Download Introduction to Management and Organisational Behaviour

The Economics of
European Integration
© Baldwin & Wyplosz 2006
Chapter 18
Fiscal Policy and
the Stability
Pact
© Baldwin & Wyplosz 2006
The Fiscal Policy Instrument
• In a monetary union, the fiscal instrument
assumes greater importance:
– the only macroeconomic policy instrument left
at the national level
– its effectiveness is increased (a result from
the Mundell-Fleming model).
• A substitute to transfers.
• Yet, many questions arise regarding its
effectiveness and use.
© Baldwin & Wyplosz 2006
Limits on Effectiveness
• The crucial role of private expectations:
– a deficit today but a debt tomorrow: who will
pay?
– a tax cut, but how permanent?
• Slow implementation:
– agreement within government
– agreement within parliament
– spending carried out by bureaucracy
– taxes not retroactive.
• Result: countercyclical actions moves can have
countercyclical effects.
© Baldwin & Wyplosz 2006
A Crucial Distinction:
Automatic vs Discretionary
• Automatic stabilizers:
– tax receipts decline when the economy slows
down, and conversely
– welfare spending rise 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.
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Automatic Stabilizers
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A Crucial Distinction:
Automatic vs Discretionary
• Discretionary actions: a voluntary decision to
change tax rates or spending.
• Technically: a change in the structural budget
balance.
© Baldwin & Wyplosz 2006
The Structural Budget Balance:
A Formal Presentation
G = G(y) and T = T(y) with G’ < 0 and T’ > 0.
Actual budget balance: B(y) = G(y) – T(y) with B’ > 0.
Cyclically adjusted balance: B(yp) = T(yp) - G(yp).
So, roughly: B(y) = B(yp) + B’(yp)(y - yp).
Budget balance (B)
B2 p
B0 p
y
yp
Budget2
Budget0
Budget1
0
GDP (y)
B0
B1 p
B1
© Baldwin & Wyplosz 2006
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
© Baldwin & Wyplosz 2006
Example: the Netherlands
6
Output gap
Budget balance
Cyclically adjusted budget balance
4
The output gap and
the overall budget
tend to move together
2
0
-2
-4
-6
1991
1993
1995
1997
1999
2001
2003
2005
© Baldwin & Wyplosz 2006
Example: the Netherlands
6
Output gap
Budget balance
Cyclically adjusted budget balance
4
The steady improvement of
the cyclically adjusted is not
directly refected in the actual
budget outcomes
2
0
-2
-4
-6
1991
1993
1995
1997
1999
2001
2003
2005
© Baldwin & Wyplosz 2006
A Crucial Distinction:
Automatic vs Discretionary
• Discretionary actions: a voluntary decision
to change tax rates or spending.
• Technically: a change in the structural
budget balance.
• But no automatic correction of deficits, so
a problem of discipline.
© Baldwin & Wyplosz 2006
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 externalities via trade:
– important and strengthened by monetary
union.
© Baldwin & Wyplosz 2006
Income Spillovers 1972-2005
Output gaps
8
6
4
2
0
-2
-4
-6
1972
1975
1978
Switzerland
1981
1984
1987
Germany
1990
1993
France
1996
1999
2002
2005
Netherlands
© Baldwin & Wyplosz 2006
Should the Instrument be Subjected
to Some Form of Collective Control?
• Yes, if national fiscal policies are a source of
several externalities.
• Income externalities via trade:
– important and strengthened by monetary
union
– a case for some coordination.
• Borrowing cost externalities:
– one common interest rate
– but euro area integrated in world financial
markets.
© Baldwin & Wyplosz 2006
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
2002
2006
© Baldwin & Wyplosz 2006
The Most Serious Concern:
The Deficit Bias
The track record of EU countries is not good:
Public debts in 2005 (% of GDP)
Austria
64.6
Belgium
95.1
Cyprus
42.4
Czech Rep.
76.9
Denmark
43.3
Estonia
5.3
Finland
46.5
France
68.7
Germany
67.7
Greece
111.4
Hungary
57.6
Ireland
26.9
Greece
111.4
Hungary
57.6
Ireland
26.9
Italy
104.7
Latvia
16.1
Lithuania
23.2
Luxembourg
5.2
Malta
75.9
Netherlands
58.9
Poland
50.8
Portugal
61.7
Slovakia
46.1
Slovenia
28.2
Spain
47.6
Sweden
50.3
UK
42.7
Eurozone
72.2
© Baldwin & Wyplosz 2006
© Baldwin & Wyplosz 2006
© Baldwin & Wyplosz 2006
What is the Problem with the
Deficit Bias?
• Fiscal indiscipline in parts of the euro area might
concern financial markets and:
– raise borrowing costs: unlikely, markets can
distinguish among countries.
• More 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.
© Baldwin & Wyplosz 2006
The Answer to Default Risk:
The No Bailout Clause
• The no-bailout clause:
Overdraft facilities or any other type of credit
facility with the ECB or with the central banks
of the Member States (hereinafter referred to
as ‘national central banks’) in favour of
Community institutions or bodies, central
governments, regional, local or other public
authorities, other bodies governed by public
law, or public undertakings of Member States
shall be prohibited, as shall the purchase
directly from them by the ECB or national
central banks of debt instruments. (Art. 101)
© Baldwin & Wyplosz 2006
The Answer to Default Risk:
The No Bailout Clause
• The no-bailout clause.
• Still, fears remain:
– informal pressure
– impact on euro.
