Fiscal delegation in a monetary union: Instrument assignment and stabilization properties

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1 Fiscal delegation in a monetary union: Instrument assignment and stabilization properties Henrique S. Basso and James Costain 1 Banco de España June Opinions expressed in this presentation are those of the authors. They do not necessarily coincide with those of the Banco de España or the Eurosystem. Basso/Costain (BdE) Fiscal delegation June / 42

2 Problem: debt bias and volatility in a monetary union Joining a monetary union increases sovereign debt fluctuations and levels Monetary union increases debt bias (Beetsma/Bovenberg (1999), Buti et. al. (21), Chari/Kehoe (27)). Fiscal policy substitutes for independent monetary policy as stabilization tool (particularly for asymmetric shocks) Cross-country banking flows amplified (Bruche/Suárez 21; Obstfeld 213) Independent monetary policy unavailable to resist speculative attacks (Eichengreen/Hausmann 25, DeGrauwe 211) Basso/Costain (BdE) Fiscal delegation June / 42

3 Conventional Wisdom - Solutions: The Good The federalism vision Higher risk sharing, incorporating share deposit insurance, common unemployment insurance and Euro Bonds Problem: creates moral hazard in national fiscal decisions. US might not be such a great example, budget of states relative to federation cannot be compared to national vs Brussels. Basso/Costain (BdE) Fiscal delegation June / 42

4 Conventional Wisdom - Solutions: The Bad There is no solution Go back to (a subset) of national currencies while keeping Europe perhaps as a free trade area retaining a few institutions (e.g. competition laws) Problem: How one goes about making the return smooth? Perhaps Brexit will start showing the way and Grexit the end... Basso/Costain (BdE) Fiscal delegation June / 42

5 Conventional Wisdow - Solutions: The Ugly Rules - updated Maastricht Treaty Improve the enforcement of rules (and, more importantly, sanctions) with Stronger European Authority. Lets punish the governments that are not responsible and make them pay! Problem: Did it work in the past? Should one rely on uniform rules applied to all economies in the EU? Basso/Costain (BdE) Fiscal delegation June / 42

6 Are these the only alternatives?... Oversimplifying, there are three strategies for the Eurozone:...return to national currencies... current approach based on Maastricht Treaty of and, finally, the more ambitious version of federalism. My own clear preference is for the federalism version but I am not at all convinced that Europeans are ready to make it work successfully... - Jean Tirole (215) Basso/Costain (BdE) Fiscal delegation June / 42

7 Are these the only alternatives?... Oversimplifying, there are three strategies for the Eurozone:...return to national currencies... current approach based on Maastricht Treaty of and, finally, the more ambitious version of federalism. My own clear preference is for the federalism version but I am not at all convinced that Europeans are ready to make it work successfully... - Jean Tirole (215) The Acceptable / The Alternative Delegating monetary policy to independent central banks has reduced inflation bias... maybe it s time to delegate (some aspects of) fiscal policy to an independent fiscal authority. Basso/Costain (BdE) Fiscal delegation June / 42

8 Fiscal Delegation - Concerns Is fiscal policy delegation appropriate? From a political economy perspective delegation is appropriate to correct biases due to democratic processes, when a consensus goal exist but it is inappropriate for redistributional decisions with many dimensions One should not delegate all fiscal decisions Basso/Costain (BdE) Fiscal delegation June / 42

9 Fiscal Delegation - Concerns Is fiscal policy delegation appropriate? From a political economy perspective delegation is appropriate to correct biases due to democratic processes, when a consensus goal exist but it is inappropriate for redistributional decisions with many dimensions One should not delegate all fiscal decisions But how about delegating an (subset of) instrument of fiscal policy to ensure budget balance? Question - Which instrument can be viable? Basso/Costain (BdE) Fiscal delegation June / 42

10 Fiscal Delegation - Concerns II Does it correct for debt biases? While doing so, does it allow for appropriate stabilization of shocks? Question - What is the gain in reducing biases relative to costs due to potentially impaired stabilization? Finally, is it feasible? We provide some discussion on possible ways of implementing such institutional design in Europe. Basso/Costain (BdE) Fiscal delegation June / 42

