Discussion Papers in Economics. Graham Bird (Claremont McKenna College, Claremont Graduate University and University of Surrey)

Transcription

1 Discussion Papers in Economics WILL EUROPE S FISCAL COMPACT HELP AVOID FUTURE ECONOMIC CRISES? By Graham Bird (Claremont McKenna College, Claremont Graduate University and University of Surrey) & Alex Mandilaras (University of Surrey) DP 12/12 Department of Economics University of Surrey Guildford Surrey GU2 7XH, UK Telephone +44 (0) Facsimile +44 (0) Web ISSN:

2 WillEurope sfiscalcompacthelpavoidfutureeconomiccrises? GrahamBird*andAlexMandilaras** *ClaremontMcKennaCollege,ClaremontGraduateUniversityandUniversityofSurrey **UniversityofSurrey Abstract Theeurozonecrisishasfocusedattentiononwhatcausedit,howitcanbehandled and what can be done to avoid future crises. Against this background all but two member states of the European Union have signed a draft treaty, the fiscal compact, that seeks to eliminate structural fiscal deficits. This paper critically examinesthetheoreticallogicbehindthecompact.italsoempiricallyestimatesthe relationshipbetweenfiscaldeficitsandeconomiccrisesineurope.itconcludesthat economiccrises,measuredintermsofoutputshortfalls,havehadlittletodowith publicsectordeficits.privatesectordeficitsandcrisesinthebankingsectorappear tobemoreimportant.thepaperalsoidentifiesanumberofflawsinthedesignof thecompactandarguesthatitwilldorelativelylittletoensurethatfuturecrisesare avoided. The fact that in spite or these reservations the agreement was signed reflects the significance of a particular combination of contemporary political economyfactors.

3 1.Introduction Itisoftenassumedthatlargefiscaldeficitseventuallyleadtocrisesinonewayor another.thefirstgenerationcurrencycrisismodel,forexample,presentsfiscaldeficits asplayingthekeyroleincausingcrises.herefiscaldeficitsaremonetised.thisresultsin inflation,adeclineincompetitiveness,acurrentaccountdeficit,afallininternational reserves,evaporatingconfidenceandacollapseinthevalueofthecurrency.thegreek crisisinthelate2000shasalsobeenwidelyattributedtoloosefiscalpolicy;althoughin thiscaseitdidnotleadtoarapidgrowthinthemoneysupplybuttoanexcessivebuild upofdebt. Againstsuchabackground,itiseasytoseewhyitmightalsobeassumedthat constrainingoreliminatingfiscaldeficitswillsignificantlyreducetheincidenceofcrises. The fiscalcompact negotiatedbyeuropeanstatesin2012appearstoreflectthispoint ofview.butisitreasonabletomakethisassumption?doesitnecessarilyfollowthat Europe sfiscalcompactwillbeaneffectivewayofavoidingfuturecrises?anumberof elementsarecontainedinansweringthisquestion.thefirstrelatestothetheoretical connectionsbetweenfiscaldeficitsandeconomiccrises,andtothemacroeconomic effectsoffiscalpolicy.thesecondinvolvestheempiricalconnectionbetweenfiscal deficitsandcrises.hasthecrisisineuropebeenfiscallydrivenorhavetherebeenother forcesatwork?tomakesenseofeurope sfiscalcompact,itwouldneedtobe establishedthatbothfromatheoreticalandempiricalperspectivetherearesignificant linksbetweenfiscaldeficitsandtheincidenceofcrises. Thethirdelementrelatestothedetaileddesignofthecompact.Doesitprovidean appropriateavenueforfiscalcoordinationineurope,orisitpossiblethatthecompact couldmakemattersworse?thefinalelementiswhetherthecompactwillactuallybe implementedandwhetherthesignatorieswillcomplywiththecommitmentsthatthey havemade.inthisarticlewetrytoanswerthesequestions. 2

4 Thearticleisorganisedasfollows.Section2providesabriefinstitutionaldescriptionof Europe sfiscalcompact.section3investigatesthelinksbetweenfiscaldeficitsand crisesfromatheoreticalpointofview,andalsodiscussesthecontemporary(andless contemporary)theoreticaldebatesabouttheeffectsoffiscalpolicy.section4uses descriptivedatatoconsiderthecausesofthecrisisintheeurozone.section5goeson toexaminemoreformallytheconnectionsbetweenfiscaldeficitsineuropeandthe eurozonecrisis.section6assessesthefiscalcompactinthelightoftheanalysisinthe previoussectionsandconsiderswhetherthecompactcouldmakeeconomiccrisesmore likelyandmoresevereratherthanlesslikely.italsoexploresthepoliticaleconomyof thecompactandthelikelihoodthatcountrieswillhonourtheircommitments.inthe concludingsectionweexaminetheimplicationsofouranalysisforthedesignof macroeconomicpolicywithineuropedirectedtowardsreducingthelikelihoodoffuture crises. 2.Europe sfiscalcompact:theinstitutionalbackgroundanddetails Europe sfiscalcompactisformallyembodiedinthetreatyonstability,coordination andgovernanceintheeconomicandmonetaryunion(tscg).thiswassignedbyall membersoftheeuropeanunion,withtheexceptionoftheunitedkingdomandthe CzechRepublic,inMarch2012andisscheduledtobeactivatedinJanuary2013,subject toratificationbyatleasttwelveeurozonemembers.thetscghasthestatusofan intergovernmentalagreement,althoughtheintentionistoadoptitaseuropeanlaw withinfiveyearsofitsactivation.onlyeurozonemembersareboundbythecompact, althoughothereusignatorieswillbecomeboundbyitiftheyjointheeurozone. Thecompactreflectsthelateststageinanhistoricaltrendtowardsattemptingto imposetighterfiscalconstraintsineurope.itbuildsonthestabilityandgrowthpact (SGP)whichseekstolimitthesizeoffiscaldeficitsinmemberstatestonomorethan3 percentofgdpandtheamountofdebttonomorethan60percentofgdp.inmarch 3

