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European Fiscal Policy

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European Fiscal Policy:
Coordination of fiscal policy in Eurozone
Wibowo Suhaidi (1235036) Tilburg University Course: Financial Economics Professor: S.C.W. Eijffinger October 2011

ABSTRACT The Stability and Growth pack has been discussed extensively in determining whether it is sufficient to undermine fiscal policy coordination in the Eurozone. Even before the recent sovereign debt crisis hitting the Eurozone the SGP has been in much of critics and the current situation calls for deeper analysis on the SGP and whether more coordinated fiscal policy in Eurozone is necessary in strengthening fiscal policy framework. This paper analyzes the implementation of fiscal policy in Eurozone with the SGP as the guideline and found out that despite effectively maintain the budgetary balances of Eurozone countries, the SGP failed to deliver overall fiscal stability. Therefore, a more coordinated form of fiscal policy is required in order to achieve the goal of fiscal stability in Eurozone.

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I. Introduction The formation of European Monetary Union and the adoption of Euro as the single currency have the consequence that member countries are losing their monetary policy independence at the national scope. Therefore, one possible solution is to use fiscal policy in order to mitigate the asymmetric shocks, as fiscal policy is still on the hand of the national government of each member countries. However, from the Monetary Union point of view it is not desirable to leave fiscal policy absolutely on the hand of the national governments as it has the potential to create negative spillovers within the Union. One example of the negative spillovers is when the national governments perform an excessive budgetary deficit and gives an extra inflationary pressure to the ECB. Other negative spillover is the inflationary debt bailout1, this can happen when excessive debt taken by member countries leads to fiscal trouble, which further spread and disrupt the bond markets and the banking system, thus forcing the ECB to bailout in order to save the banking and financial system, with the cost borne not only by the citizen of the offending country but also the citizen of the EU as whole. In order to avoid the danger of the negative spillovers when fiscal policy is fully in the objective of the national governments, the Eurozone adopted the Stability and Growth Pact (SGP) in 1997 as a tool to maintain fiscal discipline and to monitor fiscal policy implementation in the Union. The major aims of the SGP are to maintain sustainable budgetary balances and low public debt level (Buti et al., 2003). The SGP consists of fiscal monitoring of member countries by European Commission and the Council of Ministers, in which require the budget deficit not to exceed 3% of GDP and the debt level not to exceed 60% of the GDP. The SGP also suggests member countries to have fiscal position in balance or surplus in the boom period in order to leave room for automatic stabilize to operate in the case of recession. However, the SGP is not free from critics2 and there are some proposals for reform. Furthermore, the fact that the Eurozone is currently under financial crisis derived from the bad fiscal policy implementations from some of the member countries has created one

1 Eichengreen B. and C. Wyplosz (1998), The Stability Pact: More than a Minor Nuisance. 2 According to the criticsthe SGP has several shortcomings: it reduces budgetary flexibility; work, s asymetrically; is too uniform; does not sanction politically motivated fiscal policy; discouraged public investment; disregard the area fiscal stance and long term sustainability; and hamper economic growth (Buti et al., 2003)

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question mark on whether the EU should have a more coordinated fiscal policy, and that is what this paper is trying to address. The organization of this paper is as follow: Section 2 will discuss and review the past literatures in this topic; Section 3 will be the main part of the analysis and divided into two parts, in the first part empirical analysis is performed to review the current fiscal policy implementation in the EU and whether it is already on the line with the SGP, the data for the empirical analysis are gathered from IMF and the World Bank. The second part is dealing with the question: what kind of fiscal coordination is optimal given the characteristics of Eurozone and the types of crisis that hit the region3; and finally Section 4 will be the conclusion. II. Review of the Literature There are some literatures that already dealt with the fiscal policy implementation in Europe (and especially the Eurozone). Eichengreen and Wyplosz (1998) discussed the cost and benefit of the SGP as the framework of fiscal policy implementation the EU and came up with the conclusion that the benefit of the SGP is as small as its cost. One interesting remark regarding their literature is that they singled out the prevention of inflationary debt bailout as one of the rationales of the SGP, which in the present time proven to be wrong as the ECB had to bailout the likes of Greece and Portugal as the result of the sovereign debt crisis affecting those countries. Buti, Franco, Ongena (1998), discussed the implementation of the SGP post-EMU and examined the potential problem that can arise in the early years if EMU in the transition to balance budget in the time of economic slow down. They stressed the importance of having a close to balance or in surplus in good times in order to give room for automatic stabilizers to operate in bad times. Therefore they argued that the SGP should change the behavior of the member countries that tend to be pro-cyclical in good times via close monitoring and early warning system. Buti, Roeger, and In’T Veld (2001) analyzed the game between an inflation conservative central bank and a fiscal authority subject to upper limit in the budget deficit level in response to the shocks. They found that under non-cooperation deficit bias will

