Download THE MAASTRICHT CRITERIA

FISCAL POLICY IN
THE MONETARY
UNION: THE
STABILITY AND
GROWTH PACT
Week 7
Ch.10
References
• De Grauwe, P. chapter 10
• Reading material:
1) De Grauwe, P. (2003), “The Stability and Growth Pact in
Need of Reform”
(written before the 2005-reform, which we’ll investigate next
time).
2) “Ties that bind” (2004), article from The Region
3) “Reform of the Stability and Growth Pact” - article from
“Monetary Policy and the Economy”
4) “The Reform of the SGP: an Assessment” – Speech by Josè
– Manuel Gonzalez-Paramo, member of the Executive Board
of ECB – Frankfurt – October 2005.
LECTURE PLAN
• In a monetary union (=one currency, one
monetary policy) should we maintain national
fiscal policy?
• Yes. “ What else do you wanna take out of our
hands?!?!” – the OCA criticism
• No. “Monetary union cannot work without
contraints on national fiscal policies”- the SGP
1) THE ROLE OF FISCAL POLICY IN A
MONETARY UNION
• What is (macro) economic policy?
• a) Monetary policy: movement of short-term
interest rate (i) in order to affect GDP (via
consumption and investment)
• b) Exchange-rate policy: movement of nominal
exchange rate (E) in order to affect balance of
payments- current account (export minus
imports) and GDP
• c) Fiscal policy : movement of government
spending (G) to affect directly GDP, and taxation
/ transfers to affect consumption and then GDP
(maybe! If….)
• In a monetary union:
• a) is managed by ECB
• b) disappears together with national currencies
• c) is the only macroeconomic policy tool left
in national hands.
• How it should be used?
Recall Optimal Currency Area (OCA)
theory
• OCA= a monetary union can take place only among
•
•
•
•
•
countries which form an optimal currency area.
• How do we define it?
If these countries are hit by an asymmetric shock, there
must be enough:
- wage flexibility
- labour mobility
so to allow the equilibrium to be restored.
Why? Because there’s no much of national macroeconomic
policy left to be fired at asymmetric shocks. So there’d
better be some real mechanism able to correct the
situation.
Germany
France
PF
PG
SG
SF
D’G
DF
D’F
DG
YF
YG
TWO CASES
• 1) Monetary union with budget centralization
(=common fiscal policy)
• 2) Monetary union without budget centralization
(=national fiscal policy)
• In case 1):
• - there is risk sharing: the centralized budget
(automatically) redistributes income from
Germany to France
• In case 2):
• - Germany accumulates fiscal surplus (reduces
deficit) and reduces debt
• - France increases deficit and debt
• - we have inter-generational transfer: hardship
today is paid for by future generations.
• If financial markets work efficiently, the risksharing can be accomplished also in case 2), so
with no need of common fiscal policy.
• A window on the future: COMMON FISCAL
POLICY and INTEGRATION OF FINANCIAL
MARKETS are going to be the two next (and final)
topics.
• Important: this insurance system (=transfer of
resources) can only be temporary, otherwise we’ll
have a permanent transfer of resources towards
the negatively-hit country, which can be hardly
sustainable from a political point of view in the
EU.
• If the shock is permanent, factors stressed by
OCA have to move (price and wage flexibility,
labour and capital mobility) in order to
permanently correct the situation.
• Example: Southern Italy
So……
• It would be best to have a centralized budget
(=common fiscal policy) to be able to deal with
asymmetric shock
• If this is not possible, then fiscal policy (the only
macroeconomic policy tool left) must be managed
at national level, and used in a flexible way (=no
limits), in order to fight adequately asymmetric
shocks.
• SO THIS VIEW ARGUES FOR NATIONAL AND
INDEPENDENT FISCAL POLICY IN A MONETARY
UNION.
• Is that really the case?!?!?!
FISCAL RULES TO MAKE EMU WORK
• What does it mean to have a single currency?
• Having a single (short-term) interest rate,
manouvred by a common central bank.
