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  1. CLASS ANNOUNCEMENTS • No class on Friday, April 23

  2. Fiscal Policy and the Stability and Growth Pact • Monetary union – loss of monetary policy BUT fiscal policy still remains • National fiscal policies affect other countries • A country has 2 macroeconomic instruments: • Monetary policy – lost in a monetary union • Fiscal policy – retained even in a monetary union

  3. Fiscal Policy and the Stability and Growth Pact (cont.) • In the Euro area fiscal policy therefore becomes very important! • In case of asymmetric shocks fiscal policy is the only available macroeconomic instrument • But fiscal policy is more difficult to activate and less reliable than monetary policy

  4. Fiscal Policy and the Stability and Growth Pact (cont.) • Fiscal policy – changes in spending and/or taxes • Fiscal policy is also very slow to implement • Ex. In monetary policy – central bank can change interest rates very quickly;

  5. Fiscal Policy and the Stability and Growth Pact (cont.) • In fiscal policy – establishing the budget is a very long process • Government must agree on budget • Ministers will negotiate • Parliament must approve budget • Spending must be enacted by bureaucracy • Taxes take time to increase • Sometimes during this process the situation fiscal policy is trying to solve dissapears

  6. Fiscal Policy and the Stability and Growth Pact (cont.) • Another way of looking at fiscal policy: government borrows and pays back on behalf of its citizens • During a slowdown – government budget deficit financed by public borrowing • During an upswing – government budget surplus – government pays back its debt

  7. Fiscal Policy and the Stability and Growth Pact (cont.) • Individual firms and citizens could lead to the same effect, in principle, by borrowing in bad years and paying back in good years • The government simply acts as a bank vis-a-vis its citizens • This makes sense because when the economy slows down lending becomes generally riskier and banks become cautious

  8. Fiscal Policy and the Stability and Growth Pact (cont.) • Many citizens and firms cannot borrow in bad times • When governments are considered a good risk (as is the case in Europe) they can borrow at a relatively low cost

  9. Fiscal Policy and the Stability and Growth Pact (cont.) • Europe also fares poorly in inter-country transfer (remember OCA theory!) • This is the equivalent of a transfer • When a country faces a negative asymmetric shock its government can borrow from countries that are not affected by the shock

  10. Fiscal Policy and the Stability and Growth Pact (cont.) • Instead of receiving a loan or grant from other EMU governments the affected country can borrow on international private markets • This way fiscal policy makes up for the absence of a “federal” transfer in a monetary union

  11. Fiscal Policy and the Stability and Growth Pact (cont.) • Basically – if government borrows to reduce taxes now it will raise taxes later to pay back its debt • In an asymmetric shock the country facing the negative demand shift can borrow from countries not affected by the shock – equivalent of a transfer

  12. Fiscal Policy Externalities • Spillovers and Co-ordination • Fiscal policy actions in one country may spillover to other countries through different channels • İncome and spending • Inflation • Borrowing costs

  13. Fiscal Policy Externalities (cont.) • Such spillovers are called externalities • They can help or hurt other countries • Countries need to consider other countries when implementing fiscal policy and the effect other countries policies will have • Countries should coordinate their policies • Will the EMU countries want to give up more of their sovereignty to coordinate fiscal policy after loss of monetary policy?

  14. Fiscal Policy Externalities (cont.) • Formally, fiscal policy remains a national prerogative • However, deepening economic integration among EMU countries may call for some coordination • Fiscal policy coordination that requires binding agreements would limit each country’s sovereignty at a time when fiscal policy becomes an important tool • The question to ask: • Does sharing the same currency increase spillovers to the point where some new limits on sovereignty are warranted and justified?

  15. Fiscal Policy Externalities (cont.) • Cyclical Income Spillovers: • Business cycles – transmitted through exports and imports • Ex. Germany enters an expansion phase • Germany gets more imports • Partner countries have more exports and more incomes • (GRAPH) • Spillover is stronger the more countries trade with one another and the larger the coutnry taking action • This is why Germany is so important

  16. Fiscal Policy Externalities (cont.) • What does this mean for fiscal policy? • Ex. 2 monetary union member countries undergoing synchronized cycles suffering from a recession • Each country will want to adopt an expansionary fiscal policy but ignoring the other country’s actions may mean the combined action may be too strong • If each government relies on the other to do the work – too little may be done • If the cycles are asynchronized – expansionary fiscal policy in one country may boost spending in the booming country; a contradictory fiscal policy move in the booming country may deepen the recession of the other country

