Fitoussi, Jean-Paul

English

Research Papers in Economics

1
Briefing paper N°3-2001
The fiscal stance and economic coordination in Europe
Jean-Paul Fitoussi
On the 30
th of August, Governing Council of the ECB decided to lower the key interest rates by 25
basis points. May be this decision was the only available in view of the evolution of core inflation in
Europe, but for reasons made clear below, it is not going to ease the fiscal debate in Europe. In his
introductory statement, President Duisenberg said “under the present circumstances, the automatic
stabilisers should only be allowed to work fully in those countries whose budget positions are closed
to balance or in surplus”. What should one think of such a position?
The Fiscal debate
The slowdown of growth in Europe, has had as a normal consequence an increase in “headline”
deficits almost everywhere. This has given a pretext to the Commission for inviting some member
States, namely Germany, France, Italy and Portugal, on the basis that they have been too lax in good
times, to pursue a procyclical fiscal policy: they “have missed the opportunity of the recent favourable
growth environment to meet the target of the Stability and Growth pact”. Then one is left with the
impression that if you do it wrong once, you are almost condemned to do it wrong for ever. This
evaluation of European fiscal policy is also missing an important point: you can’t evaluate economic
policy without taking into account the initial conditions of the economy. There is a broad agreement
that both monetary and fiscal policy have been procyclical for obvious reasons in the few years
preceding the launching of the euro and that this procyclical episode has left the three “big economies”
designated by the Commission with a mass unemployment problem and a negative output gap, which
preclude a strongly restrictive fiscal policy at the outset of a new growth period. The return to a
“normal” countercyclical policy will take more time, just because the European governments had it
wrong (admittedly for good reasons, the Maastricht criterias) to begin with. And, above all, past errors
are not justifications for present ones; so, to say the least, Member States are right when they declare
that one could let the automatic stabilisers play. The debate will certainly gain in transparency if
structural deficit figures instead of current ones are used. But that will also imply more confidence in
the methods used to evaluate the output gap.2
Much ado about nothing?
What is the extent of the problem? First, the fiscal deficit of the euro area is low and although
forecasted to increase, it will still be less than 1% in 2001 (from –1,2% in 1999, 0.3% in 2000, -0.8%
in 2001.) And of course the structural deficit which was –0.5% in 2000 will be according to the IMF
of about -0.6% in 2001.) There is no reason to worry about these figures: neither about the level nor
about the evolution of the deficit. It has to be remembered that in the US the deficit has turned into a
surplus only in 1998-1999 after 6 to 7 years of expansion, and two years after a sizeable increase in
potential growth. And the Congressional Budget Office has just forecasted a federal deficit of $9bn for
2001! It is thus hard to understand the big words used in the fiscal debate in Europe. Truly these
figures are higher than those forecasted by the governments in their medium term fiscal programs, but
the latter were conditional on hypotheses regarding the rate of growth which, at least for 2001, proved
to be too high. There is no wonder then that actual deficit are higher than planned ones.
Should European governments be accused to have embarked on tax cut programs during a
favourable growth context?  As already emphasised, a procyclical fiscal policy in a period of quasi-
stagnation, has meant for most European countries an increase in taxes and/or social contributions,
leaving the economies when growth conditions turned to normal with an abnormally high tax burden
as a ratio to GDP. This is a structural disequilibrium that governments had to address once the
momentum of meeting the Maastricht criterias has been passed, and whatever the growth context. And
that they did it in 2000 led by chance to the right timing, as these reforms will begin to sustain internal
demand as from now, and hence may contribute to a reversal of the path of growth. So one of the
arguments against the use of discretionary fiscal policy, that is the long and variable delay of
implementing it, does not apply in this instance. Luck is not forbidden, as we have here an example of
a structural fiscal policy which by chance has a countercyclical effect.
“Plus royaliste que le Roi”
On all these issues, the Commission seems to be more demanding than the ECB. The last monthly