5 2011theSGPwasreformedtomakemoreautomatictheproceduresforpenalising countriesthatfailedtocomplywiththerules(theso]calledexcessivedeficitprocedure oredp).thereformofthesgpwasreferredtoasthe sixpack becauseitinvolvedfive newregulationsandonedirective.followingthesixpackreform,somemembersofthe eurozone,ledbygermany,soughttostrengthenstillfurthereurope soversightand influenceoverfiscalpolicyinmemberstatesandtoextendenforcementbyinvolving theeuropeancommissionandtheeuropeancourtofjustice.germanyproposedthe ideaofa transferunion withinwhichaccessto bailout fundswouldbeconditionalon acceptingdirecteuropeancontrolofnationalbudgetarypolicy.germanyalsoarguedin favourofmemberstatesadoptingbalancedbudgetlawsinordertolimitthefuture accumulationofdebt(so]called debtbrakes ).Althoughtheseideasmetwithsome initialresistance,thefiscalcompactsharessomesimilarfeatures. Thecompactinvolvesthefollowingcomponents.First,generalgovernmentbudgetsare tobebalancedorinsurplus,withanannualstructuraldeficitnotexceeding0.5percent ofgdp(theruleislessstrictforcountrieswithgovernmentdebtsignificantlybelow60 percentofgdp).second,memberstatesarerequiredtointroducelegislationto enforcethisrule,withthelegislationincorporatinganautomaticmechanismfor correctingexcessivefiscaldeficits.thelegalprovisions(quotingfromthedrafttreaty) shouldhave bindingforceandpermanentcharacter,preferablyconstitutional. Third, memberstateswithpublicdebtinexcessof60percentofgdparerequiredtoreduceit byanaverageannualrateof5percentagepointsuntiltheycomplywiththe60percent upperlimit.fourth,stateswithexcessivefiscaldeficitsarerequiredtosubmittothe EuropeanCommissionandCouncilaprogrammethatexplainshowthedeficitswillbe corrected.theimplementationoftheprogrammewillthenbemonitored.fifth,states thatdonotadoptabalancedbudgetrulewillbefinedupto0.1percentofgdp.sixth, accesstofinancialassistancefromtheeuropeanstabilitymechanism(esm)willbe conditionaluponcompliancewiththerulesofthefiscalcompact. 4

6 3.Thefiscalcompactandeconomictheory Thefiscalcompactraisesarangeofcontroversialtheoreticalissues.Manyofthemare fundamentaltoenduringdebatesinmacroeconomics.keynesiansandneo]keynesians favourtheactiveuseoffiscalpolicyasatoolformanipulatingaggregatedomestic demandinordertodelivernon]inflationary full employment.thisimpliesinjecting aggregatedemandintotheeconomybyrunningafiscaldeficitwhenthereisaproblem ofloweconomicgrowthandhighunemployment,andrunningafiscalsurpluswhen thereisaproblemofinflationandanunsustainablecurrentaccountdeficit.according tothisview,thestructuralcomponentsofthefiscalbalanceshouldbeusedtoreinforce theautomaticcounter]cyclicalandstabilizingeffectsoffiscalpolicy,asdeficitsincrease duringarecessionwiththedeclineintaxrevenueandtheincreaseingovernment expenditureonwelfareprogrammesandunemploymentbenefit.incircumstances wherethereisaliquiditytrapthatpreventsinterestratesfrombeingreducedfurther, Keynesiansbelievethatitisunwisetolimitthediscretionaryuseoffiscalpolicy. Criticsofthisapproachincludemonetaristsandnewclassicalmacroeconomists.While expressingrelativelylittleoppositiontoautomaticfiscalstabilizers,theystronglyoppose themanipulationofstructuraldeficitsinanattempttomanageaggregatedomestic demand.theessenceoftheircaserests,formonetarists,onbeliefsthattherearelong andvariablelagsintheoperationoffiscalpolicythatmayresultinitbeingdestabilizing. Bydrivinguptherateofinteresttheyalsoclaimthatincreasedgovernmentexpenditure crowdsoutabroadlyequivalentamountofprivatesectorinvestment.fornewclassical macroeconomistsitrestsonthenotionofricardianequivalence.anincreaseinthesize ofthefiscaldeficitencourageshouseholdstodeferconsumptionandincreasesavingin anticipationofhigherlevelsoftaxationinthefuture.forbothgroupsoftheorists,the conclusionisthatfiscalpolicywillbeanineffectiveinstrumentforaffectingdomestic aggregatedemand. 5

