This article was featured in our Fall 2012 issue of the CER Journal. Chris Belfried and Tom Lee are contributors from Cambridge University.
In 1961, Robert Mundell introduced the idea that it may be optimal for independent sovereign states to share a common currency. The European Union (EU) embraced this idea, first with the European Monetary System in 1979 and then with the introduction of the euro in 2002, creating a fully-fledged monetary union. Initially, the European Economic and Monetary Union (EMU) benefited from the economic efficiency and stability gains associated with a common currency. However the recent sovereign debt crisis has underlined the inherent problems in a monetary union operating without some degree of fiscal union. Spillover effects, fiscal indiscipline, and asymmetric shocks suggest some level of fiscal union is required. We explore these issues by considering three possible degrees of fiscal union.
Under a monetary union we shall define three states of fiscal union that can exist as follows:
- Fiscal independence – The fiscal stance of the individual nations is entirely and autonomously determined by the national fiscal authorities.
- Rules and constraints – Each national government stipulates its own fiscal policy subject to predetermined constraints coupled with a supranational institution that may have discretionary authority over member states and powers of enforcement.
- Fiscal Union – The individual nations provide revenue to a supranational institution, which determines the fiscal policy across all nations, comprised of a communal budget and policy coordination.
The strength of a fiscal union depends on the amount of revenue apportioned to the communal budget and the extent of policy coordination. A fiscal union is likely to be coupled with rules and constraints on individual national budgets.
The EMU lacks a communal budget, although there is a limited EU budget that performs some of the functions of a hypothetical EMU budget. However, the EU budget is capped at maximum 1.23 percent of EU GNP (Financial Programming and Budget, 2011) and does not serve the same collection of countries as the EMU. It therefore cannot fulfill the stabilizing functions of a communal budget under fiscal union. National autonomy is constrained by the Stability and Growth Pact (SGP), which stipulates that the national government deficit and debt levels cannot exceed 3 percent and 60 percent of GDP, respectively. Countries have, however, continuously violated these fiscal rules without being subject to sanctions. During the creation of the EMU only seven of 12 original members had public sector debt under 60 percent; Italy entered the EMU with public debt at 114 percent of GDP (Llewellyn and Westaway 2011). Over the period 2000 to 2003 only four of the original members met the conditions of the SGP (Ferrero 2005). Because countries have not adhered to the SGP, the EMU effectively functions as a monetary union with fiscal independence.
The sovereign debt crisis has demonstrated the fiscal problems apparent in the EMU. Our analysis will explore the economic consequences of a monetary union under different states of fiscal union, seeing whether there are inherent problems with fiscal independence or with the design of the EMU.
In line with the current body of literature, we make the following assumptions. National fiscal authorities are maximizing their own welfare and not coordinating in order to maximize aggregate welfare of the monetary union. The welfare function is increasing in income and decreasing in volatility of income. Given the fiscal policies of other nations and the monetary policy of the independent central bank, the fiscal policies that are optimal for individual nations may not be optimal for the union.
Lambertini and Rovelli (2002) point out that because countries under a monetary union are closely integrated, there are spillover effects in terms of aggregate demand and inflation. Aggregate demand and inflation influence both the volatility and level of national income and thus impact the welfare function. Through its impact on domestic imports, exports, and exchange rates, the policy stance of one country can also potentially impact the aggregate demand and growth of all the other countries. Additionally, the existence of short-term nominal rigidities creates non-trivial interactions between monetary and fiscal policy: consumption and investment decisions, for example, depend on interest rates determined by the independent central bank to control inflation.
As fiscal policies influence aggregate demand and therefore the inflation rate, they will also affect the interest rate. Fiscal policies often aim to reduce unemployment and therefore are typically expansionary. In the case of expansionary fiscal policy, monetary policy will then have to be contractionary to limit inflation. This conflict tends to cause fiscal policy to be over expansive compared to union-wide optimality, potentially causing public sector spending to crowd-out private investment. With national authorities acting independently, there is no cooperation and a sub-optimal Nash equilibrium emerges.
