EMU Governance: Fiscal Policy Francesco Saraceno MPA - 2012 1
Outline What is Fiscal Policy (trivial) The role of Fiscal Policy (less trivial) Some Definitions i i (boring boring!) Fiscal Policy in the EMU: The Stability and Growth Pact (the real thing) 2
What is Fiscal Policy The set of macroeconomic policies aimed at impacting the macroeconomic outcome of the economy through: Revenues of the government (tax policy) Expenditures of the government 3
Outline What is Fiscal Policy The role of Fiscal Policy Some Definitions i i Fiscal Policy in the EMU: The Stability and Growth Pact 4
The Role of Fiscal Policy Macroeconomic stabilization Collective insurance Provision ii of public goods Redistribution (more controversial) 5
Outline What is Fiscal Policy The role of Fiscal Policy Some Definitions Fiscal Policy in the EMU: The Stability and Growth Pact 6
Some Definitions Output Gap: : difference between actual and potential (full employment) output Government deficit, or net lending: : Difference between government expenditures and revenues Public Debt: : Stock of cumulated deficits. Primary y deficit or surplus: : government deficit or surplus net of interest payments Structural or cyclically adjusted deficit: what the balance would be if the output gap were zero Automatic stabilizers: : Changes in revenues and expenditure that happen without discretionary i action. 7
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. 8 8
Automatic Stabilisers: Principles A two-wayway relationship. Their strength depends on: Sensitivity of economic activity to cyclical changes in government revenues and spending Sensitivity of government revenues and spending to economic fluctuations public sector size progressivity of the tax and benefit system levels of unemployment benefits sensitivity of unemployment to economic fluctuations 9
Automatic Stabilisers Percentage of fluctuations smoothed by automatic stabilization Bundesbank model QUEST model NiGEM model INTERLINK model (1) (2) (3) (4) France 19 23 7 14 Italy 14 21 5 23 Netherlands 14 20 6 36 UK 24 18 n.a. 30 Germany 23 17 18 31 Unweighted average 18.8 19.8 9.0 26.8 Std error 48 4.8 24 2.4 61 6.1 85 8.5 Source: Creel and Saraceno (2010) 10 10
Outline What is Fiscal Policy The role of Fiscal Policy Some Definitions i i Fiscal Policy in the EMU: The Stability and Growth Pact From Maastricht to the reform of 2005 The rationale for a fiscal rule The debate on the SGP Conclusion: What happened? 11
The Maastricht Convergence Criteria: a Reprise Inflation: not to exceed by more than 1.5 per cent the average of the three lowest inflation rates among EU countries. Long-term interest rate: not to exceed by more than 2 per cent the average interest rate in the three lowest inflation countries. ERM membership: at least two years in ERM without being forced to devalue. Budget deficit: deficit less than 3 per cent of GDP Public debt: debt less than 60 per cent of GDP, or approaching towards that level at a sufficiently fast pace 12 12
Convergence Criteria: Budget Deficit and Debt Historically, all big inflation episodes born out of runaway public deficits and debts. Hence requirement that house is put in order before admission. Problems,, clear already at the time: A few years of budgetary discipline do not guarantee long-term discipline Artificial/arbitraryarbitrary ceilings Convergence period 13 13
Debt and Deficit in 1998 14 14
The Stability and Growth Pact (SGP) Amsterdam Treaty (1997) and reform of 2005 Meant to avoid discretion and to only allow automatic stabilization. Requirement to attain a position of close to balance or in surplus in the mid-run (what does this imply, in terms of structural balance?) 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, and countries avoided fines so far. 15 15
How the Pact Works A A limit on acceptable deficits: 3% of GDP A A preventive arm Stability programmes and peer pressure Aims at avoiding reaching the limit in bad years Calls for surpluses in good years A A corrective arm early warning when deficit is believed to breach limit, plus recommendations EDP procedure for excessive deficit: recommendations, to be followed by corrective measures, and ultimately sanctions 16 16
How is (would) the Fine (be) Levied The sum is retained from payments from the EU to the country (CAP, Structural and Cohesion Funds). It 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. 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 17 17