7 Criticsalsobelievethatgovernmentswillbeunabletoresistthetemptationtoexploit theirabilitytousefiscalpolicyforshorttermpoliticalpurposesandthattheywilloptto expanddemandinordertogarnerpoliticalsupport,particularlyshortlybeforeelections, onlytooptfortighterfiscalpolicyoncetheyhavebeenelected. Morerecently,criticsoffiscalstimulationasawayofpullingoutofrecessionhavegone furtherandhaveclaimedthatfiscaldeficitsanddebthaveanadverseeffecton householdandmarketconfidenceandthereforeonaggregatedemand.theyarguethat, asaconsequenceofthis,fiscaldeficitsareactuallycontractionary.whiletraditionally therewouldhavebeenadebateaboutthesizeofthegovernmentexpenditure multiplier,thereisnowadebateaboutitssign,withcriticsoffiscalstimulationarguing thatfiscaldeficitshaveanegativeeffectoneconomicgrowthandthat fiscalausterity hasapositiveeffectbycreatinggreaterconfidence;theso]called expansionaryfiscal contractionshypothesis.muchoftherecentliteraturehasfocusedontheseissues(see, forexample,alesina,2010,elmendorfandfurman,2008,freedmanetal.2010,ilzetzki etal.2009,imf,2010,romerandromer,2010,tsibourisetal.2006,andvonhagen andstrauch,2001). Anothersimple,butnonethelessusefulmacroeconomicconceptinassessingtheimpact offiscaldeficitsisthefamiliaropeneconomyexpression: X M=(S I)+(T G) Thisexpressionliesattheheartofthe twindeficits approachthatlinksfiscaldeficits andcurrentaccountdeficits.theformulashowsthat,providedthereisnochangeinthe privatesectorbalancebetweensavings(s)andinvestment(i),thenitfollowsthatan increaseingovernmentexpenditure(g)relativetotaxrevenue(t),orafallintrelative togwillbeassociatedwithanincreaseinimports(m)relativetoexports(x)anda deteriorationinthecurrentaccountofthebalanceofpayments. 6

8 Withanenduringfiscaldeficit,thecurrentaccountdeficitwillultimatelybecome unsustainableandthenacrisisislikelytooccur.however,thecentralassumption relatestothestabilityof(s I).Iftheprivatesectorbalanceisunstable,changesinit caneitherendorseorneutralisetheeffectofthechangingfiscalbalanceonthecurrent account.thus,forexample,anincreaseinthefiscaldeficitwillnotleadtoaweaker currentaccountifprivatesectorsavingrelativetoinvestmentincreasesbyatleastas muchastheincreaseinthefiscaldeficit.forthisreason,fiscalandcurrentaccount deficitsmaynotinpracticebetwinned. Theopeneconomyexpressionshowshowcurrentaccountdeficitsmayarisefrom excessesineithertheprivatesectororthepublicsector,andthatcorrectingfiscal deficitswillnotnecessarilyleadtoareductionincurrentaccountdeficits.largecurrent accountdeficitsthatreachcrisisproportionsmayintheoryoccuralongsidesituations wherethereisfiscalbalanceorevenafiscalsurplusiftheprivatesectorexhibitsa sufficientlylargedeficit.asnotedabove,someaspectsoftheoryassumethatthereisa functionalconnectionbetweentheprivatesectorandthepublicsector,withan increaseinthefiscaldeficitbringingaboutanincreaseinprivatesectorsavingandafall inprivatesectorinvestment,eitherthroughfinancialcrowdingoutandricardian equivalanceorthroughtheadverseeffectsofthedeficitondebtandthereforeon marketconfidence. Fromthisalbeitsimplisticdiscussionoftheunderlyingtheory,itcanbeseenthat,in principle,theassociationbetweenfiscaldeficitsandcrisesisfarfromstraightforward. Fiscaldeficitsmayleadtocriseswheretheyresultinunsustainablecurrentaccount deficitsandexcessivedebtaccumulationthatdamagesmarketconfidence.theeffects willbemorepronouncedwherefinancialmarketshavemiscalculatedrisksandwhere domesticsavingislow.however,theymaynot,wheretheyoccuragainstabackground ofunderutilisedproductivepotentialandsignificantoutputgaps,orwherecrowdingout 7

9 servestosimplyredistributeaggregatedemandbetweentheprivateandpublicsector ratherthanaffecttheoveralllevelofdemand;althoughinthislattercasethereare likelytobedifferentmarginalpropensitiestoconsumeandtoimportacrosssectors, andsectoralredistributionmaythereforeindirectlyaffectimportantmacroeconomic aggregates.furthermore,fiscaldeficitsmaynotleadtocriseswheretheprivatesector isinsurplusandwherethestockofdebtislow. PolicymakerswhohaveadvocatedtighterfiscaldisciplineintheformofEurope sfiscal compactappeartohavebeenmorepersuadedbytheargumentthatfiscaldeficitshave haddeleteriouseffectsandthattheyhavesignificantlycontributedtotheincidenceof crises.theythereforealsobelievethateliminatingfiscaldeficitswillreducethe incidenceofcrises.againstthistheoreticalbackground,inwhatfollowsweproceedto investigatesomeempiricalconnections.inthenextsectionweplotoutwhatwas happeningtofiscalimbalances,currentaccountimbalancesandcompetitivenessprior tothecrisisintheeurozoneattheendofthe2000s.afterthat,andinsection5,we moreformallyestimatetherelationshipbetweenfiscaldeficitsandcrisesintheformof declinesinoutput. 4.FiscaldeficitsandcrisesinEurope:somedescriptivestatistics Chart1providesinformationaboutfiscaldeficitsinthebuilduptothecrisisinthe eurozone.allofthecountriesshowninthecharthavebeenaffectedbythecrisisbut,as thechartshows,notallofthemhadexperiencedfiscaldeficitsintheperiodpriortoit. Thusin2007,bothIrelandandSpainhadfiscalsurpluses.Fiscaldeficitsweremore limitedinitalyandportugalthantheywereingreece.indeed,itisgreecethatprovides themostdramaticevidenceofaconnectionbetweenfiscaldeficitsandcrisis.the questionthenarisesastowhetherthesituationingreecehasbeeninaccurately assumedtoapplytoallproblemcountries. 8