  17. Fiscal Policy Externalities (cont.) • Borrowing Cost Spillovers: • Fiscal expansion – increases public borrowing OR reduces public saving • The Government is the country’s biggest borrower – large budget deficits – push interest rates up • However, EMU countries share the same interest rate • One country’s deficits (especially if the country is large and the deficits sizeable) may impose higher interest rates throughout the Euro area • High interest rates – deter investment and affect long term growth

  18. Eurozone Government Bond Spread

  19. Excessive Deficits and the No-Bailout Clause

  20. Excessive Deficits and the No-Bailout Clause (cont.) • Debt build-up – partly related to the oil shocks of 1970s and 1980s • What happens when a public debt becomes unsustainable? • Financially hard-pressed governments may ask the central bank to finance their deficits – this would lead to inflation • If the Eurosystem did this – inflation in Euroland would increase • The Maastricht Treaty forbids the Eurosystem (ECB and NCBs) from providing direct support to governments

  21. Excessive Deficits and the No-Bailout Clause (cont.) • Spillover 1: • If 1 country had heavy borrowing – could trouble international financial markets • If markets believe debt is unsustainable • The whole Euro area comes under suspicion • Capital outflow from Euro area would occur

  22. Excessive Deficits and the No-Bailout Clause (cont.) • Spillover 2: • If a government cannot pay its debt – this would lead to a default which would mean: • Massive capital outflow • Collapse of the exchange rate and the stock markets • Deep recession • Rising unemployment • In a monetary union this may affect all member countries

  23. Excessive Deficits and the No-Bailout Clause (cont.) • The Maastricht Treaty has a no-bailout clause • No official credit can be extended to a distressed member government • In spite of the no-bailout clause in case of an emergency some arrangement could be found to bail out a bankrupt government • Ex. The ECB could “informally” relax its monetary policy to make general credit more abundant at a lower cost • It should be remembered that defaults do not occur out of the blue – it takes years to accumulate large debts • Preventative measures could be taken during this time

  24. Collective Discipline • Why do governments accumulate such high deficits? • To win elections (paying money back takes a long time – usually the spenders are out of office by then) • Public spending favors narrow interest groups (civil servants, military, public road contractors, etc.) while debt service is diffused and borne by the majority (Theory of Collective Action) • Collective Discipline could be used as a substitute to refuse spending for these purposes

  25. Public Debts in Europe in 2009 (%GDP)

  26. Fiscal Policy • Existence of spillovers – 1 argument for sharing policy • Broader question: At which level of government (regional, national, supranational) should policies be conducted? • Theory of fiscal federalism • Principle of subsidiarity

  27. Theory of Fiscal Federalism • Theory asks how in one country fiscal responsibilities should be assigned between the various levels (national, regional, municipal) • Asks the question of which responsibilities should stay in national hands and which responsibilities should be transferred to Brussels

  28. Theory of Fiscal Federalism (cont.) • 2 arguments for sharing responsibility: • Spillovers lead to inefficient outcomes when each country is free to act as it wishes • Some policies are more efficient when carried out on a large scale • Ex. Use of money, defence

  29. Theory of Fiscal Federalism (cont.) • One solution is coordination which preserves sovereignty but needs repeated negotiations • Another solution is giving up sovereignty to a supranational institution • In Europe the European Commission (internal market and trade negotiations) and the ECB (monetary policy) have already taken on some important tasks

  30. Excessive Deficits and the No-Bailout Clause (cont.) • 2 arguments for keeping sovereignty: • Preferences are heterogenous and a supranational institution will create dissatisfaction • Ex: common law concerning family life – preferences in these types of areas differ across countries • Information asymmetries – policies need to be understood at the local level • Ex: decisions regarding where to build roads, etc. – requires knowledge of that particular geographic area – information asymmetries may occur (more knowledge regarding such issues is available more so at the local level than the global level)

  31. The Principle of Subsidiarity • Principle embraced in the Maastricht Treaty • Basically means that decisions should be made as close to the people as possible and that the EU should not take action unless doing so is more effective than action taken at national, regional or local level • The broad definition of subsidiarity is that decisions should be taken at the lowest level possible

  32. The Principle of Subsidiarity (cont.) • European Commission’s definition: • “The subsidiarity principle is intended to ensure that decisions are taken as closely as possible to the citizen and that constant checks are made as to whether action at the Community level is justified in the light of the possibilities available at national, regional or local level.” • The problem is that the dividing lines between the EU and the national level are unclear and ever changing. This makes the subsidiarity principle an ambigious principle.

