Speeches and Presentations

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Introduction
Ladies and Gentlemen,
It is a great pleasure for me to address this symposium held in honor of Prof. Winckler. For this occasion, I chose a topic which is currently a burning issue and which touches on some of Prof. Winckler’s important academic work in the area of fiscal and monetary policy and their interaction in a monetary union. 

According to Art. 4(2) of the Maastricht Treaty, the primary objective of monetary policy ”shall be to maintain price stability.” Accounting for the fact that tensions may exist between fiscal policies on the one hand and a price stability-oriented monetary policy on the other hand, Art. 4(3) establishes that economic policies of Member States shall entail compliance with ”sound public finances” and ”stable prices.” Accordingly, governments have pledged to pursue fiscal policies as specified by the fiscal rules of the Maastricht Treaty and the Stability and Growth Pact (SGP).[1]

During the past few years, however, some countries faced serious difficulties in complying with these rules. Germany, France and Portugal had or have deficits clearly above the 3% reference value and improvement is not around the corner. Moreover, according to the latest European Commission forecast, budget figures show worrying signs of deterioration also in Italy, Greece and the Netherlands. As is well known, all these developments have intensified the political and economic debate about the euro area’s fiscal rules.


The Impact of Unsound Public Finances on the Economy and the Interaction of Monetary and Fiscal Policy

Let me start my analysis by briefly reviewing the impact of unsound public finances on the economy from a very general perspective. It is widely undisputed among economists and policymakers that excessive levels of public deficits and debt entail significant medium- and long-run costs. Sustained periods of government deficits drive up real interest rates, which adversely affects private investment and productivity growth.[2] High debt ratios will – sooner or later – increase the tax burden, thus generating distortions in the economy and, hence, efficiency losses. Furthermore, a large stock of government debt can quickly become difficult to control – a fact that might force governments to sudden discretionary tax increases or spending cuts. The resulting economic instabilities interfere with economic agents’ long-term consumption and investment plans. In addition, high deficits and a large stock of public debt can adversely affect the confidence of financial market participants and undermine the stability of the financial system. In sum, unsound public finances will reduce the medium- and long-term growth prospects of an economy.

Once these negative effects are recognized, one might pose the question why governments recurrently tend to run excessive fiscal deficits. In my opinion, the answer to this question is deeply rooted in the political process: Politicians have an intrinsic interest in being re-elected and, therefore, keep budget deficits higher than optimal while passing on the debt burden to future generations, which suggests the existence of a ”deficit bias” with negative medium- and long-term consequences for the economy.

It is well understood that unsound fiscal policies can also interfere with a price stability-oriented monetary policy. If the debt level is high, fiscal policymakers might be tempted to exert pressure on the central bank to lower interest rates or to monetize the outstanding stock of government liabilities. Such actions, provided that the central bank is forced to concede, would certainly be harmful for monetary policy credibility and ultimately lead to high inflation rates – and the economic and social costs of such a policy are well known from history. The most important conclusion to be drawn from this argument is to protect central banks from the financing needs of governments by ensuring their independence.

The ECB and many other central banks are independent and cannot be forced to monetize public debt; in the case of the ESCB, direct government debt financing is explicitly prohibited (Art. 21.1, Statute of the ESCB and the ECB). However, also in the absence of this channel of direct interference, fiscal policy may complicate the task of pursuing a price stability-oriented monetary policy because it has noticeable effects on price developments (through demand effects, indirect taxes, social security contributions, public sector wages, to give a few examples). 


The Necessity of Fiscal Rules in EMU

In a monetary union, fiscal discipline is, due to the presence of externalities, even more important. As recently argued by Prof. Bruni, monetary union membership can give rise to moral hazard and free-riding problems:[3]

First, moral hazard weakens the incentives for maintaining disciplined national budgets if fiscal policymakers expect that other member countries or even the central bank will bail out countries with unsustainable debt levels.
Second, in a monetary union member countries can engage in free-riding behavior because fiscal laxity in one country drives up the union-wide interest rate. 

The existence of these externalities, therefore, clearly justifies the fiscal rules laid down in the Maastricht Treaty and the SGP.
Some economists have argued that fiscal rules are not necessary, since market forces should in principle be able to penalize excessive borrowing by Member States. I think that EMU provides a good example for the difficulties in verifying this assumption: Observed default risk premia among EMU member countries are practically non-existent although debt-to-GDP ratios vary substantially from 33% in Ireland to 106% in Italy.[4] This observation is consistent with two different explanations:

First, financial markets lack trust in the ”no-bail out clause” of the Maastricht Treaty and hence spread country-specific risks across the whole Union; and, second, markets expect that debt-to-GDP ratios will ultimately decrease as Member States are expected to comply with the SGP in the longer term.[5]

In the light of the recent developments, the latter hypothesis can be more and more doubted. In any case, there are serious reasons to believe that the market mechanism will hardly deter monetary union members from pursuing unsound fiscal policies.