10 Chart1:BudgetBalance(%GDP)forSelectedEurozoneMembers Otherimbalancesapartfromfiscalonesalsoappeartobeconnectedwiththeeurozone crisis.chart2forexampleshowsthatportugal,ireland,italy,greeceandspain (conventionallyreferredtoasthepiigs)hadpersistentcurrentaccountdeficitsinthe periodsince2000,withireland,overtheperiod2010]2011,beingtheonlyexception. Chart3showsthatforallthePIIGStherealexchangerateappreciatedovertheperiod 1999]2011relativetoothermembersoftheeurozone.InthecaseofIreland,thedatain Chart1showtherapiddeclineinthebudgetarybalancethatwasassociatedwiththe government spoliciesdesignedtounderwritethebankingsystem.thiswouldsuggest thateconomiccrisesmay,insomecircumstances,betheconsequenceofproblemsin theprivatesectorandinthebankingsector. Thedescriptivedatarevealedbythechartsthereforeimplythat,whilefiscaldeficitsare certainlyfarfromirrelevant,theyarenotbyanymeansthewholestory.other imbalancesandmacroeconomicmisalignmentsappeartohaveplayedanimportantpart 9

11 inleadingtotheeurozonecrisis.asimilarargumentisdevelopedinmoredetailby Wihlborgetal.(2010)wheretheyclaimthattheeurozonecrisis isn tjustfiscal. Chart2:CurrentAccountBalanceas%ofGDP,PIIGS(1980]2010) 10

12 Chart3:RealEffectiveExchangeRate,PIIGS(1980]2010) Theimplicationfollowsthatapolicyresponsethatfocusesnarrowlyoneliminatingfiscal deficitsmaynotbesufficienttoeradicate,orevensignificantlyreduce,thepossibilityof futurecrises.amoreroundedapproachthatdealswithotherimbalancesand misalignmentsmaybeneeded. However,beforereturningtothisissueandafullerexaminationofthelogicbehind Europe sfiscalcompact,inthenextsectionweempiricallyinvestigatetheassociation betweenfiscaldeficitsandeconomiccrisesinalittlemoredetail. 5.FiscaldeficitsandcrisesinEurope:regressionanalysisandresults Aneconomiccrisiscanmanifestitselfinseveralways.Inthispaper,weconfine ourselvestoexaminingcontributingfactorstosignificantdropsinrealoutput.we 11

13 defineanoutputcrisisasanannualpercentagereductioninrealgdpthatliesinthe10 th percentileoftheempiricaldistribution(foreachcountry). 1 AscanbeseenfromTable1 thereare74suchepisodesinoursample. 2 Chart4showsthatoutputcrisestendtobe synchronised.thisisparticularlyevidentfortherecentcrisis,duringwhichalmostevery EUcountryexperiencedasignificantdropinoutput. Chart4:OutputCrisesintheEU,1980]2010 Dataonthebudgetbalance(%GDP)arefromtheEconomistIntelligenceUnit.We constructanadditionalvariablebysubtractinginvestmentfromnationalsavings(again expressedas%gdp).thishelpsustoreflectthebalancebetweenprivatesectorsaving andinvestment.dataonthesetwovariablesaretakenfromtheimf sworldeconomic Outlook.OurfirstspecificationissupplementedbyadummyvariableforEMU membership.thefirstcolumnintable1showshowmanyyearsacountryhadbeena 1 RealGDPdataarefromtheWorldBank sworlddevelopmentindicators. 2 Oursampleconsistsofthe27EuropeanUnionmembers,asin

