Rotating Slumps in a Monetary Union

In the decade since its creation in 1999, the European Economic and Monetary Union (EMU) has experienced surprisingly large and persistent inflation differentials across member states causing substantial shifts in relative price levels. At the same time, member countries exhibited distinct non-synchronized output fluctuations, giving rise to a pattern of ‘rotating slumps’ (a term coined by Olivier Blanchard). This paper presents a stylized theoretical model of a monetary union which demonstrates how inflation differentials and relative output movements interact dynamically. A number of implications are derived from the model. In particular, national fiscal policies are shown to have an important role in containing internal macroeconomic disparities in a monetary union. An optimal fiscal policy rule is derived from the model for that purpose.     

The Macroeconomic Role of Fiscal Policy

This article examines the new consensus that fiscal policy shouldhave no macroeconomic role in ‘flexible inflation targeting’regimes. There is little basis for this presumption. Fiscalpolicy remains important in setting the policy mix and in managingshocks and imbalances. The credibility of an inflation-targetingregime should be enhanced rather than reduced if fiscal policyplays its proper role. It is true, nevertheless, that the costsof focusing fiscal policy narrowly on public-sector concernsmay not be very great, most of the time. However, when interestrates cannot be used, the role of fiscal policy must be different.With interest rates at their lower bound of zero, there is noplausible alternative. For asymmetric shocks and adjustmentsin EMU, fiscal policy needs, ideally, to substitute for theinterest-rate policy reaction function of the consensus, butthe difficulties are very great. We suggest a policy focus onreal exchange rates as a way of resolving some of the dilemmas.There is a serious danger that orthodox views about fiscal policy,drawn from the consensus, will be inappropriately applied, especiallyin Europe. Footnotes ¹ E-mail addresses: christopher.allsopp{at}new.ox.ac.uk; david.vines{at}economics.oxford.ac.uk     

Macroeconomic adjustment programmes in the euro area: an overall assessment

Since the start of EMU (Economic and Monetary Union), the euro area, and more broadly the global economy, experienced an unprecedented credit boom. The expansion of credit was particularly strong in Greece, Ireland, Portugal and Cyprus and all of them subsequently needed official financial support. In each of the four programmes, financial assistance has been provided and promised against the commitment of each country to fulfil certain economic policy conditions contained in the macroeconomic adjustment programme. In general, a macroeconomic adjustment is a process driven by policies but also by changes in private spending behaviour (consumption, imports, investment) and improvement in competitiveness that countries are required to undertake after a large shock. In the case of the four countries, the shock emerged as a consequence of an excessive accumulation of imbalances in different parts of the economy: in the public sector in Greece, in the housing and banking sectors in Ireland, external imbalances in Portugal and in the banking sector in Cyprus. The paper looks at the feasibility of the fiscal adjustment comparing the macroeconomic conditions in the four countries and emphasising the role of the fiscal multipliers in the process. It also assesses the fall in the output in a comparative framework, stressing the role played by the different components of demand either in amplifying the effect of the fiscal consolidation or in offsetting it. In addition, it considers formulation of the programmes as well as their implementation with most attention devoted to reforms aiming at improving competitiveness, growth and employment in the framework of a cross-country approach.     

Designing Fiscal Institutions in a Monetary Union

This article explores the policy and wealth consequences of alternative institutional arrangements through which fiscal policy interacts with monetary policy in a monetary union such as the EMU. The central issue of the article is the design of the appropriate monetary and fiscal institutions through a comparison of alternative arrangements to distribute power over monetary and fiscal authorities between the central authority of the union and the individual members of the union and evaluating their performance. The main results of this article reveal that delegation of the fiscal policy to a council of country representatives and the monetary policy to a council of governors is the appropriate institutional design to reduce inflation bias and better stabilize regional, idiosyncratic supply and demand shocks in a monetary union.     