• As we have repeatedly seen, this interest rate
determines (directly or indirectly) the whole
structure (=term structure) of the many interest
rates in the economy. For the whole Union.
• For the whole Union.
• For the whole Union.
• For the whole Union.
• So national states, around the Union, cannot
implement policies that put upward / downward
pressure on the interest rate.
• Because now the interest rate is common.
• Guess what are the policies that usually put the
most (upward) pressure on the interest rate
structure?
• FISCAL POLICY
• Debt issuing increases interest rate:
• 1) Financial-market effect
• 2) Risk-premium effect
SOMEONE QUESTIONS THE
RELEVANCE OF BOTH CHANNELS
• 1) Financial Market-effect: in a 15 (and more)
member monetary union, the impact of a single
country’s fiscal indiscipline on EMU interest rate is
negligible (1% deficit increase, 0.1% national
interest rate increase)
• HOWEVER……
• a) Slovenia or Germany?!?! (differences in sizes)
• b) Dangerous talking…….what if everybody start
thinking this way?!
• 2) Risk-premium effect: “there is the no-bail-out
clause”!!!!
• HOWEVER….
• You can write all the no-bail-out clause you
want….when a country is in financial trouble,
central banks do step in to save it.
• Even when a simple commercial bank is in
trouble, central banks do the same…….any
example recently?!?!?!
• Northern Rock (nationalized by BoE), Bear Sterns
(saved by Fed the other day).
A row-boat with 15 people and some smart
ass
• A fiscal expansion has a benefit (increased
aggregate demand and output) and a cost
(increased interest rate).
• In a monetary union, countries can benefit from
fiscal expansion while spreading the costs on
everybody else.
• The upward pressure on the interest rate, in fact,
is beared by the whole Union.
• It’s like someone suddenly stops rowing and lays
back enjoying the sun. The boat still
goes…..other people have just to row more
intensively.
The “old” SGP (1997)
• 1) In the short-run, member States
should not exceed 3% limit for their
deficit / GDP ratios.
• 2) In the medium run, member
States should achieve balanced
budget positions
What if they don’t?
- Ecofin (on the basis of Commission’s proposal) issues an
early warning.
- If the country does not get back below 3%, Ecofin imposes
a fine equal to 0.2% of its GDP plus 0.1% for every
percentage point of violations, up until a maximum fine of
0.5% of GDP.
- After two years, if the country has met the 3% limit it gets
its money back; otherwise, it looses permanently the
deposit (which is equally spread to other member states).
- A budget deficit in excess of 3% can be tolerated if
considered as resulting from “exceptional circumstances” :
natural disaster, or a severe (more than minus 2% drop in
annual GDP growth) economic downturn.
- If the downturn is between minus 0.75% and minus 2% the
country can present arguments in order to justify the
excess deficit.
Stability and Growth Pact: short-run
prescriptions
• EMU is: having a common interest rate
• To make it sustainable, there can’t be pressure
on the interest rates coming from national and
independent fiscal policies.
• Opposite view to the earlier one (national
flexibility).
• So we need common rules for national fiscal
policies in the short-run.
• But what rules exactly?
• Rescue the fourth Maastricht criterion:
• Deficit / GDP ratio = 3%
SGP: medium-run prescriptions
• Member States should
have balanced budget (or
in surplus) over the
medium term.
• G+iB-T = 0
(no deficit)
• This means that, in time,
debt/GDP ratio will go to
zero.
t
gt
d 
bt
1  gt
• dt = total deficit / GDP
• gt= rate of growth of
nominal output
• bt =debt/GDP
•
•
•
•
•
•
•
•
Or, if you prefer:
ABSOLUTE LEVEL:
Since Bt = Bt-1 +Dt
If Dt = 0
B remains fixed at Bt-1 and stays there.
Now go back to the RELATIVE LEVEL:
B/Y
If the numerator stays fixed and the denominator
keeps growing, sooner or later the fraction will go
to zero.