11 This paper in more detail Simple reduced form model of deficit bias in a monetary union where, No policy maker can commit. Elected policy makers are impatient Local policy makers are better informed about local preferences Institutions with simple, feasible, quantitative mandate acts with bias towards that mandate Basso/Costain (BdE) Fiscal delegation June / 42

12 This paper in more detail Simple reduced form model of deficit bias in a monetary union where, No policy maker can commit. Elected policy makers are impatient Local policy makers are better informed about local preferences Institutions with simple, feasible, quantitative mandate acts with bias towards that mandate Focus on the equilibrium of dynamic policy games when instruments are controlled by different institutions Analyze dynamics after government spending shocks and distortionary steady state. Basso/Costain (BdE) Fiscal delegation June / 42

13 Institutional Set-up One central bank chooses inflation, discretionally: J regional governments choose fiscal policy, discretionally: Regional governments are impatient Each region has its own budget constraint Regional governments may issue debt Regional governments act noncooperatively Baseline scenario: Monetary policy delegation only Alternative scenarios include two forms of fiscal delegation - Delegated authority dislikes when debt moves away from its target. Basso/Costain (BdE) Fiscal delegation June / 42

14 Economy of region j - key features Output depends on surprise inflation and taxes: (Alesina/Tabellini 1987) x j,t = ν(π t π e t τ j,t ) Loss function depends on inflation, output, and public services: (Leith/Wren-Lewis 211) L Sj = T t= β t S {α πs π 2 t + (x j,t x j,t ) 2 + α gs (g j,t g j,t ) 2} Basso/Costain (BdE) Fiscal delegation June / 42

15 Fiscal environment of region j Each region faces its own government budget constraint: d j,t = R( d t, π e t, π t )d j,t 1 + qg j,t τ j,t κπ t Ex post real interest rate exhibits interest rate contagion and erosion of nominal debt: R( d t, π e t, π t ) = 1/β S + δ d t + χ(π e t π t ) Ex ante real rate depends on average debt d t 1 J J j=1 d j,t - Interest Rate Contagion Fraction of nominal debt is χ Basso/Costain (BdE) Fiscal delegation June / 42

16 First Best - Planner Consider an omniscient, cooperative, committed Pareto planner: ( ) Vt P dt 1, ɛ t = max π t, {d j,t, τ j,t, g j,t } J j=1 + 1 J j=1 J [ ( x ντ j,t j,t x j,t { 1 α πs πt 2 2 ) ] 2 ( ) } ( ) 2 + αgs gj,t g j,t + β S E tvt+1 P dt, ɛ t+1 s.t. d j,t = R ( dt 1 ) dj,t 1 + q L g j,t τ j,t κπ t j. Omniscient: q = q L Cooperative: planner chooses τ j,t, d j,t for all j Committed: π e t = π t cancels out Pareto: planner respects J distinct budget constraints Basso/Costain (BdE) Fiscal delegation June / 42

17 OCCPP: Conditions Intratemporal trade-offs νˆx j,t α πs π t = α gs q L ĝ j,t, = κα gs q L ĝ t Solution is determined by d t = R( d t 1 ) d t 1 κ P π t + z t, π t = β S ( R( dt ) + R ( d t ) d t ) Et π t+1, Basso/Costain (BdE) Fiscal delegation June / 42

18 Policy Functions Symmetric solution of the planner s problem can be characterized by an inflation function - π t = I P ( d t 1, ɛ t ) a gross borrowing function dt = B P ( d t 1, ɛ t ) Such that B P ( d t 1, ɛ t) = R( d t 1 ) d t 1 κ P I P ( d t 1, ɛ t) + z t ( ) I P ( d t 1, ɛ t) = β S β 1 S + 2δB P ( d t 1, ɛ t) E ti P (B P ( d t 1, ɛ t), ɛ t+1 ). Steady State d S ss = B S (d S ss, ). Use intratemporal conditions to determine output x t = X P ( d t 1, ɛ t ), and spending ḡ t = G P ( d t 1, ɛ t ) Basso/Costain (BdE) Fiscal delegation June / 42