• Prevention is better, especially given a
tradition of indiscipline.
© Baldwin & Wyplosz 2006
In the End, Should Fiscal Policy
Independence be Limited?
• The arguments for:
– serious externalities
– a bad track record, anyway.
• The arguments against:
– the only remaining macroeconomic instrument
– national governments know better the home
scene.
© Baldwin & Wyplosz 2006
The Stability and Growth Pact
• Formally, the implementation of the
Execessive Deficit Procedure (EDP)
mandated by the Maastricht Treaty.
• The EDP aims at preventing a relapse into
fiscal indiscipline following entry in euro area.
• The EDP makes permanent the 3 per cent
deficit and 60 per cent debt ceilings and
foresees fines.
• The Pact codifies and formalizes the EDP.
© Baldwin & Wyplosz 2006
The Pact’s short but tumultuous
life
• Original Pact: 1999 – November 2003
• Limbo: November 2003 – March 2005
• Adapted Pact: March 2005 - ?
© Baldwin & Wyplosz 2006
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
– Aims at encouraging prompt action when deficit is
above limit
– Sanctions applied if limit repeatedly breached
© Baldwin & Wyplosz 2006
How the Pact Works
• Recognition that the budget balance worsens
with recessions:
– exceptional circumstances when GDP falls by
2 per cent or more: automatic suspension of
the EDP
– when GDP falls by more than 0.75 per cent,
country may apply for suspension
– leniency when slow growth continues over
several years
• Precise procedure that goes from warnings to
fine.
© Baldwin & Wyplosz 2006
The Procedure
• When the 3% is not respected:
– the Commission submits a report to ECOFIN
– ECOFIN decides whether the deficit is
excessive
– if so, ECOFIN issues recommendations with an
associated deadline
– the country must then take corrective action
– failure to do so and return the deficit below 3
per cent triggers a recommendation by the
Commission
– ECOFIN decides whether to impose a fine
– the whole procedure takes about two years.
© Baldwin & Wyplosz 2006
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 2006
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.
© Baldwin & Wyplosz 2006
The Broad Economic Policy
Guidelines
• Emphasis on precautionary measures to avoid
warnings and fines.
• The stability programmes are embedded in the
wider BEPG, a peer-monitoring process that
includes the Lisbon strategy.
• Each year, each country presents its planned
budget for the next three years, along with its
growth assumptions.
• The Commission evaluates whether the
submission is compatible with the Pact.
© Baldwin & Wyplosz 2006
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.
© Baldwin & Wyplosz 2006
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 2006
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 2006
Issues Raised by the Pact
• What room left for fiscal policy?:
– if budget in balance or surplus in normal years, plenty
of room left for automatic stabilisers
– some limited room left for discretion action.
• 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.
© Baldwin & Wyplosz 2006
The Early Years (Before Slowdown)
Austria
Belgium
Finland
France
Germany
Greece
Ireland
Italy
Luxembourg
Netherlands
Portugal
2001
1998
Spain
-6
-4
-2
0
2
4
6
8
© Baldwin & Wyplosz 2006
The November 2003
decision
France
Germany
2
2
1
1
0
0
-1
-1
-2
-2
-3
-3
-4
-4
1999 2000 2001 2002 2003 2004 2005 2006
1999 2000 2001 2002 2003 2004 2005 2006
© Baldwin & Wyplosz 2006
The November 2003
decision
• ECOFIN decides to suspend the Pact
• The European Court of Justice:
– recognizes the right of ECOFIN to interpret
the pact
– considers that the suspension decision is
illegal
• The governments commit to re-examine
the pact
© Baldwin & Wyplosz 2006
Why did the pact go wrong?
• Economic flaws
– Annual deficits are endogenous
– Annual deficits tell little about fiscal discipline
– Evolution of debt is more important
• Political flaws
– Fiscal policy remain national sovereignty
– Large vs. small countries
© Baldwin & Wyplosz 2006
The March 2005 decision
• Principles of the pact of upheld
– 3 % deficit limit
– fines, to be decided by ECOFIN
• Flexibility introduced
– Will take into account debt level
– Will take into account growth over recent years
• Pact strengthened
– Add preventive arm (when growth is high) to
corrective arm (when growth is slow)
• Pact undermined
– Allows excess deficit when spending is "good” (long
list)
© Baldwin & Wyplosz 2006
And now?
• ECOFIN free to apply or not the pact
– Will large countries always escape?
• Serious reform has been put off
• If pact is dead, how bad is it?
© Baldwin & Wyplosz 2006
And now? The2005 figures
Finland
Denmark
Sw eden
Estonia
Ireland
Spain
Belgium
Luxembourg
Slovenia
Latvia
Austria
Lithuania
Netherlands
Portugal
Italy
France
UK
Greece
Germany
Slovak Rep.
Cyprus
Malta
Czech Rep.
Poland
Hungary
-5
-3
-1
0
1
© Baldwin & Wyplosz 2006
And now? The 2005 figures
Finland
Denmark
Sw eden
Estonia
Ireland
Spain
Belgium
Watch Germany
in the coming
year!
Luxembourg
Slovenia
Latvia
Austria
Lithuania
Netherlands
Portugal
Italy
France
UK
Greece
Germany
Slovak Rep.
Cyprus
Malta
Czech Rep.
Poland
Hungary
-5
-3
-1
0
1
© Baldwin & Wyplosz 2006
© Baldwin & Wyplosz 2006