• So the medium-run prescription of the SGP
seems to suggest that the long-term debt/GDP
ratio should be 0.
Is that desirable?
• No.
• Debt is a rational way to finance all those expenditure that
benefit current AND future generations.
• Debt issuing, in fact, is a way to make future generations
pay (through future interest payments, or debt service).
• There are a lot of public expenditure that fall into this
category (infrastracture, etc). Rigorously, they should be
financed mainly by debt emission, so to spread their
financing over next generations.
• So a zero level of debt is not optimal. It means:
• Either that we are not doing any investment
• Or that part of those that will benefit from it (future
generations) will have it for free.
So why the medium-run prescription?!
• Remember potential GDP? The structural level (or
the structural rate of growth) of output
(determined ultimately by total factor
productivity and population growth).
• Every year actual GDP fluctuates around potential
output.
• It can be above: the economy is operating above
its potential (=inflationary pressures).
• It can be below: the economy is not exploiting all
its potential.
• Don’t get confused with recession: two quarters
of negative growth.
One step back: how can fiscal policy affect
GDP?
• Fiscal policy affect aggregate demand (and hence
GDP) via:
1) Government spending (goods, services,
investment): it directly creates demand
2) Taxation: it affects private consumption by
increasing / decreasing consumers’ disposable
income
3) Transfers (social security, unemployment
benefits, and so on): same as taxation
DEFICIT = 1+3 -2
= G+Tr – T
How does fiscal policy reacts to GDP
movements?
1) When GDP is below potential (or even in recession):
a) Increase G
b) Decrease T
c) Increase Tr
= INCREASING THE DEFICIT
So that aggregate demand increases and GDP growth can go
back to potential.
2) When GDP is above potential
a) Decrease G
b) Increase T
c) Decrease Tr
= REDUCING THE DEFICIT
So that the economy cools down and avoid inflationary
pressures.
• Fiscal policy aimed at stabilizing the economy
moves the deficit in a counter-cyclical fashion:
• Stimulate aggregate demand (=increase the
deficit) when the economy is below potential
• Cool down aggregate demand (=reduce the
deficit) when the economy is above potential
• In this way, fluctuations of GDP (=volatility) is
minimized (=reduction of uncertainty, etc).
• ………but……
• To be able to implement counter-cyclical fiscal
policy the deficit must be zero when GDP is in
line with potential.
• So that it has a lot of “room to manouvre” (for
example, 3% of GDP!!!!) when the economy
needs a shot in the arm.
• But government has to save (=reduce the deficit)
when GDP is above potential.
• SAVE DURING GOOD TIMES, TO BE ABLE TO
SPEND (AND SPEND A LOT) WHEN YOU
REALLY NEED IT.
• That’s why SGP prescription: in the medium
run keep the deficit in balance (we assume
that in the medium run GDP is in line with
potential, simply because that’s the way it’s
computed).
Can governnment resist temptation?
• What temptation?
• To spend in bad times but also in good times.
• To be able to implement counter-cyclical fiscal
policy you need to save during good times
(=reducing the deficit when GDP is above
potential).
• If you fail to do that (possibly due to political
cycles) you simply watch your deficit grow, with
the risk of being forced to reduce it (=restrictive
fiscal policy) when the economy is below
potential or even in recession.
• This is exactly what happened with the Stability
and Growth Pact.
THE OLD SGP -1999-2003
(why “growth”?!)
• Short-run prescription (corrective arm): 3% deficit / GDP
• Medium-run prescription (preventive arm): “achieve a
budget position close to balance or in surplus over the
business cycle”.
• WHERE ARE WE IN HISTORY?
•
•
•
•
1997
Natalie Imbruglia was singing “Torn”
Princess Diana died.
Opening a newspaper of your choice, you couldn’t find two
consecutive articles with no reference to the “new
economy”.
• Growth was sustained (4,5, 6% in the US) and people were
predicting the “end of the business cycle”.
What exactly was this new economy?
• A wave of technological innovations started by
the true revolution of our times: Internet (do you
know where it came from?)