Fiscal Leadership and Coordination in the EMU

We analyze the role of fiscal-monetary policy interactions and fiscal coordination in EMU under the assumption of strategic wage setting in unionized labour markets. We find that production subsidies and real wage distortions are strategic complements. The literature on macroeconomic stabilisation policies and policy games usually neglects this point and reaches overoptimistic conclusions about the desirable effects of accommodating fiscal policies. Central bank preferences also affect the desirability of fiscal coordination in a monetary union. In fact, contrary to Beetsma and Bovenberg (1998), we find that fiscal coordination improves outcomes in the case of a conservative central banker, whereas it leads to worse outcomes with a populist one.

Lessons from historical monetary unions - is the European monetary union making the same mistakes?

This article examines three historical monetary unions: the Latin Monetary Union (LMU), the Scandinavian Monetary Union (SMU), and the Austro-Hungarian Monetary Union (AHMU) in an attempt to derive possible lessons for the European Monetary Union (EMU). The term ‘monetary union’ can be defined either narrowly or broadly depending on how closely it conforms to Mundell’s notion of ‘Optimal Currency Area’. After examining each of the historical monetary unions from this perspective, the article concludes that none of them ever truly conformed to Mundell’s concept, nor does the EMU. Nevertheless, the article argues that some lessons may be learned from these historical experiences. First, it is necessary that there exist robust institutions such as a common central bank and a unified fiscal policy in order to withstand external shocks. The three early unions could not withstand the shock of WWI. Another important lesson is that continuing national rivalries can undermine any monetary union.     

Monetary Union in West Africa: An Agency of Restraint for Fiscal Policies?

Could a monetary union in West Africa (either an informal monetaryunion of the non-CFA countries, or a possible future monetaryunion of all ECOWAS members) be an effective ‘agency ofrestraint’ (Collier, 1991) on fiscal policies? We discussthe ways, both positive and negative, that monetary union couldaffect fiscal discipline and the arguments for explicit fiscalrestraints considered in the literature about the European MonetaryUnion (EMU), and consider their applicability to West Africa.The empirical evidence, EMU literature and CFA experience allsuggest the possibility that monetary union could create thetemptation for fiscal profligacy through prospects of a bail-out,or costs that are diluted through the membership. We concludethat a monetary union in West Africa can be an effective agencyof restraint on fiscal policies only if the hands of the fiscalauthorities are also tied by a strong set of fiscal restraintcriteria, applicable not just for accession to monetary union,but throughout the life of the union.     

Multiple wage-bargaining systems in the single European currency area

Little attention in the EMU literature has been paid to theinteraction between central bank monetary rules and systemsof collective wage bargaining. Analytically and empirically,coordinated wage-bargaining systems respond with real wage restraintto non-accommodating monetary policy. Since wage determinationis dominated by collective bargaining in all the EMU memberstates and wage coordination within the member states has grownsince 1980, this is a topic of potential importance. In particular,the replacement of the Bundesbank, directly targeting Germaninflation, by a European Central Bank (ECB) targeting Europeaninflation will remove a major institutional support of wagerestraint in Germany. The consequences of this for EMU are workedout under two scenarios, that inflation expectations will begenerated by ECB monetary policy and that they will reflectGerman inflation outcomes. Possible institutional developmentsare discussed including government union bargains. The Bundesbankalso played a major role in maintaining fiscal rectitude: forunderlying structural reasons, therefore, it is possible thatGermany will move to a period of fiscal activism with wage restraintand low inflation purchased through social contract negotiations.     

The assessment: macroeconomic policy after EMU

In this paper we discuss the emergence of the new European macroeconomicstructure within EMU. We focus on three important elements:the wage-fixing authorities in each country, the fiscal authoritiesin each country, and the single European Central Bank (ECB).We identify serious problems which might arise in coordinatingboth the wage-setters and the fiscal authorities, and arguethat these problems could be exacerbated if the ECB conductsmonetary policy inappropriately. In the light of this we providerecommendations for the conduct of monetary policy by the ECB.The paper also briefly discusses financial stability issuesand the interaction between the countries in EMU and the restof the world.     

