Fiscal and monetary policy in EMU
Speech by José Manuel González-Páramo,
Member of the Executive Board of the European Central Bank
10. Internationales Finanz- und Wirtschaftsforum
Vienna, 11 November 2004
We European central bankers have a unique perspective from which to view the interaction of fiscal and monetary policies. Unlike most central bankers around the world today, and throughout history, our point of reference is no longer the traditional one-to-one fiscal-monetary policy relationship. At the European Central Bank (ECB), we have to concern ourselves with the implications for our monetary policy of the 12 fiscal policies of the countries of the euro area.
The economic policy framework of Economic and Monetary Union (EMU) combines a supranational monetary policy, conducted at the euro area level, with decentralised fiscal policies, which remain the responsibility of national governments. Such a Monetary Union was only made possible by the emergence of a consensus that macroeconomic stability, built on sound public finances and a stability-oriented monetary policy, is a prerequisite for sustainable economic growth.
The framework for fiscal and monetary policies in EMU is built around this consensus. Under this framework, sound public finances are to be guaranteed by the commitment of Member States to avoid excessive deficits and to correct them promptly should they nonetheless occur. In this respect, the Stability and Growth Pact puts “flesh on the bones” of the fiscal rules and procedures of the Maastricht Treaty. It strengthens and clarifies the procedures for mutual surveillance and peer pressure among Member States. And by committing Member States to achieve close-to-balance or in-surplus budgetary positions over the medium term, it aims to ensure that the avoidance of excessive deficits does not come into conflict with the operation of automatic stabilisers in the short term.
Meanwhile, monetary policy is conducted by an independent central bank with a clear mandate to maintain price stability. Monetary policy is thus protected from short-term political considerations. It is also protected from the direct effects of fiscal policy. Monetary financing is prohibited. And the Eurosystem is explicitly forbidden to “bail out” Member States with financial difficulties. In short, fiscal and monetary policies are kept at arm’s length from one another.
Of course, fiscal and monetary policies matter for each other in EMU as anywhere else. For this reason, a regular dialogue between the fiscal and monetary authorities takes place, in particular in the Eurogroup. But this does not imply any ex ante coordination or blurring of responsibilities. Rather, each institution and government is responsible for “keeping its own house in order”.
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What can be said after nearly six years of experience with this framework? First, the “Maastricht consensus” remains valid. At least, I do not hear voices directly questioning the need for sound public finances and price stability. Second, monetary policy is doing its job. Markets and the general public seem confident that the Eurosystem will live up to its mandate. Third, fiscal policies are proving more problematic. In a number of countries, fiscal positions have deteriorated in recent years. Excessive deficits have emerged. And the procedures of the Stability and Growth Pact aimed at preventing and correcting these excessive deficits have not always been properly complied with.
This lack of compliance calls into question the effectiveness of the EMU fiscal rules. And it has led to an intense debate, in academia, among the informed public and among policy-makers. I should like to concentrate the remainder of my remarks on this debate; to ask, and hopefully provide some answers to, questions related to this debate: Why do we need fiscal rules in EMU? Are there costs associated with these rules? Are our rules sensible? And, finally, what can be done to improve their implementation?
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Let me start with why we need fiscal rules at all. In this respect, I think it is useful to distinguish between the single country case and the specific context of EMU.
In a purely national setting, fiscal rules are very desirable as part of an institutional design geared towards achieving sound public finances. It is by now widely accepted that governments driven by the short-term interest of re-election are prone to increasing deficits and debt. Fiscal rules at the national level can help to correct this “deficit bias”. By committing governments to achieve a certain fiscal outcome, fiscal rules can also create appropriate benchmarks for markets and the public to judge fiscal policy.
Fiscal rules should prevent unsustainable debt developments. To the extent that they succeed in fostering sustainability, they should help to mitigate uncertainty as to government actions and thereby facilitate the long-term planning of economic agents. They can also contribute to improving the quality of public finances by influencing the size and composition of government spending and taxation.
For these reasons, fiscal rules at the national level are in the interest of the country concerned. The absence of such rules would possibly lead to higher deficits and debt, but whether or not to adopt such rules is essentially a domestic issue.
