Fiscal Solvency in Europe: Budget Deficits and Government Debt under European Monetary Union

By Caporale, Guglielmo Maria | National Institute Economic Review, May 1992 | Go to article overview

Fiscal Solvency in Europe: Budget Deficits and Government Debt under European Monetary Union


Caporale, Guglielmo Maria, National Institute Economic Review


Introduction

The debate on European monetary union has brought the issue of European fiscal policy into public scrutiny. This note discusses the problems of fiscal policy coordination in Europe over the next decade, and analyses the evolution of debt and deficits over the 1970s and 1980s. We then look more formally at the concept of a sustainable path for public debt and report on some tests that investigate whether or not debt paths in Europe have been on a stable trajectory. The note by Barrell and In't Veld in this Review considers the importance of fiscal solvency in constructing large scale macro models, and casts further light on the issues discussed here.

Fiscal policy issues and EMU

The prospect of monetary union in Europe has led to an increase in interest in the size and evolution of the government debt of the members of the European Community. The Maastricht Treaty on Monetary Union has laid down convergence criteria that potential members of the Union must meet. The Treaty explicitly refers to the need to 'avoid excessive public deficits', and sets the following thresholds which should not be exceeded:

- public deficits as a share of GDP should not be higher than 3 per cent;

- gross public debt should be contained within 60 per cent of GDP.

If these criteria were to be interpreted strictly it is very unlikely that EMU could go ahead according to the prepared timetable with all (or even most) of the member states of the EC as participants. Thus the importance attached to the fiscal indicators may well determine the whole shape of EMU at least in its early years. The EC Commission has expressed repeatedly its concern that the process of formation of the union should involve both keeping the evolution of debt stocks under control and constructing a set of effective fiscal safeguards.

Divergent fiscal trajectories could make the transition to EMU more difficult, because of their implications for exchange rate movements. This can be seen clearly within a portfolio approach to the determination of exchange rates. In such a theoretical framework, the main determinant of the exchange rate is asset equilibrium. If a large amount of public sector debt is issued denominated in one currency, this will change its equilibrium nominal exchange rate, and put downward pressure on it, which will have to be offset by market intervention or higher interest rates. EC countries could find it difficult to resist these pressures in the run-up to EMU. A budget deficit is commonly associated with a current account deficit, and hence a decline in net financial assets (the difference between gross assets and liabilities) for the economy as a whole. Therefore large budget deficits will often raise the risk premium on the currency of the country. If the nominal exchange rate is fixed, this will mean a higher interest differential, which conflicts with the objective of macroeconomic convergence. However, with the establishment of a monetary union assets denominated in different currencies will become perfect substitutes and risk premia will be abolished, thereby eliminating the problems encountered in the run-up to EMU.

Why then should the Community be concerned with the fiscal policies adopted by the individual states once EMU has been created? Should there be consistency between those policies and the common monetary policy at the Community level? The Delors Report (1989) asserted that 'the large and persistent budget deficit in certain countries has remained a source of tensions and has put a disproportionate burden on monetary policy' (paragraph 5), and voiced the concern that '...access to a large capital market may... facilitate the financing of economic imbalances' (paragraph 30). It also advocated 'binding rules... (involving) effective upper limits on budget deficits of individual countries' (paragraph 33).

Deficits have to be financed either by issuing debt or by creating base money.

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