Although Lambertini and Rovelli’s paper shows the negative externalities associated with independent fiscal policy, their choice to model fiscal and monetary policy as being chosen simultaneously constitutes a major limitation. In contrast, Nordhaus (1994) models a game in which fiscal authorities are represented as a leader who incorporates the central bank’s reaction into his decision-making. Nordhaus finds that the solution of the Stackelburg game dominates the Nash outcome. This is because national governments know that a more expansive fiscal policy will lead to tighter monetary policy that counteracts the perceived benefits of an overly expansive policy. The authorities set less expansive fiscal policy and so optimal monetary policy is less contractionary. This model more effectively captures the EMU’s institutional structure; the mandate of the ECB clearly states it shall target under a 2 percent year-on-year increase in the Harmonised Index of Consumer Prices (ECB Monthly Bulletin 1999). Given the constraint of fiscal independence, this model leads to a superior outcome with less volatility. However, the individual nations are still in conflict rather than a state of cooperation. As we explore later, once we allow for some degree of fiscal union, superior social welfare outcomes can be found.
Ferrero (2005) reaches a drastically different conclusion. He compares the benevolent central planner’s optimal plan, in which the central authority chooses monetary and fiscal policy to maximize the present discounted value of the welfare objective for the entire union, to fiscal independence.Ferrero concludes that the welfare difference is minimal and thus fiscal independence is viable. However, this paper has little relevance to practical applications due to the social welfare function chosen, which models national fiscal authorities maximizing union-wide welfare rather than individual national welfare. There is little reason to believe governments would want to maximize union-wide welfare while maintaining fiscal independence. This assumption internalized the spillover externalities outlined in this section, making this result not only irrelevant but also expected.
In addition to allowing conflict between fiscal and monetary objectives, fiscal independence permits individual countries to run large fiscal deficits. In 2010 Greece’s public sector debt GDP ratio reached 142.7 percent and Italy’s 119.1 percent (CIA World Factbook, 2011). As 10-year bond yields rose to above 7 percent in Italy, there were calls for the ECB to underwrite Italian debt, because default threatened the stability of the common currency. The current crisis has demonstrated that “indisciplined fiscal policy, possibly unsustainable in the long run, forces the central bank to give up its independence and monetize the fiscal debt” (Sargent and Wallace 1981). This deviation from the central banks’ inflation targeting mandate creates uncertainty about credibility and risks, resulting in large discrepancies in expected and actual inflation rates. Unexpected inflation lowers social welfare because it increases uncertainty about present and future states of the economy, reducing investment and altering consumption decisions.
Rules and Constraints
Evidence overwhelmingly shows that in Europe the SGP was not followed and stringent penalties were not imposed. However, to continue our analysis, we shall examine the effects of such constraints if they were in place and enforced.
The major benefit of such a rule stems from the problem of undisciplined and unsustainable fiscal policy outlined in the previous section. The Stability and Growth Pact states that the government debt to GDP ratio cannot exceed 60 percent. At this level there is little or no risk of default, a prospect that would destabilize the common currency.
Lambertini and Rovelli (2002) argue that the spillover effects of independent fiscal policies persist under the SGP, as they did under fiscal independence. Expansive fiscal policy, even within the 3 percent of GDP deficit limit prescribed by the SGP, can increase aggregate demand and thus create inflation. Fear of such an outcome was evident in 2001 when the European Commission made a formal recommendation against Ireland’s expansionary fiscal policy. Despite Ireland’s compliance with SGP requirements, with a fiscal surplus of 4 percent of GDP and a debt level of only 40 percent, Ireland’s policies were rejected because they would increase aggregate demand and generate inflation across the EMU. It is clear many of the same problems outlined for fiscal independence are still applicable, if constrained by an upper bound.
Hishow (2007) argues the SGP can be detrimental as it restricts the individual countries’ ability to use fiscal policy to boost aggregate demand in times of recession or slow growth. The independence of the central bank means it would refuse to monetize individual fiscal expansions. However, these expansions are sometimes required to boost aggregate demand and stabilize the business cycle. Yet without a loosening of monetary policy, there can be large crowding out effects and a country can fail to return to trend growth. This effect is greater for larger economies, as they require greater fiscal stimuli for recovery.