bulletin of the ECB (August) underlines the increased uncertainty surrounding economic growth in the
euro area in the second half of 2001. But the editorial adds that fortunately (which is the way I
understand the statement), “positive effects on euro area economic growth should stem from the
impact of tax reductions in several euro area countries..” But the same bulletin contains also an article
devoted to “Fiscal policies and economic growth”. And here the position of the ECB is unambiguous.
Stressing rightly the importance of fiscal policy for long term growth, it clearly concludes that for
short term purposes automatic stabilisation has to be preferred to discretionary fine tuning.  It also3
asserts several times that fiscal policies in Europe are on the right track, e.g., p.52: “fiscal deficits have
come down and sound budgetary positions have been achieved in the majority of euro area countries.
The volatility of fiscal balances is much reduced and public debt is declining. There is no reason for
complacency, and countries with imbalances remain, but major progress has been achieved compared
with the situation only a few years ago.” Notwithstanding the reserve contained in the last sentence,
this statement resembles much a congratulation to fiscal authorities which is sufficiently rare from a
Central bank to be noticed.
The policy mix and discretionary fiscal policy
A new way of thinking about macroeconomic policy evaluation has emerged from events and
research of the last two decades (see, e.g., John B. Taylor, 2000). In a nutshell, using a new
“neoclasical synthesis” framework, and looking at what happens to the fluctuations of real output and
inflation under alternative policy rules, the research concludes that the job of stabilisation is better left
to monetary policy than to discretionary fiscal policy. The reasons are well known: the implementation
lags are much shorter for monetary policy than for fiscal policy, monetary policy may be quickly
reversed which is not the case for fiscal policy etc.. But this conclusion deserves two qualifications.
First, automatic stabilisers should be left to play their role, creating thus an element of certainty for
the private sector. One just has to imagine the increase in uncertainty for private agents if discretionary
fiscal policy is aimed at compensating the effects of automatic stabilisers to understand the strength of
the argument. In addition, as set by Taylor, “The overall size of the actual changes in taxes and
spending due to automatic stabilisers are frequently much larger than even the proposed discretionary
changes. Both types of changes in taxes and spending impact aggregate demand, but the automatic
ones are more predictable and work more quickly than the discretionary ones.” This statement is all
the more true in Europe, where the level of taxes in proportion to GDP is higher and where the social
protection system is more generous implying a greater automatic increase in social spending when
unemployment increases.
Second, the conclusion is valid only if monetary policy does actively its job (see e.g. Creel and
Fitoussi 2001). It is also and perhaps mainly because monetary policy was (in the US) systematically
and strongly reacting to the cyclical state of the economy, that the “new normative macroeconomics”
has emerged. Were monetary policy more passive or more constrained by its mandate, discretionary
fiscal policy would have to come in. This is recognised by these new types of models especially in the
case where the Central bank has to focus only on inflation and/or in the case of a fixed exchange rate
system, not to say an unique currency. But, after all, these conclusions are well known: monetary
policy should be the preferred instrument to fight common shocks, like a more or less general
slowdown of growth, but fiscal policy should be activated to fight asymmetrical shocks or whenever a4
common shock has asymmetrical effects. It also has to be activated if monetary policy is reacting too
softly to common shocks.
Hence, the assignment problem can’t be solved in Europe as easily as in the United States. But
notice that in all cases, at minimum, automatic stabilisers have to be left to play their role. There is no
justification in the economic literature, whatever its doctrinal inspiration, for a procyclical fiscal policy
which is synonymous with not letting automatic stabilisers to play.
Economic policy coordination
As just underlined, there is no escape in Europe from discretionary national fiscal policies. A
common monetary policy can’t fit all euro area countries and something else is needed to perform the
cyclical function, that is discretionary fiscal policy. To belabour the obvious -- a point which has been
made in the early debate -- a country enjoying a boom will also, most likely, have a lower real interest
