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Chapter 18 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Chapter 18 Fiscal Policy and the Stability Pact 2 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition 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. 3 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition 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. 4 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition GDP and budget balance © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Automatic Stabilisers 6 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition 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 7 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Structural balance © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Example: the Netherlands 6 Output gap Budget balance Cyclically adjusted budget balance 4 2 0 -2 -4 -6 1991 1993 1995 1997 1999 2001 2003 2005 9 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Example: the Netherlands 6 The output gap and the overall budget tend to move together Output gap Budget balance Cyclically adjusted budget balance 4 2 0 -2 -4 -6 1991 1993 1995 1997 1999 2001 2003 2005 10 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Example: the Netherlands 6 Output gap Budget balance Cyclically adjusted budget balance 4 The steady improvement of the cyclically adjusted balance is not directly reflected in the actual budget outcomes 2 0 -2 -4 -6 1991 1993 1995 1997 1999 2001 2003 2005 11 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition 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. 12 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Similar output gaps and business cycles Output gaps 8 6 4 2 0 -2 -4 -6 1972 1975 1978 Switzerland 1981 1984 1987 Germany 1990 1993 1996 1999 France 2002 2005 Netherlands 13 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Fiscal Policy externalities (cont.) • Borrowing cost externalities: – one country’s deficit would induce higher interest rate for everyone • Long-term growth effects • Growth data: http://epp.eurostat.ec.europa.eu/tgm/table.do?tab=table&pl ugin=1&language=en&pcode=tsieb020 – but euro area integrated in world financial markets • Still, capital inflows can appreciate common currency and affect competitiveness 14 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The Most Serious Concern: The Deficit Bias • The track record of EU countries is not good. EU public debt (% of GDP) 80 70 60 50 40 30 20 1970 1974 1978 1982 1986 1990 1994 1998 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition 2002 2006 The Most Serious Concern: The Deficit Bias © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition European public debt 2010 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition 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 (article 103), stipulates explicitly that neither the Community nor any Member State is liable for or can assume the commitments of any other Member State. – German finance minister, Peer Steinbrück, let the cat out of the bag last February when he said: "The euro-region treaties do not foresee any help for insolvent states, but in reality the others would have to rescue those running into difficulty." 18 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition 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 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The Stability and Growth Pact (SGP) http://ec.europa.eu/economy_finance/economic_governance/sgp/index_en.htm • 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). New reformulations are on the agenda 20 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition The Stability and Growth Pact (SGP) http://ec.europa.eu/economy_finance/economic_governance/sgp/index_en.htm The SGP: meant to avoid excessive deficits upon entry into euro area. 21 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition 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 22 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Excessive deficit procedure http://ec.europa.eu/economy_finance/economic_governance/sgp/deficit/index_en.htm 23 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition 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. © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition 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. 25 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition 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. 26 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition 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. © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition 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. © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition 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. 29 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition Recent budget balances 30 © Baldwin&Wyplosz 2009 The Economics of European Integration, 3rd Edition