In EMU the situation is intrinsically different. Because the countries of the euro area share a common currency, the externalities arising from their fiscal policies are of a completely different order of magnitude. And these externalities are liable to give rise to adverse incentives.
In a monetary union, it remains primarily the country relaxing its budgetary policy that enjoys the short-term political benefits. But, in so doing, it taps the common pool of savings, putting upward pressure on interest rates in the whole euro area. Part of the cost of borrowing is thereby passed on to other member countries. In the absence of exchange rate risks within the monetary union, the sanctioning role of financial markets also declines. This can clearly be seen in euro area government bond yields, which point to a narrowing of spreads across countries and the emergence of a highly integrated bond market. And if excessive borrowing in one country or group of countries leads to inflationary pressures or even, in the extreme, to a risk of default, the implications in terms of monetary policy and financial stability will be felt by all the members of the union.
In a monetary union, fiscal rules are essential not only to contain domestic deficit biases but also to protect against cross-country externalities and adverse incentives. Indeed, without such rules, the countries of the euro area would never have agreed to share a common currency.
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Even if fiscal rules are necessary in a monetary union, do they nonetheless imply costs? Some would argue that fiscal rules limit the stabilisation function of fiscal policy; and that in EMU active fiscal policies are all the more necessary given the loss of monetary policy as an instrument with which to deal with country-specific shocks.
This argument assumes that activist fiscal policy is effective in helping to stabilise the economy. But both theoretical and empirical research raise doubts about the success of active fiscal stabilisation policies.
Indeed, the past experience of most countries shows that the use of discretionary fiscal policy for short-term demand management is extremely difficult to implement successfully. Given the time-lags involved in recognising the cyclical situation and then passing the necessary legislation, the impact of the measures taken often comes too late. In some cases, discretionary measures intended to be counter-cyclical even turn out to be pro-cyclical by the time their impact is felt. And expansionary fiscal measures have proven difficult to reverse, exacerbating the deficit bias of governments.
The limitations of an active fiscal policy may be even greater when there is uncertainty about future income developments. This is the case today in many European countries where there is growing concern about the difficulties faced by public pension and health care systems in view of demographic trends. Under such circumstances, tax cuts and expenditure increases today simply translate into higher taxes or lower expenditure tomorrow. Aware of this, the public increasingly reacts to fiscal expansions by raising precautionary savings rather than consumption.
In contrast to active fiscal stabilisation, the public budget is, generally, an effective tool for smoothing cyclical fluctuations automatically. It does this through the operation of its built-in stabilisers. Most tax revenues and certain social benefits respond counter-cyclically to output fluctuations. And they do so with more or less immediate effect and without any discretionary action on the part of government.
However, fiscal policy can only act as an effective stabilising tool when there is the necessary room for manoeuvre. The experience of industrialised countries in recent decades clearly shows that persistent fiscal imbalances limit the room for fiscal policy to stabilise the economy. Imbalances often necessitate tight fiscal policies during downturns to prevent unsustainable deficits and debt developments. Well-designed fiscal rules should address this problem. In the case of the Stability and Growth Pact, the close-to-balance-or-in-surplus requirement is intended to create room for automatic stabilisation while respecting the 3% limit on budget deficits. And respecting this requirement should ensure appropriate debt developments so that sustainability is not put at risk. In this way the rules should support rather than limit the stabilisation function of fiscal policy.
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Fiscal rules are necessary in a monetary union to ensure long-run sustainability. And, if appropriately designed, they should not imply costs in terms of short-run stabilisation. But are our rules well-designed? Do the rules of the Stability and Growth Pact make economic sense? This is a hotly debated question. It is also a complex question; and answering it requires an appropriate perspective and a certain amount of realism.
It has to be borne in mind that the Stability and Growth Pact is not a rule for a single country. It is a framework for ensuring fiscal discipline among the 25 Member States of the European Union, and is particularly important for the 12 countries of the euro area. Designing a set of rules in a multinational context is always going to be more challenging than designing rules for the single country case. On the one hand, what makes sense for one country will not always make sense for others; but on the other hand, you can’t have different rules for everybody. Fairness demands equal treatment.