Furthermore, markets usually tend to react very slowly and hesitantly to rising deficit and debt levels. Then, at some point in time – and our knowledge about currency crises supports this notion – a sudden change in the market’s assessment may cause abrupt and strong corrections. However, when fiscal imbalances have already been built up, higher interest rates can quickly trigger a vicious circle of growing debt and further increasing interest rates. For all these reasons, I am firmly convinced that fiscal rules are a necessary condition for a credible and successful monetary union.


Some Issues of Relevance in Light of the Current Debate on the SGP

In the course of the discussion on Europe’s weak economic performance, it has been argued that the SGP should be changed or abolished altogether. According to some critics, the Pact imposes unacceptable constraints on the stabilization function of fiscal policy. The SGP is further criticized for limiting even Europe’s growth potential by hindering structural improvement through deficit financed investment in infrastructure. Not surprisingly, I do not share this view. Let me clarify my position.

Does the SGP overly restrict fiscal policy?

Sound fiscal policy with a medium-term orientation can significantly contribute to stabilizing the economy. However, due to time lags in policy implementation and uncertainties about the future course of the economy, discretionary fiscal demand management has often proved to be pro-cyclical rather than counter-cyclical. In contrast to discretionary measures, automatic stabilization provides a timely and symmetrical adjustment, and should hence be seen as a more appropriate response to business cycle fluctuations.

Under the provisions of the SGP, the degree to which automatic stabilizers can work, differs between countries which have already attained a budgetary position of ”close to balance or in surplus” in the medium run and countries which have not.
For countries that have reached a sound budgetary position, the SGP provides sufficient leeway for the full operation of automatic stabilizers without incurring the risk of breaching the 3% deficit reference value. 

Just now, to a large extent the SGP is questioned because three big countries are facing a limited room for maneuver. However, this is not a failure of the SGP. Rather, it reflects the fact that some countries did not take advantage of favorable growth conditions in the past to sufficiently decrease structural fiscal imbalances as other countries did. And I am convinced that it should be possible to reduce the structural deficit by 0.5% to 1% of GDP a year, given the size of the public sector in most European countries.

I also want to emphasize that it is important to focus not only on deficit reference values but also on debt levels. High debt countries – and currently, three Member States still have debt levels of above 100% of GDP – should pursue ambitious consolidations to ensure sustainable fiscal positions. 

What are the economic effects of consolidation efforts?

An important issue is the question of the short- and medium-term effects of fiscal consolidation. 
The traditional Keynesian view holds that fiscal retrenchment is associated with adverse short-term output and employment effects. However, this view has been seriously challenged. If individuals expect that consolidation efforts increase their permanent income or their level of wealth, via lower future taxes or lower interest rates, then current consumption or investment may actually rise. 

Supportive evidence for the presence of non-Keynesian effects of consolidation in European countries has been presented by the European Commission, which has analyzed the output effects on the basis of both comprehensive case studies of EU Member States and model simulations. 

According to the case studies, in total about half of all consolidation efforts had expansionary effects.
The simulation exercises reveal that fiscal consolidation in Europe may have a slightly negative effect in the short run, but clearly positive growth effects thereafter.[6] Furthermore, consolidation is more likely to be successful if individuals expect it to be permanent, credible and if it is based on expenditure reductions rather than tax increases.[7] 

Overall, the European Commission concludes that – and I quote – ”given the limited impact on output in the short run, these results are in contrast with the assertion that fiscal consolidation should be avoided during slowdowns and show that sizeable positive effects could materialise” in the medium- and long run.[8]

The growth prospects of sound public finances can further be enhanced by structural reforms. I think it is of great importance to provide measures that enhance the functioning of labor and product markets and to improve the quality of public expenditures. In this context, the Lisbon strategy gives good guidance and provides an important framework.
Therefore, I consider it crucial that countries which currently have high fiscal deficits take committed steps to move towards balanced budgets. This will not only widen the room for automatic stabilizers, but also allow for a credible and sustainable perspective of lowering the tax burden.

Is the overall framework of the SGP appropriate?

In my view, the SGP has many merits. It is simple and transparent, which facilitates monitoring and evaluation. In principle, the excessive deficit procedure, if enforced strictly, ensures the credibility of the SGP. Also, as argued before, the SGP offers sufficient flexibility for stabilization policy. Furthermore, the SGP, by requiring a budget position of close to balance or in surplus over the medium term, will induce a significant reduction in debt-to-GDP ratios. This is of particular importance in the light of substantial budgetary burdens which will be caused by aging populations.[9]

As such, the fiscal rules of the Maastricht Treaty and the SGP are appropriate. Nevertheless, there is scope for improvement concerning their implementation. 
In particular, to be able to identify a deterioration of underlying fiscal balances already at an early stage, an intensified surveillance and monitoring process of budgetary developments might be helpful. Measures which improve the quality and comparability of budgetary statistics (timely provision of data, application of rigorous accounting rules to avoid large data revisions) would enhance transparency and should facilitate the monitoring process. 

