Lars Calmfors, What Remains of the Stability Pact and What Next? SIEPS 2005:8
November 8, 2005
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The risk of a deficit bias under discretionary political decision-making provides a general argument for constraints on fiscal policy. Fiscal rules represent one form of such constraints. The underlying idea is that commitment to such rules at the “constitutional level” are easier to uphold than commitments to specific discretionary policy actions, because violations of rules impose larger reputational costs on decision-makers.
This does not, however, explain why such rules should be supranational – like the EU fiscal rules – rather than national.
In principle, there exist two sets of motivations for such supranationality.
The first rationale for supranational rules is that they may be more effective than national rules even if the deficit bias arises for purely domestic reasons.
The second type of justification for supranational fiscal rules is that policies in one country may have negative spillover effects on other countries that are not duly taken account of at the national level. In particular, a national deficit bias may be exacerbated in a monetary union because part of the cost of government debt accumulation for an individual country can be shifted on to the other member countries. In a country that has its own currency and a flexible exchange rate, a large government budget deficit is likely to trigger increases in both short-term interest rates (because of the response of the national central bank to the implied threats to price stability) and long-term ones (because of changes in inflation expectations in financial markets) as well as exchange rate changes. But such reactions will be eliminated if a country is a member of a currency area with a common monetary policy that responds only to area-wide developments. This means that an important disciplining force for fiscal policy has disappeared.
Another reason for a worsening of the deficit bias in the EMU is the probability that other countries will be forced in the end to bail out an individual country that runs unsustainable government deficits. This creates a so-called moral hazard problem, as the incentives at the national level to avoid such deficits are reduced. Ex post, other countries in a monetary union face a strong temptation to bail out a defaulting government, as government bankruptcy in one country can cause large capital losses for lenders in other countries and lead to systemic financial crisis.
A bail-out can be direct if other governments assume debt-servicing costs or if the ECB buys up the debt of the government in question. But the largest risk is indirect bail-outs through inflation. The argument is that, even if the ECB tries ex ante to achieve price stability, it will not be able ex post to withstand pressure to reduce the real value of outstanding debt through inflation, if debt levels are very high.
When a country has its own currency, its government has an incentive to fully consider the risk that large debt accumulation will in the end force the central bank to allow higher inflation. But in the euro area, the budget deficit of each government has only a small effect on the total stock of euro-dominated government debt and hence on the incentives of the ECB to allow inflation. Therefore, each government will not take all the effects of its debt accumulation into account. In the absence of rules constraining fiscal behaviour, this may ultimately result in excessive levels of both government debt and inflation.
Such fears that fiscal indiscipline – mainly in Italy and
other Southern European countries – would jeopardise price stability in the
whole euro area was a major driving force behind the original German
proposals on the stability pact in 1995. 18
18 A detailed account of the genesis of the stability pact is given by Stark (2001). See also Costello (2001).