The appropriation of monetary policy by the ECB increases the importance attached to fiscal policy in the pursuit of national aims. Chris Dailey investigates the flexibility allowed under the Stability and Growth agreement, and what leeway this will allow countries facing recession. He argues that the current rules are too strict and will cause major difficulties if Europe is faced with a downturn in demand.
On January 1, 1999, eleven of the fifteen EU member states entered into monetary union, thereby relinquishing control of all national monetary policy to a central authority; the European Central Bank (ECB). Exchange rates between the countries are now irrevocably fixed and control over money supply and interest rates is controlled exclusively by the ECB. The major concern over the loss of monetary adjustment mechanisms is the potential difficulties euro area countries may have in absorbing future economic shocks in their absence. Many theorists believe active fiscal policies will become increasingly necessary to ease the negative impact of such shocks, a situation formerly dealt with mainly through exchange rate and interest rate adjustments. Unlike most monetary unions however, the euro area will not have a central authority to determine fiscal policy. This results from the reluctance of member states to give up control of sacred taxation and expenditure policies. The thought of entering monetary union without fiscal coordination consequently bred fears of greater fiscal laxity and budgetary indiscipline within the euro area. As a result, euro countries agreed upon strict fiscal guidelines as outlined in the Maastricht Treaty (1992) and the Stability and Growth Pact (1997). Significant debate has arisen as to whether the restrictions on national fiscal policies will adversely affect the ability of member states to respond to future negative economic shocks. This essay aims to examine the current role of fiscal policy within EMU and determine whether it will exhibit sufficient flexibility in the face of recession in Europe.
Fiscal Policy in a Monetary Union
In formulating monetary policy, the ECB will be able to take into account shocks that have a common symmetric effect across the euro area, but will have no means of policy response for asymmetric shocks concentrated in local, regional or national areas. In most federal countries a large part of such asymmetric stabilisation occurs through automatic wealth redistribution via the centralised federal budget. For example, in the case of a localised demand shock in the United States, money will be injected into the affected region through increased unemployment benefits and less will be extracted due to declining tax revenues. Thus the central budget redistributes income, automatically stabilising the asymmetric shock and restoring the aggregate economy closer to equilibrium. The EU budget, however, cannot perform such a function due to its small size and lack of harmonisation in taxation and expenditure. Highlighting this downfall, the EU budget currently represents 1.2% of the Union's GDP, while in the United States, government expenditure accounts for approximately 25% of GDP. How then, will the EU cope with national or regional recessions? Is centralisation of the EU budget possible in the near future? If not, are there other mechanisms by which this adjustment can occur? It is these questions to which we now turn.
Optimum Currency Areas
During the planning of EMU, it seems that very little notice was taken of the volumes of literature written on the theory of optimum currency areas (OCAs). OCA theory analyses the costs associated with formation of monetary unions and subsequently lays out the features necessary of an economic area before it should adopt a common currency. The theory claims that in order to minimise the costs associated with relinquishing control of national monetary policy, the area in question must have: (1) flexible wages and prices, (2) a high degree of labour mobility and (3) centralisation of budgetary transfers.
In order to justify the OCA criteria, we take the hypothetical example of Germany and France joining a monetary union without centralising their government budgets. A negative demand shock in France will result in an increased budget deficit due to declining tax receipts and increasing unemployment payments. As shown above, if budgets were centralised, income would automatically be transferred from Germany to France helping to cushion the adverse impact of the demand shock. Budgets are not centralised however, so France instead sees an increase in external debt that will likely restrict its fiscal flexibility in the future. A similar lack of budgetary centralisation in the euro area should make us wary of the deficit restrictions imposed by the Stability and Growth Pact, as will be discussed below.
Even without budgetary centralisation, however, adjustment could occur through declining wages and prices in France or labour emigration to Germany. Thus labour mobility and wage flexibility would significantly reduce the need for budgetary transfers between regions or countries. Unfortunately, wages in Europe are notoriously inflexible and labour mobility low. This is probably the reason the MacDougall Report in 1977 came to the conclusion that monetary union in Europe should be accompanied by significant centralisation of the EU budget. "Failure to do so", it claimed, "would impose great social strains and endanger monetary union". Thus far, it is evident that the euro area does not fulfill the optimum currency area criteria, and consequently may face severe difficulty in adjusting to economic downturns, particularly those of asymmetric nature. The lack of wage flexibility, labour mobility and budget centralisation, combined with the loss of exchange rate and interest rate controls, will increasingly place the burden of adjustment on national fiscal policies. We must now examine the degree of fiscal flexibility currently afforded to national finance ministries and determine whether this is sufficient to cope with future economic shocks.
In 1992, the Maastricht Treaty implemented criteria for fiscal convergence between the potential EMU participants. These criteria required annual budget deficits to be held to 3% of GDP and the gross debt-to-GDP ratio reduced to 60% in order to ensure the avoidance of ‘excessive' borrowing by member states. Subsequently, the ‘Stability and Growth Pact', signed in 1997 in Amsterdam, clarified the financial sanctions to be imposed on member states that violated the Maastricht budgetary guidelines after implementation of EMU. If a country exceeds the 3% deficit requirement, it is subject to fines of between 0.2% and 0.5% of GDP. Initially, the penalty takes the form of non-interest bearing deposits, which are only converted into fines if the ‘excessive' deficit is not corrected after two years. Furthermore the fines will not be applied if the country in question is deemed by the Council to be experiencing ‘exceptional circumstances'. Exceptional circumstances include natural disasters or major recessions where GDP declines by more than 2% in one year. The Stability Pact calls on members to aim for a balanced budget over the medium term to enable the proper functioning of automatic stabilisers and also requires the annual submission of a ‘program for stability' by each member.