The stability and growth pact, fiscal policy institutions and stabilization in Europe

Ever since its inception, the EMU has been subject to controversy. The fiscal policy rules embedded in the Maastricht Treaty, and clarified in the Stability and Growth Pact (SGP), are probably the most contentious. The SGP has constantly been accused of being too rigid and of forcing procyclicality in fiscal policy. However, in an influential paper Galí and Perotti (2003) concluded that discretionary fiscal policy has actually become more countercyclical in EMU countries since the Maastricht Treaty. This paper argues that this conclusion stands up to several robustness tests using ex-post data, including the use of institutional variables, but not to the use of real-time data. Using ex-post data, there is some evidence pointing to a more countercyclical use of discretionary fiscal policy (or at least to less use of procyclical discretionary fiscal policy). However, the use of real-time data for the period 1999–2006 reveals that discretionary fiscal policy has been designed to be procyclical. Hence, the actual acyclical behaviour of discretionary fiscal policy in the period after 1999 seems to be simply the result of errors in forecasting the output gap, and not the result of a change in the intentions of policy-makers. As a result, there is no evidence to support the view that Maastricht rules have forced euro-area policy-makers to change their behaviour and design countercyclical discretionary fiscal policies.     

A competitive growth of a small midle-income country in the eurozone is far to be assured

The dichotomy of the increasing diversity of eurozone member countries and the institutional “one-size-fits-all” setting has exposed the deficiencies of the institutional economic architecture of the eurozone in the financial and economic crisis of 2008–2010. It has particularly exposed the weaknesses of middle-income countries within this framework. Greece, Ireland, and Portugal are experiencing outright financial crises. This article’s thesis is that small middle-income countries (MICs) in the eurozone face two general macroeconomic problems: (1) there is inherent macroeconomic instability; and (2) there is a problem of “competitiveness and convergence.” Small MICs’ ability to grow and catch up is demand-based and largely export-driven. Price competitiveness is an important factor of competitive growth within the eurozone. A national fiscal policy is crucial to countries’ ability to form and implement national policies for economic stability and competitive growth, which would enable a durable, above-average growth rate. Calls for a fiscal union along with the monetary union may therefore backfire.     

Macroeconomic stabilization through monetary and fiscal policy coordination: Implications for European Monetary Union

In a two-country model, we consider the implications of monetary and fiscal policy coordination for macroeconomic stabilization. We show that the optimal regime is one of monetary and fiscal policy coordination under flexible exchange rates. In the context of the European Community, this suggests that the desire to fix exchange rates may not be costless. In addition, we show that fiscal coordination requires a relatively high degree of flexibility in fiscal policy. This result suggests that limits on the flexibility of fiscal policies, as suggested in the Delors Report, may hinder macroeconomic stabilization.     

The Precarious Fiscal Foundations of EMU

After a brief overview of the fiscal theory of the price level, we consider the insights it provides into monetary policy formation under certain kinds of deflationary and inflationary stress. Then we consider how the institutions of the EMU are equipped – or unequipped – to deal with such stress. The conclusion is that fiscal institutions as yet unspecified will have to arise or be invented in order for EMU to be a long-term success.     

The third leg of the stool: Financial stability as a prerequisite for EMU

The Third Leg of the Stool: Financial Stability, as a Prerequisite for EMU. — Concerns about fiscal and monetary stability have dominated discussions on EMU, while issues relating to financial stability have received less attention. This paper argues that monetary and fiscal stability are like two legs of a stool. A third leg, stability of the financial system, is required to keep EMU on its feet. The empirical evidence shows that in many European countries, governments still have a large hold on the domestic financial sector, both as owner and as principal debtor. The author argues that governments should leave bank ownership to the private sector, holdings of government debt to the public, and supervision to a specialized, independent European institution.     

Japan's fiscal policy and fiscal reconstruction

This paper investigates the macroeconomic effects of fiscal policy and the fiscal reconstruction movement in Japan. We first summarize Japan's fiscal policy in recent years and discuss advantages and disadvantages of government deficits. Next, we investigate the macroeconomic effects of Japanese fiscal policy and evaluate the plausibility of non-Keynesian effects. We also analyze the possibility of the crowding-in effect of fiscal policy and investigate the spillover effects of deregulation. Finally, we discuss political constraints in the fiscal reconstruction attempts and propose some measures for successful fiscal reforms in the near future.     