rate than average, as if monetary policy were procyclical. And conversely, a country in the midst of a
slump will be penalised by too high a real interest rate. When cycles are not synchronised, this
problem arises automatically.
Thus, unsynchronised cycles, asymmetrical shocks etc.. imply to go beyond automatic stabilisers,
and are powerful arguments not to restrain too much the room of manoeuvre of budgetary policies.
On the other hand, the plurality of national fiscal policies increases the opacity of the European
policy mix, and the complexity of the job of monetary policy. So what are the pros and cons of
economic policy coordination? By that I mean two things, the coordination between fiscal authorities
and the coordination between the latter and the ECB. One is just left to guess how long the process of
coordination will be. This length has to be added to the implementation lags of national fiscal policies
to understand that stabilisation policies will have a hard time in Europe.
One can argue that in a common currency area, there is no need for coordination of national fiscal
policies (Cf. J.P. Fitoussi, 1999; De Grauwe end Polen, 2000). A national expansionary fiscal policy
will have two effects on other European countries: a trade effect and a financial effect. It is most likely
that the first will dominate the second. The trade effect will not by definition be dissipated by nominal
exchange rates movements, and if the expansionary country exhibits as a consequence, a higher rate of
inflation, the trade effect will be reinforced by an increase in its real exchange rate (a lost in
competitivity). The financial effect refers to the possible increase in interest rates, short and long,
which may follow the increase in the euro area inflation rate and public deficit. But the inflation rate
increase may be insignificant and it is probable that the public deficits in the others countries will be
lower as a consequence of their induced expansion. It is thus unlikely that the two effects balance. The
most probable outcome is that the other European countries will benefit from the expansion without
having to bear any cost. At maximum, the increased deficit in the expanding country will be reflected5
in its bond yields, as there is no chance of a bail out by the centre. One may even go as far as saying
that the stability pact may lead to a restrictive bias in fiscal policy, as no country has interest in being
the first mover, each having interest in others doing it. Another restrictive bias may arise from an
increase in the dispersion of national public deficits around their European mean.
From this analysis, I conclude that in the euro area, not only will each country retrieve a full fiscal
sovereignty, but this retrieved fiscal sovereignty will by no means be unfavourable to the other
countries within the area, on the contrary. After all this is what the subsidarity principle is all about.
There is another argument against policy coordination. Competition between fiscal policies may
favour experimentation, innovation and the selection of best policies. But this argument should not be
pushed too far: fiscal and social competition may have, and in actuality often have, adverse unintended
results which may be harmful in the long run. They generally lead to a sub-optimal provision of public
goods in sectors which are crucial for long term growth (education, health, infrastructure etc.., not to
speak of social cohesion).
The arguments for coordination are of two kinds (Cf. P. Jacquet and J. Pisani-Ferry, 2000). First,
only coordination may provide the public goods which are needed at the European level. Preserving
the single market is a public good which implies fiscal and social harmonisation, as well as that of
regulations. In this sense, budgetary discipline would also be a public good as it allows for a clear
definition of the policy mix which, seen from outside Europe, is of the collective responsibility of
member states. This type of coordination is called by Peter Kinnen, regime preserving coordination, as
it allows for the continuation of the present regime.
The second kind of argument refers to externalities linked with national policies of the kind we
have already discussed: for example monetary policy is geared towards the control of the average rate
of euro area inflation. National policies including structural ones may influence this rate leading to a
change of monetary policy adverse to other countries. To cope with these externalities, strategic
coordination is required. But in view of the complexities of implementing such a coordination which
in general implies discretionary policies, the temptation of adding new rules to constrain the policy
maker may become too strong: for example a country experimenting a boom will be constrained to
