Academic journal article National Institute Economic Review

Fiscal Policy and EMU

Academic journal article National Institute Economic Review

Fiscal Policy and EMU

Article excerpt

1. Introduction

If monetary union goes ahead in Europe (or in part of it) this must, whether countries like it or not, involve a comprehensive change in the framework of macroeconomic policy formation - a change in regime. Clearly, a key issue is what happens to fiscal policy. What is its role when nominal exchange rates are irrevocably fixed and differential monetary policies are ruled out? How should it be co-ordinated between countries and how should it relate to a centralised monetary and exchange-rate policy for the union as a whole? These are large questions and past experience, country by country, may be a poor guide to future requirements or problems. It is necessary to ask some rather fundamental questions about how fiscal policy works and about what it is for - in the short term and in the medium term.

The line developed in this article is that fiscal policy will indeed need to be more actively used for short-term stabilisation in a future common currency area, but that its role needs to be carefully defined: fiscal policy is an appropriate response to demand shocks but not to a sustained change in relative competitiveness. Contrary to the 'fiscal federalist' position, this need not involve centralisation. But the co-ordination difficulties are serious and tend towards too little fiscal activism rather than too much.

This latter tendency is much exacerbated by a different problem - the medium-term objective in most European countries of curtailing deficits and debt under the Maastricht fiscal convergence criteria. These are usually seen as an imperfect response to the potential need, in the medium term, to contain 'irresponsible' fiscal authorities. Here, it is argued, they are better seen as reflecting a coordinated response to the generalised objective of fiscal consolidation in Europe and, as such, something similar is also likely to be a feature of Stage 3 of the Maastricht process.

The clear danger is that governments are underestimating the difficulties of fiscal consolidation in a large area such as Europe. Success would require a sustained, medium-term rise in private sector investment (or reduced private savings) which is unlikely to happen automatically. A significant, perhaps very significant, cut in interest rates is needed.

The key issues concern the interactions between the short and medium-term problems. Whilst we argue that fiscal policy could plausibly be decentralised, the real challenge is to design a system which delivers short-term stabilisation against demand shocks whilst containing the rise in debt in the medium term.

The article is organised as follows. The next section sketches some of the background to the debate over fiscal policy and EMU. Section 3 puts forward a view of the role [TABULAR DATA FOR TABLE 1 OMITTED] of fiscal policy, in the short term and the long run. Section 4 is concerned with the Maastricht-type issue of medium-term control over fiscal deficits and debt. Section 5 turns to the key role of fiscal policy in short-term stabilisation - a role which would become more important under EMU with no scope for differential monetary or exchange-rate policies. Section 6 concludes.

2. Background

It is widely agreed that with currency union in Europe, fiscal policy would need to play a larger role. Thus, the Delors Report called both for an increase in regional and structural expenditure under the EC budget and for coordination of national fiscal policies. In the Maastricht treaty, the emphasis shifted markedly away from an enhanced positive role for fiscal policy to the avoidance of the negative effects of large deficits and debts, with the famous convergence criteria under Stage 2 of limits of 3 per cent for government deficits and 60 per cent for government debt. When written into the protocols, these were about average levels for the EC countries. Slow growth and recession in the 1990s have meant that very few countries are likely to meet the criteria - probably not even France and Germany - unless draconian policies are instituted or the criteria are interpreted 'flexibly' (see Table 1). …

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