14 eurozonememberby2010.weestimatealogitmodelwithcluster]robusterrors,where alltheexplanatoryvariables,withtheexceptionofemumembership,arelaggedbyone year. 3 Theestimatedcoefficientsaswellasthemarginaleffectsarereportedinthefirst twocolumnsoftable2. Wediscoverthatthedifferencebetweennationalsavingandinvestmentissignificantly associatedwithoutputcrises,incontrasttothebudgetbalance,whichisinsignificant. Thenegativesignimpliesanegativerelationshipbetweenoutputcrisesandnational savingsminusinvestmenti.e.improvementsinthelatterarelinkedtoareduced probabilityofasharprecession.otherthingsbeinggiven,anincreaseinnationalsaving, incorporatingprivatesectorsavingisassociatedwiththereducedprobabilityofan outputcrisis.ofcourse,thisisnotnecessarilyacausaleffect,astheresultsmayreflect animprovingprivatebalanceduringnon]crisisyears.theemudummyisalsosignificant indicatingthatoutputcrisesoccurmorefrequentlyforcountriesthathaveadoptedthe euro.thismayimplythatthelossoftheexchangerateinstrumenthascarriedacostin termsofoutputshortfalls. Asarobustnesscheck,butnotreportedindetailhere,wealsoestimatedamodelthat includesconsumption,investment,thecurrentaccountbalanceandthebudgetbalance (allexpressedasapercentageofgdp),aswellastheemudummyontherighthand sideoftheequation.againwefindthatthebudgetbalanceisinsignificant.inaddition totheemudummy,consumptionandthecurrentaccountbalancearesignificantand havetheexpectednegativesigns.outputcrisesaresignificantlylinkedtohigherlevels ofprivatesectorconsumptionandtothecurrentaccountdeficitswithwhichthismay beassociated.buttheyarenotlinkedtofiscaldeficits. Movingon,weconsideranextendedspecificationofourbasemodelwithadditional controlvariables.consistentwithourpreviousdiscussion,weincludethepercentage 3 Thepanellogitestimatorisnotsignificantlydifferentthanthepooledestimator,i.e.thepanellevel varianceisinsignificant.resultsreportedherearefromapooledmodel. 13

15 changeintherealeffectiveexchangerate,andtheincidenceofbankingcrises.dataon bankingcrisesaretakenfromreinhartandrogoff(2008),anddataontheeffectiverate arefromtheworlddevelopmentindicators.averagevaluesofthesevariablesforeach EUcountryarereportedinTable1.Wealsoincludedataondebt,againtakenfrom ReinhartandRogoff,sincethefiscalcompactandtheSGPincorporatelimitsonit,and sincemuchofthepublicdiscussionoftheeurozonecrisishasfocusedonexcessive indebtedness.finally,weincludedataoninternationalreserves(fromwdi)since,in principle,theseshouldallowcountriestocushionthemselvesagainstoutputshortfalls. Intheextendedestimation,nationalsavingsminusinvestmentandtheEMUdummy retaintheirsignsandstatisticalsignificance.interestingly,thebudgetbalancenowhasa positiveandsignificantcoefficient.itisdifficulttoknowhowtointerpretthisresult.it wouldseemtosuggestthatautomaticstabilisationisnotadominantfactorin influencingthebudgetbalanceduringrecessions.perhapsthestatisticalassociation capturesthelinkbetweenmeasuresoffiscalausterityandoutput.thisconnectionhas beenexaminedindetailbytheimf(imf,2009).debtseemstohaveasimilar relationshipwithoutput;increasesinindebtednessofthecentralgovernmentare associatedwithlessfrequentoutputcrises. 14

16 EMU Dummy Table1:DescriptiveStatistics1980]2010 Output Crisis Banking Crisis Growth SPI Budget Balance REER Debt Reserves (Sum) (Sum) (Sum) (Mean) (Mean) (Mean) (Mean) (Mean) (Mean) Austria ]0.25 ] Belgium ]4.64 ] Bulgaria ]3.95 ] Cyprus ]4.58 ]4.58 ]0.32 NA CzechRep ]3.78 ] NA Denmark Estonia ] NA NA Finland ] France ]3.46 ] Germany ]1.76 ] Greece ]5.37 ] Hungary ]3.97 ] Ireland ]1.94 ] Italy ]1.08 ] NA 3.13 Latvia ]6.67 ]2.13 NA NA Lithuania ]7.44 ]3.77 NA NA Luxembourg ]0.24 NA 0.58 Malta ]6.45 ]5.64 ]0.31 NA Netherlands ]2.85 ]0.22 NA 5.02 Poland ]3.78 ]2.76 ]38.28 NA Portugal ]6.35 ] Romania ]5.57 ]3.61 ]5.60 NA Slovakia ]5.28 ] NA Slovenia ]0.80 ]1.45 NA NA Spain ]2.97 ] Sweden ]0.65 ] UK ]1.56 ]2.82 ] Totals ]1.79 ]3.19 ] Notes: 15

17 Thecoefficientofbankingcrisesissizeableandstatisticallysignificant.Bankingcrises andsharprecessionstendtogotogether.however,thelevelofinternationalreserves doesnotappeartoplayasignificantroleinoursample.theroleofchangesinthereal effectiveexchangerateismoredifficulttodisentangle.whiletheestimatedcoefficient isinsignificant,themarginaleffectissignificant.thenegativesignindicatesthat increasesincompetitivenessarelinkedtoareductioninthefrequencyofoutputcrises. SpecI Table2:ResultsfromlogitEstimations Estimates SpecI MarginalEffects SpecII Estimates SpecII MarginalEffects SavingPInvestment ]0.067*** (0.023) ]0.005*** (0.002) ]0.106*** (0.036) ]0.007*** (0.002) BudgetBalance ]0.006 (0.042) ] (0.003) 0.080* (0.043) 0.005* (0.003) EMU 1.018*** (0.290) 0.075*** (0.019) 0.599** (0.299) 0.038** (0.019) REER ]0.109 (0.068) ]0.007* (0.004) Debt ]0.018* (0.009) ]0.001** (0.0005) Reserves ]0.032 (0.034) ]0.002 (0.002) BankingCrisis 2.549*** (0.411) 0.161*** (0.018) Constant ]2.937*** ]2.157*** (0.284) (0.301) Observations PseudoRsq Waldtest 17.74*** 91.21*** Notes:Dependentvariableisareductioninrealoutput,whichisinthe10 th percentile.independent variablesarelaggedwiththeexceptionoftheemudummy.theprivatebalance,budgetbalance,debt andreservesareexpressedaspercentagesofgdp.therealeffectiveexchangerateisexpressedasa percentchangeoverthepreviousyear.asterisks*,**and***denotesignificanceatthe10,5and1 percentlevels,respectively.clusterrobusterrorsarereportedinparentheses. Overall,ourresultssuggestthatfiscaldeficitshavenotbeentheprimecause,orevena significantcauseofeconomiccrisesineurope.overtime,crisesseemtohavebeen moresignificantlyassociatedwithdeficienciesinprivatesectorsaving(orexcessive investment)and,perhapsnotunconnectedwiththis,theincidenceofbankingcrises. 16