The Reform of Intergovernmental Fiscal Relations in China*

This paper looks at the impact of China's fiscal decentralization on the central government's ability to use fiscal policy to achieve macroeconomic objectives. It is argued that, under the fiscal contract system introduced in the early 1980s. the localities effectively controlled the tax rates and tax bases. Due to the lack of fiscal resources and policy instruments, the central government found it increasingly difficult to achieve its goals of macroeconomic stabilization and regional equalization. The adoption of the tax-assignment system in the 1994 fiscal reform was an important step taken by the central government to address these difficulties. Nevertheless, a number of elements in the current tax-assignment system may work to make this system unsustainable in the long run.     

Real exchange rate, agglomerations, and irreversibilities: macroeconomic policy and FDI in EMU

Fiscal policy in EMU has to be evaluated in the light of thechanging nature of capital mobility in Europe and its effectson growth. Most arguments about the effects of fiscal policyin EMU assume that we live in a perfect competition world witha unique natural rate of output for each country. The removalof barriers to foreign direct investment (FDI) accompanied bythe prevalence of imperfect competition mean that the naturalrate of output is to be determined by locational competition.We show that FDI is influenced by relative costs and is attractedby agglomerations, and that the level of technology dependson the stock of FDI. Sustained expansionary fiscal policieswill raise costs and make locations less attractive. Agglomerationscould be destroyed by these higher costs, and the size of thenation will shrink. These effects will constrain policy-makersmuch more than the Stability Pact.     

Real time uncertainty in fiscal planning and debt accumulation in the euro area

Using real time data from the OECD this study explores euro area fiscal policies since the late 1990s. The results indicate that in the so-called periphery countries (Greece, Ireland, Italy, Portugal and Spain) ex ante fiscal plans have been more sensitive to economic cycles in the countercyclical direction than in the other euro area countries. Accumulated debt ratios in the periphery reflect high initial debt ratios, underlying deficit biases and cumulated errors in the data on macroeconomic imbalances. Overall, reliable statistics, balanced macroeconomic developments and longer-term policy orientation are crucial for sound and sustainable public finances.     

Shall the New EU Members Introduce the Euro? Some Macroeconomic Policy Effects

After the EU enlargement in 2004, there is a clear commitment of the EU and the new member states to aim at an enlargement of the euro zone within the European Economic and Monetary Union (EMU) as well. This might have significant effects on the old EMU, the new members, and even on the global economy. The present paper analyzes some macroeconomic effects and particularly the impact on the effects of stabilization policies when switching to an enlarged euro zone under different assumptions about fiscal and monetary policy regimes in Europe and under alternative types of economic shocks. Also, the implications for the US of different European monetary regimes are evaluated. The results suggest that economic benefits for all countries are rather small. For the Central and Eastern European countries (CEECs), even disadvantages may dominate.     

Budget deficits and money creation: Exploring their relation before Bretton Woods

The sovereign debt crisis in the Eurozone has rekindled the use of the North–South (core-periphery) terminology to refer to the heterogeneity of countries belonging to the Economic and Monetary Union (EMU). In the gold standard literature, this geographical partition had already been employed to oppose the fiscal profligacy and subsequent problems of convertibility of southern countries against the fiscal probity and long convertibility records of their northern counterparts. We provide statistical evidence that the group of countries that, with available data for 1870–1938, exhibited convertibility problems during the classical gold standard, for this reason called the pre-WWI “sometimes-floaters”, shared a pattern of fiscal dominance. This finding for the sometimes-floaters (southern European and South American countries plus Japan) differs from the non-fiscal dominance pattern that we obtain for the pre-WWI “never-floaters” (northern Europe and North America countries) when the Great War and its aftermath years are omitted. We also show that the presence of fiscal dominance was partly due to the lower levels of tax efficiency and political stability in the South.