This is not to say that small countries are free from constraints. The SGP requires long term balanced budgets; to fund a fiscal stimulus the country must raise taxation once trend growth has been reached again. The resultant taxation will increase the labor supply by reducing the level of private consumption and thus raising the marginal utility of consumption. As a result, people work more in order to consume more. However, both income and consumption taxes lower the real wage and so have negative distortionary effects on the labor supply. As the tax burden increases, the negative effect dominates: it is likely that the expansionary power of fiscal stimulus will be negated.
Thus fiscal rules, if followed, stop the risk of irresponsible and excessive government debt, but they fail to correct for spillover effects and constrain the individual countries’ ability to recover from shocks. Therefore in a monetary union, a set of central policies that consists only of the SGP is not optimal.
Fiscal Union: Communal Budget
There is a general consensus in the literature that the EMU is not an Optimal Currency Area (OCA). Severely limited labor mobility due to language barriers and disparate cultural and historical backgrounds inhibits the EMU ability to function as a OCA. Limited mobility means that labor markets are less able to absorb shocks. There are also large structural differences between the member states, which mean the shocks are asymmetric. This partially explains the divergence in outcomes of the economies within the EMU and why some governments have had to increase spending to maintain growth. For example, recovery from the 2008 recession was strong in Germany, which resulted in less expansionary policy in the following years than would have been optimal for other nations. This, at least to some extent, hindered recovery in many EMU countries. A communal budget could help to create business cycle convergence that would reduce these asymmetries.
An OCA without perfect labor mobility requires an automatic fiscal transfer mechanism to redistribute money between countries suffering asymmetric shocks (Mundell 1961). As previously discussed, there is limited labor mobility in the EMU, implying the need for a fiscal transfer system. It is important that these stabilizing transfers are automatic; otherwise, the self-interests of national governments will lead to frequent demands for transfers. In addition countries may delay or refuse to transfer money in times of need due to domestic political considerations. Moreover if union-wide fiscal policy were discretionary, it is likely that public expectations would anticipate policies to be more volatile due to the lack of accountability of foreign politicians to the home population. Additionally, the non-instantaneous relationship between spending and growth means that, to avoid destabilizing effects, an EMU budget should be restricted to solely stabilizing functions.
Although an automatic transfer system may be theoretically desirable, it is unlikely that countries with strong stable economies would agree to it in practice. The recent EMU crisis has shown that countries are predominantly self-interested and in general do not like new policies that reduce national sovereignty.
Although the EU does have a small budget designed for redistribution among its members, it does not act as a communal budget to facilitate redistribution or to smooth asymmetric shocks within those countries that share the euro. In contrast, when one of the nine main regions in the USA suffers a negative shock, revenue provided to the federal budget falls by up to one third, smoothing the business cycle by 40 percent. If applied to the EMU, this could greatly improve its ability to recover from shocks. (Sala-i-Martin et al 1992).
A direct comparison to the USA cannot be made because, for reasons outlined earlier, a communal EMU budget would have to be limited to automatic stabilizers. Hishow (2007) attempts to estimate the size of such a budget assuming the worst-case scenario of the EMU’s three largest economies – Germany, France, and Italy – falling into recession. With these parameters, he concludes a budget of around 3-4 percent of total EMU output would be needed to ensure stability.
This solution is not without its caveats. The EMU budget would provide insurance for countries that pursue reckless fiscal policy and bail these countries out in times of need. In order to counteract the resultant free-rider problem, fiscal constraints need to be implemented with enforced sanctions for breaking them. There is also a terms-of-trade problem. If transfers are made to any of the large economies, their received benefits are effectively doubled due to price effects caused by their size (Hishow 2007). Expenditure in the recipient country increases, whereas expenditure falls elsewhere. Relative demand shifts along with relative prices, giving the transfer-receiving countries an additional competitive boost. A smaller economy would not benefit from this secondary effect.
In addition, the 3-4 percent budget estimate is based on a worst-case scenario, in which the three largest EMU economies fall into recession. However, during the current crisis every single member of the EMU was in recession in 2009 (Eurostat 2011). A communal EMU budget would not have prevented an EMU recession, due to the unprecedented scale of the global financial crisis. It is likely, however, that the recovery would have been stronger and more uniform than in the absence of such a budget. Nevertheless, more integrated global markets, especially in the financial sector, have led to greater interdependence between countries. This increases the transmissibility of shocks, allowing a shock to an individual country to have a wider global impact, and thus a larger budget may be required.