18 Thereisalsosomeevidencetosuggestthattheeurozonehasbeenparticularly vulnerabletoeconomiccrisesthatinvolvesharpoutputshortfalls. 6.Thefiscalcompact:apoliticaleconomyassessment. Whilethetheoreticalanalysisinsection3suggeststhatfiscaldeficitsmaysometimesbe animportantordeterminingfactorincausingeconomiccrises,theempiricalevidence presentedinthispaperraisesdoubtsabouttheirrelevanceinthecontextofsharp outputshortfallsineurope.therootcauseofproblemsmaylieelsewhere.crisesmay bemoreimportantlylinkedtoprivatesectorimbalancesandchangesin competitivenessassociatedwithrealexchangerateappreciation.thedangeristhen thateliminatingfiscaldeficitsandaimingforbalancedbudgetsthroughouttheeurozone maydolittletoreducethelikelihoodoffutureeconomiccrisesineurope.thefiscal compactmayevenmakemattersworseandleadtomore(anddeeper)crisesrather thenfewerofthem.facedwitharecession,itmaybeunwisetostriveforbudgetary balance. Fiscaldeficitsneedtobeevaluatedinthecontextoftheoverallmacroeconomicpicture. Whetherornottheyareexcessivedependsonarangeofotherfactorsincludingthesize oftheoutputgapandthesizeofprivatesectorimbalances,theamountofoutstanding debtandtherelationshipbetweenfiscaldeficitsandeconomicgrowth,whichitselfmay bedifferentintheshorttermandinthelongrun(see,forexample,imf,2009,cottarelli andjaramillo,2012,andgiavazziandpagnano,1990). Iftheassumptionbehindthefiscalcompactisthatbalancedbudgetswillleadtocurrent accountbalanceofpaymentsequilibriumacrossallmembercountriesoftheeurozone, thenitfollowsfromthealgebraoftheopeneconomyexpressionpresentedearlierthat allprivatesectorsthroughouteurozonecountrieswillalsoneedtobeinbalance.thisis nothowthingsstandin2012andnothowtheyseemlikelytostandintheforeseeable 17

19 future.inanycase,theideaofachievingbalancebetweendomesticsavingand investmentisatoddswiththebasicpurposesofmonetaryintegration.ifitisaccepted thatsomecountrieswill,atcertaintimes,berunningbalanceofpaymentsdeficitswhile othersarerunningsurpluses,thentheimplicationisthattherewillhavetobeeither privatesectororpublicsectorimbalancesthatreflectthisstateofaffairs.or,toputthe pointanotherway,ifitisacceptedthatprivatesectorsavingmaynotalwaysequal privatesectorinvestmentinallcountries,withsavingexceedinginvestmentinsome, andfallingshortofitinothers,thenitfollowsthatcurrentaccountbalancewillrequire thepublicsectortobeindeficitintheformergroupandinsurplusinthelattergroup. Thereisastronganalyticalconnectionbetweenthestanceoffiscalpolicyandthe observationthatthebalanceofpaymentsisazerosumgame.notallcountriescan simultaneouslyruncurrentaccountsurpluses.attemptstoreducecurrentaccount deficitswillfailiftheyarenotaccompaniedbyawillingnessamongstsurpluscountries toseetheirsurplusesdecline.intheabsenceofthiswillingness,suchattemptswill certainlyresultinfallingincomeandrisingunemployment.similarly,ifwithinthe eurozonethefiscalcompactforcescountriestoeliminatefiscaldeficits,butdoes nothingtoencouragecountrieswithfiscalsurplusestoreducethem,thenitislikelythat therewillbeasignificantfallineurozoneincomeandasignificantincreaseineurozone unemployment.thiswillthenincreasecyclicalfiscaldeficitsbecauseofautomatic changesintaxrevenueandgovernmentexpenditure.aimingforbalancedbudgetsor surplusesduringarecessionthereforeappearstobecounterproductive. EvidencecollectedbytheIMF,andbrieflyreferredtoearlier,confirmsthatadopting tighterfiscalpolicyhasacontractionaryeffect.inacomprehensiveexaminationofthe effectsof fiscalconsolidation basedonhistoricalexperienceandsimulation,thefund concludesthatit typicallyreducesoutputandraisedunemploymentintheshortterm. (IMF,2009).TheFundalsoclaimsthatitsfindingssuggestthat budgetdeficitcutsare likelytobemorepainfuliftheyoccursimultaneouslyacrossmanycountries,andif 18

