible Reforms
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Various proposals to compensate for these limits
have been proposed
One solution is to set limits for the cyclically
adjusted budget not the actual budget
This raises other problems – calculating the
adjusted budget is more art than science
It would also be difficult to impose sanctions on
the basis of adjusted numbers
Possible Reforms
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Another solution is to target the public debt over
the medium term – not the budget balance year
after year
Tis leaves governments free to use fiscal policy as
they see fit in the short term
The difficulty of this solution is that governments
can promise to be virtous in the future – but could
they really achieve this
Any asymmetric shocks that hit close to the
deadline could also cause difficulties
Accession Countries
Greek Debt Crisis