• A corresponding huge bubble (much later
recognized as a bubble): stock prices of hi-tech
companies reached values 20-30 times higher
than economic fundamentals.
• Under “normal” circumstances, stock prices
should reflect the expected benefits arising from
ownership of “a piece of the firm” (i.e.dividends).
• The “bubble” kept aggregate demand at a very
high level.
Here’s the question….
• Was the exceptional growth in the second half of
the 90s result of higher potential growth (=
effects of the “new economy” revolution on total
factor productivity) or a result of sustained
aggregate demand growth (=coming from the
new economy bubble?).
• In the first case: growth is structural
• In the second: growth is temporary and will go
back to the potential level sooner or later.
• We don’t know yet. But the second explanations
played a greater role than we though, and the
first one wasn’t as important as we hoped it’d be.
Some more elements
• Those stock market values (so much disentangled
from real fundamentals) couldn’t last forever.
• In March 2000 the Nasdaq collapsed.
• Aggregate demand stopped.
• 9/11 did the rest.
• Fed cut aggressively the interest rate (it reached
1% in 2003), in the desperate attempt to support
aggregate demand.
• It succeeded, but it laid the foundations for
future problems.
• a) House bubble.
• b) Derivatives and subprime.
Anyway, let’s not get carried away….
• The exceptional growth in the second half of the
90s wasn’t as structural as we thought.
• It’s a common error. Between 70s and 80s the
opposite mistake was made by economists and
policy-makers.
• In Europe, relying on a nominal growth of 5%
(=real growth of 3%) was the most evident
consequence of those years’optimism (end of
Cold War, democracy, emerging countries, and so
on).
• During those “good times”, EMU countries didn’t
bring their budget “close to balance or in surplus”
• When the business cycle turned bad, at the
beginning of the millennium, not surprisingly EMU
countries started to break the 3% ceiling of the
SGP.
Paramo speech (material n.2), pag.3
• “Since then, (after entering the euro in
1997),some euro-area countries have succedeed
in maintaining progress with fiscal consolidation.
But in a number of others, fiscal consolidation
has either stalled or even gone into reverse. At
first this lack of improvement or even
deterioration of fiscal positions was masked by a
friendly economic climate. Nominal fiscal
balances improved considerably between 1997
and 2000. But this improvement was largely
cyclical. And when growth subsequently slowerd,
fiscal balances in some countries quickly
deteriorated to reach levels close to, or above
3% of the GDP”.
CALENDAR OF VIOLATIONS
•
•
•
•
2001: Portugal (EDP started in 2002)
2002: Germany and France
2003: Greece and Netherland (2004 Italy).
In November 2003, Ecofin was supposed to start
the Excess Deficit Procedure against Germany
and France.
• Their hands trembled in that moment.
• The application of SGP was suspended.
• EU commission brought legal action to the
European Court of Justice, which in July 2004
basically said something like… “What can I say
my dear, you are right, but let’s face it…. national
government still run Europe integration process!”
• NEVER-ENDING CONFLICT OF THE EU NATURE:
FEDERAL STATE OR INTERNATIONAL
ORGANIZATION ?
No further step of European integration can ever be
taken if this question does not receive an
adequate answer.
So….
• Since we still need fiscal rules to have a wellfunctioning monetary union…..how do we change
the SGP?!?!
1) Change the numbers, making sure that this time
we get the growth right?!?!?!
• No, loss in credibility would be too high.
2) “Golden rule”: distinguish between government
expenditure in investment (which are good for
growth) and public consumption.
No. You would spend the next ten years
establishing what’s investment and what’s public
consumption.
And who said that all investments are good for
growth and all kinds of public consumption are
20th MARCH 2005: THE REFORM OF
THE SGP
• SHORT TERM PRESCRIPTIONS (or corrective
arm):
• 3% limit is maintained.
• - Tolerance is extended to include:
a) periods of negative growth
b) prolonged periods of growth below
potential
c) structural reforms that the government is
implementing.