In the real world, a number of trade-offs have to be made. The rules need to be based on an appropriate economic rationale. But they also need to be simple and transparent enough to allow for appropriate monitoring and scrutiny, including by markets and by the public. Elaborate rules may be intellectually appealing to economists. But what use are they if the measures on which they are based cannot be computed within any reasonable degree of certainty? What use are rules if they are so complex that it is almost impossible to determine whether they are being respected or not?
The rules need to be simple enough to be understood and strict enough to ensure fiscal discipline. But there also needs to be enough flexibility to take into account unusual or unforeseen events. A balance therefore has to be struck between a more mechanistic application of the rules and the exercise of judgement; between rules and discretion.
All of these issues were debated when the Stability and Growth Pact was first proposed. And the outcome of this debate was already a sensible compromise: a reflection of the need to combine economic soundness with simplicity and transparency, to balance rules and discretion. This does not mean that alternative rules would not have been possible. But by and large the current rules are appropriate. They strike the right balance. I fear that those who would like new, supposedly better, rules risk embarking on a quest for a holy grail that doesn’t exist. And they would do so unnecessarily. Nowhere has it been established that the existing rules are the source of current fiscal problems. Rather, it is the lack of implementation of the rules that is the problem. This is where we need to focus our attention.
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But how can the implementation of the Stability and Growth Pact be improved?
A first, admittedly rather simplistic, answer to this question is for governments and institutions to start living up to their commitments. If all Member States had vigorously pursued the Pact’s close-to-balance-or-in-surplus objective during the last upturn, then the current fiscal problems would be much less severe. We must learn from such mistakes.
Beyond this, a number of proposals put on the table by the European Commission represent a step in the right direction. Strengthening the focus on debt and sustainability when scrutinising national budgets would enhance the economic rationale and hence, potentially, support for the rules. Adjusting the timetable for multilateral surveillance – so that the examination of countries’ stability programmes precedes the preparation of national budgets – could help to ensure that peer pressure at the European level translates into policy action at home. A more timely use of the “early warning mechanism” could also create additional pressure to comply with the rules in good times.
Improving the information base for fiscal surveillance is also of crucial importance. If fiscal surveillance is based on wrong or outdated figures, not only will it be ineffective, but judgements made and decisions taken are likely to be wrong. It is therefore of vital importance for the credibility of fiscal surveillance that the reliable and timely reporting of government finance statistics is ensured. The European accounting rules must be fully respected when recording all types of expenditure and revenue. This should be done in a manner that is consistent and stable over time and homogeneous across countries. As stated by the ECOFIN Council, budgetary statistics must not be vulnerable to political and electoral cycles. Countries must consider the quality and integrity of their statistics as a priority matter.
If introduced and applied sensibly, many of these changes to the way the Stability and Growth Pact is implemented that have been proposed by the Commission could give rise to improvements. But one should also not raise false expectations. At the heart of the current problems is an issue of lack of compliance and lack of incentives. There is no magic formula for solving these problems.
What can be said, however, is that the current problems will certainly not be addressed by changing the Regulations of the Pact and by further complicating the rules. In this respect, proposals to make the Excessive Deficit Procedure more flexible are a cause for serious concern. If implemented, these changes would weaken rather than strengthen incentives for fiscal discipline. And they would erode the credibility of the 3% nominal anchor.
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Let me end my remarks by recalling that, in the field of monetary policy, the answer to the problem of the “inflation bias” that plagued many countries for several decades was one of governance, namely, granting independence to central banks. With an independent central bank, the euro area already has a highly predictable monetary policy. There is no ambiguity as to how monetary policy will respond to economic – including fiscal – developments. It will respond to the extent that they pose risks to price stability.
Unfortunately, the problem of the deficit bias of fiscal policy does not lend itself to such a simple solution. Nonetheless, I perceive a need to reflect further on governance issues and the strengthening of incentives for compliance, both at the European and at the national level, if the implementation of the Pact is to be fundamentally improved. Governance structures must provide the right incentives for the governments and the institutions concerned to interact in a way that ensures fiscal discipline. Responsibilities – and hence accountability – must be clear. And above all, there must be the political will to comply with the rules and to apply the procedures in a strict and timely manner. Only then is there a chance that fiscal policy in the euro area will work without conflict towards a higher level of welfare and employment. And only then will a European central banker who is asked to talk about fiscal and monetary policy be inclined to focus a little less on the former and a little more on the latter.