19 Games with Debt as a Control Variable Binding budget constraint implies one of the variables must be determined by the constraint Benchmark Monetary Union case - CB sets inflation, Regional Governments set tax and debt government spending determined such that budget constraint holds. Fiscal Delegation - CB sets inflation, Regional Governments set taxes and Fiscal Authority(ies) set debt government spending determined such that budget constraint holds. Important since each players set its control variable considering as given all the other variables set by other players, thus taking debt as given. Basso/Costain (BdE) Fiscal delegation June / 42

20 Equilibrium for Policy Games with Debt as Control Variable For all cases budget constraint, using intratemporal conditions can be simplified to d t = ( ) 1 + δ d t 1 d t 1 + (πt e β πt)(1 + χ d t 1 ) κ( d t 1 ) π t + z t, (1) S Game Choice Variables Euler Equation Θ J1 C t {π t, g ( ( ) ) t} Θ G π t {τ t, d t, g t = β G E 1 t + 2δ d,t} β t + γ + χ α πg πt+1 π S α πc d t t+1 Θ C t {π t, {g j,t } J j=1 MU } ( ) Θ G π j t = β 1 G + δ d β t E t π t+1 t {τ jt, d jt, g j,t } S F j Θ C t {π t, {g j,t } J j=1 } Θ G j t {τ jt, g j,t } F Where π t Θ F j t {d jt, g j,t } Θ C t {π t, {g j,t } J j=1 } Θ G j t {τ jt, g j,t } Θ F j t {d jt, g j,t } π t 1+κ+χ d t 1. Note R( d t) = π t = α df α πc d t + β F ( 1 β S + δ d t ) E t π t+1 ( ( ) ) π t = α df d α t + β F E 1 t + 2δ d πc β t + γ + χ α πg πt+1 π S α πc d t+1 t ( ( ) 1 + δ d β t ), R( d S t) + R ( d t) d t = 1 + 2δ d β t S Basso/Costain (BdE) Fiscal delegation June / 42

21 Figure: Borrowing and inflation policies. Comparing institutional scenarios Gross borrowing function Inflation function Debt Planner Debt One country

22 Figure: Borrowing and inflation policies. Comparing institutional scenarios Gross borrowing function Inflation function Debt Debt Planner Monetary union One country

23 Figure: Borrowing and inflation policies. Comparing institutional scenarios Gross borrowing function Inflation function Debt Debt Planner Monetary union One country Regional FAs

24 Figure: Borrowing and inflation policies. Comparing institutional scenarios Gross borrowing function Inflation function Debt Debt Planner Monetary union One country Regional FAs Union wide FA

25 Figure: Temporary public demand shock: comparing institutional scenarios Debt.6.4 Inflation.6.4 Public spending Output Instantaneous utility Accummulated Instantaneous utility Planner Monetary union One country Regional FAs Union wide FA

26 Figure: Autocorrelated public demand shock. Comparing institutional scenarios Debt Inflation 7 x Public spending Output Instantaneous utility Accummulated Instantaneous utility Planner Monetary union One country Regional FAs Union wide FA

27 Welfare Social Welfare of Region j and the union is given by W S j ( d, ɛ) = L Sj, W S ( d, ɛ) = 1 J J j=1 W S j ( d, ɛ). Welfare at steady state Wss S W S ( dss, ). S Using the policy functions we can also use polynomial approximation to determine welfare such that ) 2 W P ( d t 1, ɛ t) = α πi I P ( d t 1, ɛ t) 2 + (X P ( d t 1, ɛ t) x t +α gi (G P ( d t 1, ɛ t) g t ) 2 + βs E tw P ( d t, ɛ t + 1) Basso/Costain (BdE) Fiscal delegation June / 42