Structural reforms have clear upfront fiscal costs
but potential long-term benefits that could justify
temporarily higher deficits.
• MEDIUM TERM PRESCRIPTIONS (or preventive arm):
• The ultimate goal (pushing member States to run countercyclical fiscal policies) is maintained.
• Countries should cut their cyclically-adjusted budget deficit
(net of one-off and temporary measures).
• Target and adjustment path of this cut have changed:
• a) the Medium- Term- Objective is specified within a
corridor ranging from 1% of deficit to a small surplus.
• b) the speed of adjustment must be on average 0.5% per
year, depending on the state of the national business cycle.
• a) and b) are no longer uniform but are countryspecific, and are defined according to:
• - state of the business cycle
• - level of the debt/GDP ratio
• - potential growth
• - population aging
• At the end of the day, there are only two
words we can use to summarize the reform
of the SGP:
• MORE FLEXIBILITY
• (within the same rationale and same
ultimate goals)
The unplesant downside of
flexibility….
• How long is the prolonged period of negative
growth or growth below potential ?
• Who decides in real time the correct estimation
of potential growth (one of the hardest thing to
measure in economics)?
• All accountants in Europe couldn’t agree on the
exact specification of the terms “one-off” and
“temporary measures”….
• ….but that’s nothing compared to the fights we
could have deciding what are structural reforms
or how to measure the impact of aging
population on public finances….
• Is the “federal state” strong enough to handle
potentially 27 different country-specific mediumterm objectives?
On the other hand….positive sides of
the 2005 reform
• - debt / GDP ratio (the source of all problems….)
plays a bigger role in determining the
sustainability of member States’ fiscal positions
• - the use of cyclically-adjusted deficit net of oneoff and temporary measures is able to identify
much more adequately the fiscal stance of a
country
• - it partially settles another “injustice”…..public
expenditure is not all the same.
• - it manages to inject more flexibility in the
system without loss in credibility
• But maybe it’s too early to establish that.
CONCLUSIONS
• MACROECONOMIC POLICY: monetary, exchange
rate and fiscal policy.
• In a monetary union, fiscal policy is the only one
left in national hands.
• While we wait that the political integration makes
possible a common fiscal policy (week 12),
should they be used in a flexible way (to contrast
asymmetric shocks) or rather subject to rules?
• Although some still argue for total flexibility (“is
US fiscal policy subject to any rules”?!), we
proved that a monetary union needs fiscal rules
in order to function.
Why?
• The need to finance a large stock of public debt pushes up
interest rate (via at least two channels)
• Fiscal expansions boost national aggregate demand, which
gives rise to national inflationary pressures
Both these aspects are not-compatible with a monetary union,
where monetary policy (=determination of short term
interest rate, who affects the whole term structure) is
managed by ECB and has the explicit task of fighting
inflation.
Allowing full flexibility of national fiscal policies, allow member
States to enjoy the benefits of them (=aggregate demand
expansion) without paying the costs (=higher interest
rate).
The Old SGP (1999-2003)
• 3% limit for deficit/GDP ratio with tolerance only
in case of severe economic downturn (-2% of
GDP)
• Balance budget (for everyone) over the medium
term.
• Why didn’t it work?
• 3% limit was designed under too generous
growth assumptions.
• Countries didn’t manage / didn’t want to
implement fiscal consolidation when the business
cycle was good (1997-2000), so they rapidly
went into troubles when the economic climate
changed.
The New SGP (2005 onwards)
• More flexibility on both short term and medium
term prescriptions.
• For the latter, objectives are no longer defined
uniformly but depending on country-specific
conditions.
• More tolerance.
• In 2008, all indisciplined countries came out of
the EDP (Italy in May 2008).
• But the enforceability (and the success) of the
new SGP remains a question.
And now..?
COUNTRY
DEFICIT 2009
Ireland
11%
France
6.2%
Spain
5.4%
Portugal
4.6%
Italy
3.8%
Germany
2.9%
Greece
3.7%
Belgium
3%
EURO AREA
4%