The reform of 2005: Ordinary Exceptional Circumstances? 2003: Clash Commission-Council Council over France and Germany SGP reformulated in 2005 to avoid rigidity of Pact. New flexibility in the SGP Negative growth or accumulated loss of output over a period of low growth Taking account of all relevant factors No specific definitions Structural reforms or low debt should give more leeway Note, the SGP did not apply to the crisis of 2008-20092009 18 18
Outline What is Fiscal Policy The role of Fiscal Policy Some Definitions i i Fiscal Policy in the EMU: The Stability and Growth Pact From Maastricht to the reform of 2005 The Rationale for a fiscal rule The Debate on the SGP Conclusion: What happened? 19
Why do we Need Fiscal Rules? The perception of the role of fiscal policy has changed radically over recent decades. Discretionary fiscal policy to stabilize the economy had come to be regarded with great skepticism. Instead, the conventional wisdom today is that monetary policy should be the main stabilization tool At least until the last crisis! i 20
Criticisms against Stabilization Policies Two Major types of theoretical objections have been raised against using fiscal policy for stabilization purposes. The first one questions the technical effectiveness of such policies. The second objection questions the ability/willingness of policymakers to use fiscal stabilization policy in an effective way. 21
Criticisms against Stabilization Policies II Decision lags are longer, than for monetary policy as tax and expenditure changes have to go through a lengthy parliamentary decision-making gp process, in contrast to the almost continuous process for monetary policy. The political character of fiscal policy decisions makes it much harder to revise decisions i when circumstances change than is the case for monetary policy Fiscal policy has other central goals than stabilization, viz. income distribution and resource allocation. In addition, fiscal policy measures are often influenced by attempts of incumbent governments to enhance their reelection chances. The risk of an expansionary bias is much larger for fiscal policy than for monetary policy, as the latter has been delegated to independent central banks, which can take a more long-term view. 22
Outline What is Fiscal Policy The role of Fiscal Policy Some Definitions i i Fiscal Policy in the EMU: The Stability and Growth Pact From Maastricht to the reform of 2005 The Rationale for a fiscal rule The Debate on the SGP Conclusion: What happened? 23
The Debate on the Stability Pact Arguments in favour of the SGP usually found in the literature: Voter myopia Strategic government e behaviour Vested interests and bargaining Dynamic inconsistency All reasons for fiscal discipline that nevertheless do not require supranational rules Supranational rules can be justified on two grounds Spillovers Credibility 24
The Debate on the Stability Pact Spillover effects through (common) interest rates Empirical i evidence ill-conceived i and di inconclusive i Theoretically, the externality can be positive (standard Mundell- Fleming argument) Credibility and moral hazard: the ECB could have to bail out insolvent countries with common costs Default has never been a risk in Europe Bank regulation and debt management seem better suited to lower the risk Current fiscal practices seem to be more harmful for credibility than a remote default risk 25
Outline What is Fiscal Policy The role of Fiscal Policy Some Definitions i i Fiscal Policy in the EMU: The Stability and Growth Pact From Maastricht to the reform of 2005 The Rationale for a fiscal rule The Debate on the SGP Conclusion: What happened? 26
Fiscal Policy in the EMU The SGP has proven to have many flaws Countries have often had deficits above 3% Sanctions i have never been imposed The reform of 2005 increased discretion and arbitrareness, making the imposition of sanctions even less probable So, why bother? 27
Reactivity of Fiscal Policy 6 % 4 2 0-2 -4 EMU4 US UK JP -6 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: OECD Economic Outlook. EMU4= Germany, France, Italy, Spain 28
GDP Growth vs Fiscal Impulse 4 2 0-6 -4-2 0 2 4 6-2 -4-6 -8-10 -12 GER ITA ESP FRA EMU4 USA UK Linéaire (GER) Linéaire (ESP) Linéaire (USA) Linéaire (UK) Linéaire (ITA) Linéaire (FRA) Linéaire (EMU4) 29
The Current Crisis: A Preview Source: OECD Economic Outlook Interim Assessment: September 2012 Source: OECD Economic Outlook 91 June 2012 30
The Current Crisis: A Preview OECD area, unless otherwise stated 31