  33. Micro vs Macroeconomic Aspects of Fiscal Policy • It is very important to separate two aspects of fiscal policy: • Structural aspect (or microeconomic aspect) • Concerns the size of the budget, what public money is spent on, how taxes are raised, etc. • Macroeconomic aspect • The income stabilization role of fiscal policy • We are focusing on the macroeconomic aspect of fiscal policy

  34. Implications for Fiscal Policy • The Case for Collective Restraint: • Spillovers such as income flows, borrowing costs, and the risk of debt default can have serious effects across the Euro area • Some countries may lack the political institutions necessary for fiscal discipline necessitating the use of an external agent such as Brussels for restraint • The limits of collective restraint can range from coordination and peer pressure to mandatory limits on deficits and debts

  35. Implications for Fiscal Policy (cont.) • The Case Against Collective Restraint: • Important heterogeneities and information asymmetries exist between nations • This can lead to asymmetric shocks • A common fiscal policy in addition to a common monetary policy would leave nations without any counter-cyclical macroeconomic tool

  36. Implications for Fiscal Policy (cont.) • It is far from clear that the macroeconomic component of fiscal policy should be subject to external limits • A common fiscal policy is ruled out but some degree of coordination may be considered • This is an ongoing debate in the EU

  37. Implications for Fiscal Policy (cont.) • The subsidiarity principle implies that as long as the case is not strong fiscal policy should remain a national issue • On the other hand the spillover that could result from excessive deficits is important – this forms the basis for the Stability and Growth Pact

  38. Stability and Growth Pact

  39. The Stability and Growth Pact • Admission to the monetary union: • Budget deficit of less than 3% of GDP • Public debt of less than 60% of GDP • There was some worry that after a country joined the EMU that a breach of either of these criteria could happen

  40. The Stability and Growth Pact (cont.) • Maastricht Treaty’s Article 104: • “Member states shall avoid excessive government deficits” • The practical details of the procedure are fulfilled by the Stability and Growth Pact • The initiative was taken by Germany in 1995

  41. The Stability and Growth Pact (cont.) • Germany was worried that fiscal indiscipline could lead to inflation and insisted on a clear and automatic procedure • Germany made full use of the Maastricht Treaty to achieve its aims • The other countries were less enthusiastic but agreed because of Germany’s importance for EMU

  42. The Stability and Growth Pact (cont.) • The SGP consists of 4 elements: • A definition of what constitutes an ‘excessive deficit’ • A preventive arm, designed to encourage governments to avoid excessive deficits • A corrective arm, which prescribes how governments should react to a breach of the deficit limit • Sanctions • The SGP applies to all EU member countries but only the Eurozone countries are subject to the corrective arm

  43. The Stability and Growth Pact (cont.) • The Pact: • Deficits are excessive when they are above 3% of GDP • Recognizes that serious recessions beyond government control can lead to deepening deficits • Trying to close down deficits during a recession may lead to contradictory policies which may deepen recession • Exceptional circumstances when the provisions are automatically suspended: • If the country’s GDP declines by at least 2% in the year in question • When output declines by less than 0.75%

  44. The Stability and Growth Pact (cont.) • When a country is found exceeding the limit – commission issues a report and decides whether the country is in excessive deficit • Commission issues a report and decides whether the country is in excessive deficit • If it finds against the country – recommendations and deadline (may or may not be made public) • A country may run deficits in excess of 3% GDP for 2 successive years without incurring sanctions

  45. The Stability and Growth Pact (cont.) • Due to the EU experiences of 2001-2003: • Shallower but longer-lasting slowdowns can gradually deepend the deficit • With its revised version the SGP introduces two elements of flexibility: • It admits taht a negative growth rate or an accumulated loss of output during a protracted period of very low growth may be considered as exceptional • It suggests taking into account of ‘all other relevant factors’ • In contrast with the 3% limits and the -2 and -0,75% definitional of exceptional circumstances, these new elements are vaguealy specified.

  46. Sanctions • If a country fails to bring down the deficit below 3% by the deadline – it is sanctioned • Deposits are imposed each year until the deficit is corrected • If there is no correction within 2 years – deposits become a fine – otherwise they are returned