Furthermore, there is scope for improving the Pact’s enforceability. In fact, the strict enforcement of all rules and regulations is of paramount importance to the SGP’s credibility – and a problem nowadays. The current setting, in which those who should assess compliance with the rules are themselves subject to the rules, represents a shortcoming of the SGP. In particular, it needs only a few large countries to stop the process of the Excessive Deficit Procedure. In this context, a ”reversal of the normal onus of proof,” meaning that a qualified majority of votes would be necessary to prevent a decision in relation to the Excessive Deficit Procedure, would clearly strengthen the Pact’s enforceability.

Some have suggested also to strengthen the role of the European Commission, others, mainly academics, have even proposed to entrust an independent fiscal authority with the power of enforcement of the SGP. But, I am relatively sure that there is currently no political support at all for moving in such a direction. 


Conclusion

Ladies and Gentlemen, let me summarize and conclude.


EMU is unique in that it combines a centralized monetary policy, primarily focused on prices stability, and decentralized fiscal policies. In such an institutional setting, fiscal rules are indispensable.
The fiscal rules of the Maastricht Treaty and the SGP provide an appropriate framework for fiscal policy. They contribute to a macroeconomic environment conducive to non-inflationary economic growth while allowing for sufficient flexibility for stabilization policy.
In fact, these fiscal rules have induced a significant improvement in fiscal positions during the 1990s and some Member States have taken advantage of favorable growth conditions to remove fiscal imbalances. 
In light of current developments, it would be a grave mistake to weaken the Pact. Any such step would undermine the credibility of Economic and Monetary Union and of the single currency. It also would send a wrong signal to the new Member States in Central and Eastern Europe. Therefore, I hope very much that the next meeting of ECOFIN will be more successful than the last one.

Thank you very much for your attention!


Bibliography


Ball Laurence and Gregory N. Mankiw (1995), ”Budget Deficits and Debt: Issues and Options”, in Rethinking Stabilization Policy, Proceedings of the Symposium of the Federal Reserve Bank of Kansas City, Jackson Hole, August 29-31, 2002, p. 95-119.

Bertola Giuseppe and Allan Drazen (1993), ”Trigger Points and Budget Cuts: Explaining the Effects of Fiscal Austerity”, American Economic Review 83(1), March, p. 11-26.

Bruni Franco (2003), ”Fiscal Discipline in a Monetary Union: Issues for the EuroArea”, Manuscript of a Speech given at the SUERF Meeting, Banque de France, 24th October 2003.

Canzoneri Matthew B., Robert E. Cumby and Behzad T. Diba (2002), ”Should the European Central Bank and the Federal Reserve Be Concerned about Fiscal Policy?”, in Rethinking Stabilization Policy, Proceedings of the Symposium of the Federal Reserve Bank of Kansas City, Jackson Hole, August 29-31, 2002, p. 333-389.

European Commission (2003), ”Public Finances in EMU”, http://europa.eu.int/comm/economy_finance/publications/european_economy/public_finances2003_en.htm.

Giavazzi, Francesco und Marco Pagano (1996), ”Non-Keynesian Effects of Fiscal Policy Changes: International Evidence and Swedish Experience”, Swedish Economic Policy Review, 3(1), p. 67-103.




[1] Relevant Articles in the Maastricht Treaty are Article 99 (”Multilateral Surveillance”), Article 103 (”No-bail-out clause”) and Article 104 (”Excessive Deficit Procedure”). The SGP consist of: 1) Council Regulation (EC) No 1466/97 of 7 July 1997 on the strengthening of the surveillance of budgetary positions and the surveillance and coordination of economic policies [Official Journal L 209 , 02/08/1997 p. 0001 – 0005]; 2) Council Regulation (EC) No 1467/97 of 7 July 1997 on speeding up and clarifying the implementation of the excessive deficit procedure [Official Journal L 209 , 02/08/1997 p. 0006 – 0011]; 3) Resolution of the European Council on the Stability and Growth Pact (Amsterdam, 17 June 1997) [Official Journal C 236 of 2 August 1997].
[2] Canzoneri, Cumby and Diba (2002); Ball and Mankiw (1995).
[3] Bruni (2003).
[4] The data represent 2003 figures and are taken from European Commission (2003).
[5] Bruni (2003).
[6] European Commission (2003).
[7] Compare with Bertola and Drazen (1993); Giavazzi and Pagano (1996)
[8] European Commission (2003, p. 123).
[9] The costs of population aging are expected to lead to increased spending of between 3% and 7% of GDP by 2040 (Source: Preparation of Eurogroup and Council of Economics and Finance Ministers, Brussels, 3-4 November 2003, http://europa.eu.int/rapid/start/cgi/guesten.ksh?p_action.gettxt=gt&doc=MEMO/03/215|0|RAPID&lg=EN&display=.)