28 Table: Debt, inflation, and welfare in scenarios S where debt is a control variable Crisis cost Debt Inflation Welfare Crisis cost controlling for debt d S ss π S ss W S ss Correlated shocks (autocorrelation.7) Scenario P: Planner W S (d S ss, ɛg ) W S ss W S (, ɛ g ) W S (, ) Scenario I: single country with independent central bank Scenario MU: status quo monetary union Scenario Fj: Monetary union with regional fiscal authorities Scenario F: Monetary union with union-wide fiscal authority

29 Figure: Temporary public demand shock. Comparing institutional scenarios (Levels) Debt.6.4 Inflation Public spending Instantaneous utility Planner Monetary union One country Regional FAs Union wide FA

30 Figure: Autocorrelated public demand shock. Comparing institutional scenarios Debt.6.4 Inflation Public spending Instantaneous utility Planner Monetary union One country Regional FAs Union wide FA

31 Games with Debt as a Residual Benchmark Monetary Union case - CB sets inflation, Regional Governments set tax and spending debt determined such that budget constraint holds. Fiscal Delegation - CB sets inflation, Regional Governments set spending and Fiscal Authority(ies) set taxes debt determined such that budget constraint holds. If Debt is the residual, each player sets its control variable explicitly considering the effect it will have on the state variable tomorrow, implicitly impacting the future decisions of all players. Basso/Costain (BdE) Fiscal delegation June / 42

32 Debt as A Residual - Monetary Union Central bank no longer has a intratemporal trade-off inflation versus spending ĝ t = α πc q H α gs π t, now condition is also intertemporal. For the MU case [ ( ) χ d t 1 + κ 1 α πc π t + ν ˆx t = β S (α πc π t+1 + ν ˆx t+1 ) + 2δ d t 1 + χ d t + κ β S ( 1 + ν + q2 L ν ) (α πc π t+1 + (1 + χ d t + κ)ν ˆx t+1 ) x t+1 + α gc d t ] +(χ d tα πc π t+1 ν ˆx t+1 ) π t+1 d t Plus, one intratemporal condition linking output(taxes) and spending, and ˆx j,t = β G ( 1 β S + δ d t 1 ) E t ˆx j,t+1 d t = ( 1 β S + δ d t 1 ) dt 1 + (π e t πt)(1 + χ d t 1 ) + ( 1 ν + q2 L ν α gc ) ˆx t κπ t + z t Basso/Costain (BdE) Fiscal delegation June / 42

33 Policy Games - Debt as A Residual - Fj case [ χ d t 1 + κ α πc π t + ν ˆx t = β S (α πc π t+1 + ν ˆx t+1 )(R(d t) + R (d t)d t) + χ d t + κ +(α gc ĝt+1 (1 + χ d t) + q L (α πc π t+1 + ν ˆx t+1 )) ĝ t+1 + d t ( ) 1 + (α πc π t+1 + (1 + χ d t + κ)ν ˆx t+1 ) ˆx t+1 + ν d t ] +(χ d tα πc π t+1 ν ˆx t+1 ) π t+1 d t ĝ j,t = ( ql β G E t [R( d t)ĝ j,t+1 ˆx j,t+1 1 ) ] xt+1 α gg ν ĝj,t+1, d t [ νˆx j,t + α df d j,t = β F E t νˆx j,t+1 R( d t) + ( ) g j,t+1 q L νˆx j,t+1 α gg ĝ j,t+1 d t d t = ( ) 1 + δ d t 1 d t 1 + (πt e β πt)(1 + χ d t 1 ) + 1 S ν ˆx t + q L ĝ t κπ t + z t ], Basso/Costain (BdE) Fiscal delegation June / 42

34 Figure: Temporary public demand shock. Comparing scenarios when debt is a residual Debt.6.4 Inflation.5 Public spending Output Instantaneous utility Accummulated Instantaneous utility Planner Monetary union Regional FAs Union wide FA

35 Figure: Autocorrelated public demand shock. Comparing scenarios when debt is a residual. Debt Inflation 7 x Public spending Output Instantaneous utility Accummulated Instantaneous utility Planner Monetary union Regional FAs Union wide FA

