Monetary union and fiscal policy in member states
Co-insurance through a federal budget
- an asymmetric shock could cause problems for the EMU - once monetary
policy is unified, fiscal policy is the only instrument left, although
state-level fiscal policy is restrained by the Maastricht Treaty
- centralised budget would act as a co-insurance system (like the Federal
budget in USA or Germany)
- the budget surplus in the state benefiting from the shock would go
to offset the budget deficit in the country which was suffering from
the shock – automatic stabilisation
- e.g. in USA a fall of $1 in disposable income is met with $0.40 Federal
payments
- even if political difficulties rule out a federal budget, there could
still be a fund to act as a co-insurer
Arguments For & Against a federal budget
- against: there is no need – just increase labour mobility
- against: there is no political institution good enough to decide on
how a massive (25% of GDP) budget would be spent (or raised!) – there
is potential for a lot of disagreement - “no taxation without representation”
- for: EU budget is already involved in redistribution
Critique
- the stabilisation funds required are comparable with those used within
EU states now i.e. 35 – 40%
- there is no central budget to bring this about (EU budget just 1.2%
of EU GDP)
- proposed solution has been to remove the barriers so that migration
of workers & flexible wages can solve asymmetric shocks rather than
using redistribution of funds from one state to another
- large debts which could be used to pay for a budget deficit after
an asymmetric shock are banned (although up to 60% of GDP)
- freedom of fiscal policy is open to misuse, one state’s actions impose
externalities on other states – see below
MacDougall committee 1977
- Recommended centralisation with a federal budget of initially 2 –
2.5% of GDP (as opposed to 1.2% now)
- Increasing to 20-25% of GDP in a political union
- If wages are not flexible or labour immobile, then theory of optimum
currency areas suggests the need for a centralised budget to cushion
asymmetric shocks
Fiscal discipline and co-ordination of fiscal policy after monetary
union
- externalities of government budget deficits in monetary unions
-
- one state running a budget deficit requires borrowing, and in a monetary
union this raises the union interest rate, imposing an externality on
the other states as they have to increase the interest payments to service
their debts, all states then have to reduce their government spending
as resources are diverted to the increased interest payments
- also there is strictly no printing money (monetisation of debt) a
tactic sometimes used in the past a.k.a. seigniorage
- stability pact to combat this moral hazard caused by this and also
the potential need for an overspending state to be bailed out by the
other states
- tight fiscal policies may cause problems as governments are used to
being able to suddenly bail out the NHS for example
- fiscal policy is often affected by political factors, such as a pre-election
tax cut or spending spree – a sort of political business cycle model
Stability Pact
- This reasoning led to the restrictions in the Maastricht Treaty of
a maximum budget deficit of 3% of GDP (flow) and a maximum debt of 60%
of GDP (stock)
- System of fines if countries disobey this – fines of of 0.2% to 0.5%
of GDP
- But fines would increase a country’s problems at a time when it is
probably suffering from a recession
- In summary:
- countries have to aim at achieving a balanced budget
- countries with a budget deficit of over 3% will be fined up to 0.5%
of GDP
- fines will not be applied if the country is in exceptional circumstances
Fines may lack credibility especially if imposed on an already ailing
economy
- the PSBR rules are to prevent any state borrowing too much (think
back to rule about growth having to be greater than the interest rate
in order to pay off debts)
- evidence from USA is that states try to cheat by putting spending
off budget in order to keep within the debt limits
Capital markets will not really be able to differentiate between bonds
from different countries once EMU has been up and running a while
- after 2002 it will not be possible for countries to pull out of EMU
so it will not be possible to demand different interest payments from
bonds originating from different states
- reinforces idea that there will be externalities in terms of the interest
rate if one state decides to borrow heavily to fund an excessive budget
deficit
Seigniorage
- Mediterranean countries sometimes used monetary expansion to raise
funds esp. in the 1970s, but much less now
- It can cost less than raising taxes where tax collection is undeveloped
- It is essential for EMU that all member states have a tax system efficient
enough so that there is no reliance on seigniorage to raise revenue
for the government
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