pursue a restrictive fiscal policy, and a country in recession an expansionary one, both discretionary.
Notice that such a rule may conflict with the stability pact as it increases the dispersion of public
deficits around their European mean.
An European level Tax?
National governments have to keep a policy instrument in their hands, otherwise what are they for?
And how can they renounce this instrument if it is not clearly established that it will be used for the
good by a higher level of government. In other worlds, the “Federation of Nation States”, has to
become more of a federation if one wants national fiscal policies to be more severely constrained. That6
would imply an increase in fiscal receipts at the level of the federation, and make the case for an
European-level tax. Which tax it will be and for what associated spending are difficult questions which
require a lot more scrutiny to be answered. It is obviously not a technical question, but a thoroughly
political one, because it implies a new division of labour between the federation and national
governments. One could nevertheless argue that the tax chosen should be a tax whose setting at the
european level will avoid unfair and inefficient (because of negative externalities) fiscal competition,
like corporate taxes and/or capital income taxes. The associated spending could also for the same
reasons be devoted to social expenditures. Redistribution of this kind would help harmonising social
conditions in Europe. One can also think -- as there is a strong need for a greater integration of the
university system -- of spending on education and research, a sector which is crucial for the future of
Europe and which has to be thought of at the European level.
Concluding remarks
The fiscal debate in Europe is putting the policy maker under too straight a jacket. Voices are heard
saying that the cyclical increase in budget deficits should be prevented, recommending thus a
procyclical policy! It would be better to avoid such a simplistic debate by reasoning with structural
deficit figures.
In the European context, automatic stabilisers may not be enough and some room should be left for
national discretionary fiscal policy. This is due to the impossibility of having monetary policy fit the
situation of each country. But under present circumstances of a slowdown of growth in almost all
European countries (accompanied by a decrease in inflation and an appreciation of the euro), research
and experiences have shown that monetary policy would be the most adapted instrument … if used. If
not discretionary fiscal policy would have to enter the picture. For example, as most European
countries have decided on a pluriannual program of tax cuts, they can also decide in a coordinated way
to implement the programmes on a shorter time span.
Under the present “Economic Constitution of Europe”, there are arguments against and for
coordination of economic policies. From arguments made clear in the paper, coordination of fiscal
policies is not necessary. Of course it would help understanding the policy mix of Europe if it were
correctly designed and promptly achieved. But if it leads to rules constraining even more the policy
maker, it would be undesirable. A much better solution is to move in the direction of a federation and
to decide on a European-level tax.7
Bibliography
CREEL Jérôme et Jean-Paul FITOUSSI (2001) : “Unemployment in OECD countries : does
economic policy matter?” paper presented at the 75
th International Conference on Policy Modelling for
European and Global Issues, Brussels, July
DE GRAUWE Paul et Magdalena POLEN (2000) : “Increased capital mobility: A challenge for
national macroeconomic policies”, paper presented to the annual conference of the World Economic
Institute, Kiel, June.
FITOUSSI Jean-Paul (1999) : Rapport sur l’état de l’union européenne, Fayard, Chapitre 1.
JACQUET Pierre et Jean PISANI-FERRY (2000) : “La coordination des politiques économiques
dans la zone euro : bilan et propositions” in Questions européennes, Rapport du Conseil d’Analyse
Economique, La Documentation Française.
TAYLOR John B. (2000) : “Recessing discretionary fiscal policy” The Journal of Economic
Perspectives, vol. 14, n°3, Summer.

La coordination des politiques économiques dans la zone euro : bilan et propositions” in Questions européennes, Rapport du Conseil d’Analyse Economique, La Documentation Française.

Rapport sur l’état de l’union européenne,

Recessing discretionary fiscal policy”

Unemployment in OECD countries : does economic policy matter?” paper presented at the 75 th International Conference on Policy Modelling for European and Global Issues,

fiscal stance and economic coordination in Europe.

http://spire.sciences-po.fr/hdl:/2441/5563/resources/fitoussi.pdf

fiscal stance and economic coordination in Europe.

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