20 monetarypolicyisnotinapositiontooffsetthem. ThisisthepositioninwhichEurope findsitselfin2012/13. AnalogiesmaybedrawnwiththewayinwhichtheEastAsiancrisisin1997/98was handled.theimf sinitialresponsetothatcrisisisillustrativeofthekindofproblems thatcanarisefrominappropriateandexcessivelytightdiscretionaryfiscalpolicy,and thekindofpolicythateurope sfiscalcompactisendeavouringtoembedasaruleina formaltreaty.intheeastasiancase,thefundadvocatedtighterfiscalpolicyasawayof correctingcurrentaccountdeficitsintheaftermathofthecrisis.however,alongwith others,itfailedtoanticipateaccuratelytheextenttowhichtheprivatesectorwould respondtothecrisis,withinvestmentfallingrelativetosaving,andthisaffectedthe needforfiscalcorrection.insuchcircumstances,tightfiscalrulesmaybedestabilizing, andthetrendrateofeconomicgrowthisgenerallyacknowledgedtobeadversely affectedbysuchinstability.therearelessonsfromtheeastasiancaseforthedesignof fiscalpolicyineurope. AfurtherpotentiallyfundamentalproblemwithEurope sfiscalcompactisitsbuilt]in asymmetry.itdiscouragesstructuralfiscaldeficitsbutdoesnotdiscourage,andeven encourages,structuralfiscalsurpluses.thecompactwouldbeinternallyconsistentifthe objectivewastoachieveuniversalbalanceacrosscurrentaccounts,privatesectorand publicsectoraccounts,although,asnotedabove,thisunderminesthebasicpurposesof economicandmonetaryintegration.butthereisaninternalinconsistencywherealimit isimposedonstructuralbudgetarydeficitsbutnosimilarlimitisimposedonstructural fiscalsurpluses.suchasymmetrycreatesarecessionarybias.itmakeseconomiccrises morelikely.italsomeansthatwhentheyoccurtheywillbedeeper.countrieswillbe leftwithnoinstrumentswithwhichtheycanseektomanageaggregatedomestic demand. 19

21 Whythenwouldcountriessignuptothecompact?Thereareanumberofpotential explanations.first,thereisthebargainingpowerofgermanyaseurope sstrongest economy.itisdifficultforcountriesthatmayneedgermany sfinancialsupporttoresist Germanpressuretosignthecompact.ItsdesignreflectsGermany sinfluenceand preferences.contemporarygermanpoliciesarenotconstrainedbythecompact. Second,thereis,onesuspects,astrongelementoftimeinconsistency.Countriesmay believethattheycanderiveshorttermbenefitsbysigninguptothecompact,bothby maintaininggermany scommitmenttoprovidingfinancialassistance,andbyhavinga positiveeffectonmarketconfidence,therebyminimisingtheriskpremiumtheyhaveto payonthedebttheyissue.inthelongterm,theymaybelievethatthedetailsofthe compactleaveenoughscopeforthemtoevadetherules.thereareambiguitiesinthe treatydocumentoverwhatconstitutesastructuraldeficitasopposedtoacyclicalone. Therearecertainlydisagreementsabouthowbesttomeasurefiscalconsolidationand cyclicallyadjustedprimarybalances(see,forexample,imf,2010,forasummaryof someofthem).thefiscalcompactmakesallowancefor exceptionalcircumstances and alsoforprolongedrecessionsor,inthewordsofthedrafttreaty, severeeconomic downturns. Thismaymeanthatreluctantsignatoriesbelievethattheywillbeableto continuetousediscretionaryfiscalpolicytosomeextent. Third,experiencewiththeStabilityandGrowthPactmaybeinterpretedtoimplythat theimpositionofpenaltiesisnotentirelycredible.inanyevent,shorttermbenefitsmay beperceivedtooutweighlongertermcoststhatareheavilydiscounted.iftheweaker constraintsinvolvedinthesgphavebeenfoundtobeunenforceable,whatchanceis therethatthestrongeronesinvolvedinthefiscalcompactwillbe?theironyhereis that,inthesecircumstances,thewholeexercisewilllackcredibilityandthisislikelyto meanthattheperceivedshorttermbenefitsintermsofinfluencingmarketconfidence willnotmaterialise. 20

22 Furthermore,researchintotheimpactoffiscalresponsibilitylaws(FRLs)innine emergingeconomiesasmeasuredbykeyfiscalbalancessuggeststhattheydidnothave asignificanteffect(thornton,2009).althoughfiscalperformanceimprovedinthe countrieswithfrls,italsoimprovedinmuchthesamewayincountriesthatdidnot havethem. 7.Concludingremarks Thereisplentyofevidencetodemonstratethatitisnotagoodideatorun unsustainablylargefiscaldeficitsandtoamassexcessivelylargeamountsofexternal debt.poormacroeconomicmanagementcertainlymakescountriesmorevulnerableto acrisis.theeurozonecrisisshowsthatfinancialmarketscannotalwaysbereliedupon toeffectivelyconstrainfiscaldeficits.itthereforemayseemlogicaltoimposethe conditionthatcountriesshould,overthebusinesscycle,runabalancedbudget.thisis whatliesbehindeurope sfiscalcompactsignedin2012bytwentythreemembersof theeuropeanunion. However,rulingout(orstrictlylimiting)thescopefordiscretionaryfiscalpolicywill makemacroeconomicmanagementmoredifficult.europe snewfiscalcompactputstoo muchemphasisonachievingabalancedbudgetandavoidingdebtaccumulation. AlthoughtherearebriefallusionstotheminthedraftTreaty,thereistoolittleemphasis ontheotherpotentialwaysofminimizingtherisksoffutureeconomiccrisesthatfocus oncontrollingprivatesectordeficitsandthevulnerabilityofthebankingsystem. OnthebasisofprojectionspublishedintheIMF sfiscalmonitorandtheeffectsoffiscal consolidationreportedearlierinthisarticle,complyingwiththefiscalcompactwould implyacontractionineurozoneoutputofmorethan1percentoveratwoyearperiod, aswellasariseinunemploymentofnearlyonepercentagepoint.however,there wouldbeconsiderablevariationwithintheeurozone.theoutputandunemployment 21