Despite the benefits of a communal budget, it is clear that only having a budget is not sufficient to restoring union-wide optimality. To this end, we shall analyze and evaluate policy coordination.
Fiscal Union: Policy Coordination
In the first two sections we outlined the set of externalities and free-rider problems that make a monetary union ill-suited for co-operative fiscal policies. We then demonstrated that the SGP alone fails to correct these misaligned incentives. The Excessive Deficit Procedure (EDP) complements the SGP and aims to avoid disproportionate fiscal expansion. It is designed to impose political costs on deficits; higher debt-to-GDP ratios require greater debt reduction efforts (Von Hagen and Mundschenk 2002). However, like the SGP, the EDP is largely ignored and sanctions are not imposed.
Beyond explicit rules and sanction mechanisms, policy coordination relies on soft measures such as peer pressure and persuasion (Von Hagen and Mundschenk 2002). Larger countries will not tolerate the reprimands and public warnings required for a more open approach. Countries are currently required to submit annual stability and convergence programs; however, these run on loosely connected calendars and rarely involve the relevant politicians.
This method of coordination is weak, and worse, inequitable. Newer and smaller economies are influenced by peer pressure whereas the larger economies are more independent: 50 percent of initiatives in Belgium are influenced by the EU compared to only 15-20 percent in Germany (Von Hagen and Mundschenk 2002). This limits the scope of negotiation. It is assumed that balanced fiscal budgets are optimal for macroeconomic stability across the entire EMU. While this may be true in the long run, there is no mechanism for addressing short-term fiscal conflicts.
EMU policy coordination entirely consists of requesting that countries adhere to the SGP, which when broken, imposes no sanctions. To solve these problems, fiscal policy must be coordinated not only across countries but also with monetary policy. A framework in which EMU aggregate preferences over inflation, growth, trade and fiscal policy are decided is required. These preferences must be reconciled with centralized monetary policy and complemented by binding commitments to ensure fiscal cooperation at the national level
Monetary union with an independent central bank targeting inflation and national fiscal authorities concerned with national stability and growth causes conflict and results in a sub-optimal equilibrium. Overly expansive fiscal policies are counteracted by contractionary monetary policies. Spillover effects and externalities result from the narrow focus of fiscal policy. To overcome this, the EMU has imposed the Stability and Growth Pact, an attempt to ensure fiscal prudence that focuses on long-term balanced budgets for all members. It is continually broken without the imposition of penalties. However, even if enforced, the SGP aims to treat the symptoms of an ill-functioning system rather than the causes. It assumes balanced budgets are desirable and restricts the fiscal flexibility of individual nations, which is important for smoothing business cycle fluctuations. Currently the main method of ensuring policy coordination is through peer pressure, which benefits larger economies to the detriment of small ones.
A communal budget providing supranational automatic transfers would reduce regional discrepancies in recovering from shocks, both symmetric and asymmetric. However, this may have inequitable term-of-trade effects and reduce national fiscal discipline as it creates misguided incentives, while not addressing the inherent conflict between monetary and fiscal policy.
Policy coordination would help address these problems. Successfully coordinated policies would internalize the spillover effects, as well as reduce the conflict between monetary and fiscal policies, by collectively ensuring individual fiscal policies are not overly expansive. Although policy coordination would reduce fiscal flexibility, the communal budget would provide sufficient fiscal stimulus in times of need. In order for this regime to be effective, sanctions need to be implemented to disincentivize countries from breaking the stipulations of the coordinated policies. To maximize social welfare within monetary unions generally– and the EMU specifically – there must be some form of fiscal union comprised of a communal budget and coordinated policies. We acknowledge the difficulties of implementing such proposals given the unwillingness of individual nations to relinquish fiscal independence. Nevertheless, we believe that a communal budget of around 3-4 percent, as Hishow estimates, would be highly beneficial, if coupled with the coordination of nationally determined fiscal policies, without significantly reducing national sovereignty.
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