3 using the result from Beetsma et al (2001) 3

arise when the fiscal authority tries to push the output level beyond its natural level, and under cooperation with the same characteristic of the fiscal authority, not only deficit bias but also inflation bias will arise. They also mentioned that when the fiscal authority only pursues the cyclical stabilization the biases are disappeared and the cooperation leads to positive outcomes. Beetsma, Debrun, and Klaassen (2001) did the similar analysis with what have been done by Buti et al. (2001) but they also incorporated the Stackleberg coordination in the analysis beside the non-cooperation and cooperation (under Nash). They also differentiate the types of shocks between asymmetric and symmetric shocks and the types of fiscal authorities between representative and liberal4. Their finding will be discussed deeper in the analysis part of this paper. Buti, Eijffinger, and Franco (2003) examined the proposals of reform of the SGP and concluded that there is no need to totally ditch the SGP for a new fiscal policy framework as they argued that the benefits of the available proposals are achievable through the improvement of the SGP. They proposed to redefine the medium-term budgetary targets, improving transparency, tackling the pro-cyclical bias, moving towards nonpartisan application of the rules, and improving transparency in the data. Gali and Perotti (2003) found the evidence that EMU countries have the tendency to become more countercyclical post Maastricht Treaty. Faini (2005) examined the relationship between fiscal policy and interest rates particularly in the Eurozone. He found a positive but weak relationship between an increase in budget deficit and the increase in interest rate. Despite the weak relationship he found out further that there is a substantial interest rate spillovers among EMU members. He also noted that the spillovers are larger for high debt countries with unsustainable fiscal policies. III. The desirability of Fiscal Coordination in the EU Review on current development of coordinated fiscal policy within EMU

4 Representative fiscal authorities taking into account the inflation as the consequence of their policy and minimize the social cost while liberal fiscal authorities does not take into account the inflation and tend to minimize their loss function rather than the social cost attributed to their policy.

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In order to address the question of whether the Eurozone should have a more coordinated fiscal policy, the current implementation of fiscal policy will be reviewed to see whether it is on the line with the aim of the SGP as the framework of fiscal implementation. It is interesting to see whether EMU member countries are actually following the reference level of budgetary deficit and debt level and whether the SGP is credible in refraining to bailout member countries in the case of when crisis arise. Using the budget deficit level as the percentage of GDP of Eurozone for the period between 1995 and 2009, Figure 1 shows that countries in Eurozone are in general have lower budget deficit level compare to the reference level of the SGP. However, whether this finding implies that Eurozone countries have actually implemented good fiscal policy is not necessarily clear. Fiscal authorities have the incentives to set the budget deficit level just a little bit lower or the same with the reference value in order to avoid punishment from the SGP. When this is the case, then it is not aligned with the aim of the SGP as countries will just maintain the budget deficit at a ‘save’ level and not to pursue budgetary balance or surplus in the boom period in order to give room for the automatic stabilizers to work in the period of recession. Figure 1: Budget deficit level compare to the reference value

-8 1995

-6

-4

-2

0

2000 Period Budget Balace

2005

2010

Reference-B

5

In order to determined whether the argument above is correct, it is useful to analyze

whether Eurozone countries conduct countercyclical or pro-cyclical fiscal policy. Using the same data as in Figure 1 and incorporating it to the regression model: Budget Deficit Balancet = β0 + β1* Budget Deficit Balancet-1 + β2*Debt Levelt-1 + β3*Output Gapt-1 + ut The model is to predict the budgetary balance (in deficit) of current period based on the previous period budgetary balance along with the previous period debt level and output gap. We get the following result: Table 1: Regression result

(1) budgetbala~e budgetl1 0.222 (2.05) 0.0230 (0.66) 0.526* (3.13) -2.563 (-1.28) 14

debtl1

outputgapl1

_cons

N

t statistics in parentheses * p

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