23 costsingermanywouldbezero,whilethecostsinspain,forexample,wouldinvolvea reductioningdpofmorethan1.5percent,andariseintherateofunemploymentof morethatonepercentagepoint. Whilethecompactaimsatreducingtheincidenceofcrises,itmaydorelativelylittleto achievethis.furthermore,itwillreducethescopeforhandlingcrisesiftheydooccur. Thisisofparticularconcernwhenotheradjustmenttools,includingmonetarypolicyand, perhapsinparticular,exchangeratepolicy,arenotavailable.thiscouldmeanthatthe EMUbecomesmorepronetodeepeconomiccrisesinvolvingshortfallsinoutputand increasesinunemployment,andthismayadverselyaffectthedurabilityoftheeurozone itself.apolicydesignedtostrengthentheeurozonemayenduphavingtheopposite effect. Theanalysisinthispaperimpliesthattheremaybesuperioroptionsavailable.These wouldinvolveamoreroundedviewoffiscaldeficits.itwouldtakeintoaccountprivate sectorimbalancesandwouldputbankingsectorreformcentrestage.fiscal coordinationwouldalsobeorganisedinawaythatrecognisesthefactthatimbalances cantaketheformofsurplusesaswellasdeficits.itwouldseektoexertpressureon countrieswithstructuralsurplusesandwithprivatesectorsurplusestorelaxfiscalpolicy. Inadditiontothis,ifthereisadesiretolimitthescopefordiscretionaryfiscalpolicyby imposingconstraintsonthesizeofstructuraldeficits asrecentlyarticulatedby Blanchardetal.(2010)]thereisacaseforincreasingthedegreeofautomaticfiscal stabilization,suchthatstrongercounter]cyclicaleffectsarebuiltintothefiscalbalance. References Alesina,A.,2010,Fiscaladjustment:lessonsfromrecenthistory,paperpreparedfor ECOFINconference,Madrid,April,15. 22

24 Blanchard,O..G.Dell AricciaandP.Mauro,2010,Rethinkingmacroeconomicpolicy, IMFStaffPositionNote,SPN/10/03,WashingtonDC,InternationalMonetaryFund. Cottarelli,C.,andL.Jaramillo,2012,Walkinghandinhand:fiscalpolicyandgrowthin advancedeconomies,imfworkingpaper,wp/12/137washingtondc, InternationalMonetaryFund. Elmendorf,D.andJ.Furman,2008,If,when,how:aprimeronfiscalstimulus,The BrookingsInstitution. Freedman,C.M.Kumhof,D.Laxton,D.MuirandS.Mursula,2010,Globaleffectsof fiscalpolicyduringthecrisis,journalofmonetaryeconomics,57(5)506]526. Giavazzi,F.andM.Pagnano,1990,Canseverefiscalcontractionsbeexpansionary?Tales oftwosmalleuropeancountries,nbermacroeconomicsannual,volume5, Cambridge,Massachusetts,NationalBureauofEconomicResearch. Illzetzki,E.,E.G.MendozaandC.A.Vegh,2009,Howbigarefiscalmultipliers?CEPR PolicyInsight,No.39,London,CentreforEconomicPolicyResearch. IMF,2010,Willithurt?Macroeconomiceffectsoffiscalconsolidation,WorldEconomic Outlook,October,Chapter3,WashingtonDC,InternationalMonetaryFund. IMF,2012,FiscalMonitor,Januaryupdate,WashingtonDC,InternationalMonetary Fund. Wihlborg,C.,T.D.WillettandN.Zhang,2010,Theeurodebtcrisis:itisn tjustfiscal, WorldEconomics,11(4)51]77. Romer,C.D.andD.H.Romer,2010,Themacroeconomiceffectsoftaxchanges: estimatesbasedonanewmeasureoffiscalstimulus,americaneconomicreview, 100(3)763]801. Reinhart,C.M.andK.S.Rogoff,2008,Thistimeit sdifferent:apanoramicviewofeight centuriesoffinancialcrises,nberworkingpaper13882,cambridge, Massachusetts,NationalBureauforEconomicResearch. Thornton,J.,2009,Dofiscalresponsibilitylawsmatter:evidencefromemerging economiessuggestsnot,journalofeconomicpolicyreform,12(2)127]

25 Tsibouris,G.C.,M.A.Horton,M.J.FlanaganandW.S.Maliszewski,2006,Experiencewith largefiscaladjustments,imfoccasionalpaper,no246,washingtondc, InternationalMonetaryFund. VonHagen,J.andR.Strauch,2001,Fiscalconsolidation:quality,economicconditions andsuccess,publicchoice,109(3]4)327]