The reasoning behind the rules is simple. Many policy makers believed that national governments would have incentive to increase their already over stretched borrowing levels once in a monetary union. Consequently, countries such as Germany feared the negative externalities and spillover effects resulting from this excessive borrowing. If one country is on an unsustainable path of increasing government debt, they argued, it will borrow increasingly from the EU capital markets pushing the union interest rate upwards. This in turn increases the burden of debt on other countries, forcing them to follow unwanted deflationary fiscal policies. These spillover effects could further result in undue pressure on the ECB to loosen monetary policy.
This argument, however, is weakened by the ‘hard currency constraint' whereby countries may actually have incentive for greater fiscal discipline rather than less since they are no longer able to inflate their way out of debt repayments. Opponents of fiscal rules also argue that the fear of overborrowing is exaggerated and claim that markets will impose enough discipline on borrowing. The ‘no bailout' clause in the Maastricht Treaty strictly prohibits the ECB from bailing out national governments in the case of default. Therefore the markets will continue to attach a higher risk premium to countries with high borrowing and consequently apply incentives for fiscal discipline. Thus, the concern of increased fiscal laxity resulting from market failures that has pervaded EMU policy-making since Maastricht, may be ill founded. Euro members may come to regret the signing of the Stability Pact once hit by recession.
The Case for Flexibility
OCA theory suggests that in the absence of a centralised budget, national fiscal policies should be given greater flexibility and autonomy than is currently allowed under the Stability Pact. There exists a serious risk that the pact will interfere with automatic stabilisers. Those countries with deficits near to the 3% maximum will be restrained in their ability to run counter-cyclical deficits during downturns. This is a likely possibility in the case of Germany and France whose deficits for 1999 are projected to be 2.1% and 2.4% respectively. Such lack of budgetary ‘headroom' may force these countries to pursue restrictive fiscal policies at a time when there is a need for the opposite. Temporary cyclical fluctuations will become more severe than necessary and could result in prolonged recession.
The Stability Pact: A Step Too Far?
The Stability Pact set out to prevent one country from borrowing excessively at the expense of others, in order to aid the ECB in its primary objective of ensuring price stability. As ECB President Wim Duisenburg puts it, "it should produce a balanced policy mix that does not overburden monetary policy". The European authorities continue to support the fiscal restraints, yet few economists remain optimistic. Are the rules too strict? Many economists believe they are unnecessary and will only prevent automatic stabilisers from functioning efficiently. The Economist calls the pact a ‘fiscal straitjacket' and points out that had the pact been in force over the past ten years, Germany and France would have had to pay fines of 0.5% of GDP in 3 and 4 of those years respectively. The IMF takes a relatively more supportive view, stating that as long as countries maintain balanced medium term fiscal positions, the Stability Pact will not inhibit the operation of automatic stabilisers. In saying this, the IMF does acknowledge that ‘deep and protracted' recessions are likely to require recourse to the ‘exceptional circumstances' clause. Unfortunately, however, countries do not seem to be aiming for budgetary balance over the medium term. This is evident in the Commission's recent criticism of the French stability plan, where it complained that deficit targets for 2002 of 1.2% offered "no safety margin for the consequences of weaker than expected growth."
There is no question that the Stability Pact is restrictive. Member states have trouble keeping to the Maastricht guidelines in times of prosperity, yet are expected to prevent increasing deficits when times are tough. The ‘let-out' clauses described above also seem quite inflexible. A 2% fall in GDP constitutes a major recession. Much smaller, not to mention more common, output declines can cause significant increases in unemployment and aggravation for an economy. Fines will only increase instability and potentially lead to political dissent within the euro zone. The pact certainly has the right idea in terms of promoting balance in the medium term, and such policies, if followed, would surely leave room for the functioning of automatic stabilisers. Is this realistic? Many national governments cannot, or do not, take medium term views due to political constraints and electoral cycles. In almost all euro countries, for example, governments are constrained by democratically elected parliaments when it comes to shaping fiscal policy. If such political effects are pervasive, fiscal policy cooperation within EMU may be doomed with or without the Stability Pact.
Monetary Union has arrived in Europe. All participating countries have long known its implications for monetary policy, but even today, few can accurately predict the future of fiscal policy in Europe. EMU has gone ahead despite the existence of structural rigidities and a conspicuous lack of harmonisation in budgetary policy. As a result, future economic shocks in Europe may unduly lead to recession, and recessions may themselves become unnecessarily prolonged.
The ideal solution to cope with temporary asymmetric shocks in the euro area would be to centralise a significant proportion of the EU budget. This does not imply an EU welfare system comparable to those of European nations today, as this would lead to further economic distortions and unavoidable political consequences. Perhaps a limited centralisation of unemployment benefit systems would be the solution. This would eliminate the problem of undue pressure on ECB, automatic stabilisers would perform at the European level and the fiscal rectitude sought by the Stability pact would become easier to maintain. Unfortunately, many countries feel they already contribute too much to the EU budget and political disputes will keep such a system away for several years to come.
National fiscal policies will be integral to the success of the euro zone countries adjusting to economic shocks. They will also likely be the key source of dispute between these countries until greater coordination is achieved. Furthermore, political cycles cannot be ignored. This is evident as the recent change of leadership in Germany has already led to calls by the finance minister Oskar Lafontaine for loosening of the fiscal stance. Currently fiscal policy within the euro area does not look sufficiently flexible to cope with recession. If shocks remain largely asymmetric in nature, these downturns will be particularly painful. In the presence of such shocks, the Stability Pact must be used in a flexible manner with the Council taking a discerning role in its interpretation of the let-out clauses. If the rules are strictly applied, however, there may not be long to wait before we see the economic and political difficulties that will result from a European recession.
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