36 Table: Debt, inflation, and welfare in scenarios S where debt is a residual Crisis cost Debt Inflation Welfare Crisis cost controlling for debt d S ss π S ss W S ss Correlated shocks (autocorrelation.7) Scenario P: Planner W S (d S ss, ɛ g ) W S ss W S (, ɛ g ) W S (, ) Scenario MUdr: status quo monetary union Scenario Fjdr: Monetary union with regional fiscal authorities Scenario Fdr: Monetary union with union-wide fiscal authority

37 Figure: Borrowing and inflation. Comparing institutional scenarios when debt is a residual and a control variable Gross borrowing function Inflation function Debt Planner Debt Monetary union

38 Figure: Borrowing and inflation. Comparing institutional scenarios when debt is a residual and a control variable Gross borrowing function Inflation function Debt Debt Planner Monetary union Monetary union Debt Resid

39 Figure: Borrowing and inflation. Comparing institutional scenarios when debt is a residual and a control variable Gross borrowing function Inflation function Debt Debt Planner Monetary union Monetary union Debt Resid Regional FAs

40 Figure: Borrowing and inflation. Comparing institutional scenarios when debt is a residual and a control variable Gross borrowing function Inflation function Debt Debt Planner Monetary union Monetary union Debt Resid Regional FAs Regional FAs Debt R

41 Fiscal Delegation If excessive debt is a problem in EMU, model points to establishment of a European Fiscal Authority (EFA) That is a powerful way to control debt in each country, correcting biases due to impatient elected officials and common pool problems. Institutional set-up still is able to provide sufficient stabilization. Important considerations such as each country s capacity to obtain revenues from taxes, their rate of growth and benefits and costs of default can be taken in consideration while setting the instrument. This is a striking contrast to uniform rules, previously in place in the EMU, which are almost meant to be eventually broken. Basso/Costain (BdE) Fiscal delegation June / 42

42 A European Fiscal Authority EFA would monitor and forecast fiscal trends in each member state EFA could provide advice on fiscal impact of new policy proposals EFA would have power to set fiscal instrument(s) that give it effective control over national debt levels Does not necessarily need to be debt...taxes will do...for instance Gruen(1997) proposes adding a shift parameter X to the tax code: tax rate i,t = F (income i,t, lots of other stuff i,t ) + X t that way redistributive properties embedded in tax code are maintained. Also feasible: adjustment to public sector expenditure (Costain/de Blas (212A,B)), adjustment factors to pensions. Basso/Costain (BdE) Fiscal delegation June / 42

43 Is EFA politically feasible? Fiscally fragile countries in the Eurozone need ECB protection against speculative attacks (for example: cap risk premia). Fiscally strong Eurozone countries oppose ECB guarantees because they fear moral hazard: the weaker countries may fail to balance their budgets if they take ECB protection for granted. A feasible quid pro quo: Members voluntarily delegate one or more fiscal instruments to EFA. EFA evaluates whether instruments give it effective control of debt. When a member state has delegated an effective fiscal instrument to the EFA, ECB promises protection against speculative attacks (which might be less likely since EFA decreases biases, increases credibility, reducing premia). If EFA says instrument is not effective, or is no longer effective, ECB revokes protection. Basso/Costain (BdE) Fiscal delegation June / 42

44 Still to do More careful parametrization of reduce-form model. Include case of federal government centralizing expenditure. Increasing the complexity of the agents part of the model. Important to consider terms of trade fluctuations during stabilization. Does it prevent EFA from providing adequate stabilization? Increasing complexity of tax system. Would Gruen(1997) tax multiplier set up work well? Basso/Costain (BdE) Fiscal delegation June / 42

45 THANKS FOR YOUR ATTENTION! Basso/Costain (BdE) Fiscal delegation June / 42

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econstor Make Your Publication Visible A Service of Wirtschaft Centre zbwleibniz-informationszentrum Economics Basso, Henrique S.; Costain, James S. Working Paper Fiscal Delegation in a Monetary Union