Restoring Fiscal Policy in the Monetary Union

Panico and Purificato, Guest Bloggers

What is to be done to solve the European debt problem? In our view, fiscal policy enhancing growth and central bank interventions to reduce the interest rates on sovereign securities are necessary. To enact them, a satisfactory answer must be given to the moral hazard problem regarding the behaviour of national authorities: if the Euro governments help out national governments that are in budget difficulties, what is to prevent these nations from engaging in irresponsible budget policies in the future? The literature indicates viable solutions (Panico and Purificato). It suggests reforming the organization of the coordination process between monetary and fiscal policies in such a way as to minimize the moral hazard problem regarding the behaviour of the national Governments. A European fiscal agency can serve this purpose. It can fix, year after year, the ratio deficit-GDP for each country, taking into account the cyclical conditions and the needs of the economies, while realizing the objective of financial sustainability.

The organisation of monetary policy in the euro area is based on effective forms of coordination that minimise the uncertainty on how the national central banks implement the decisions taken at the European level. In fiscal policy, instead, national governments can agree on decisions at super-national level, but behave differently at home without suffering negative consequences. Opportunistic behaviour is then possible and this leads the monetary authorities and national Governments to defend themselves from the unreliable behaviour of the others. Under these conditions, the search for a sensible policy for the whole area is an empty aspiration.

We know which tools of coordination perform satisfactorily. Multilateral surveillance contributed to inducing discipline among the national authorities both in the 1990s and after the single monetary policy was introduced. The Stability and Growth Pact (SGP) was instead a failure. It introduced rigid rules including

  • the prohibition that the gross Government debt of a country exceed 60% of its GDP;
  • the prohibition that the current budget deficit of a country exceed 3% of its GDP;
  • the adoption of a medium-term budget position close to balance.

The drawbacks of these rigid fiscal rules already emerged during the slowdown of 2001. Several countries, including France and Germany, failed to comply with them. Their attempts to avoid paying the corresponding fines led to a reform of the SGP in March 2005. The reform was widely criticized for failing to address key problems.

There was consensus in the economics and policy literature on the need to:

  • formulate transparent (i.e. unambiguous) rules,
  • increase flexibility (i.e. the ability of the rules to differentiate among cyclical conditions and the problems of each economy),
  • pay attention to financial sustainability, to the avoidance of pro-cyclicality, to the introduction of structural reforms and innovation and to the formation of physical and human capital,
  • strengthen the enforcement in order to enhance cooperative attitudes.

There was, at the same time, diversity on other issues. Some authors, close to the New Consensus in Macroeconomics (Alesina, Blanchard, Canzoneri, etc.) stated that the introduction of rules imposing discipline on national Governments and maintaining central bank independence and the adoption of “inflation targeting” generates satisfactory outcomes. These authors proposed reforms of the rules of the SGP and of its enforcement. Their aim was to achieve a satisfactory balance between transparency and flexibility in order to focus on the sustainability of government finance and to favour the use of counter-cyclical policies and structural reforms. Owing to their theoretical views, these authors disregarded the reality that punitive measures against the regions showing disequilibria in competitiveness and financial sustainability can deepen the imbalances and cause recession.

A second group, comprised of authors with heterogeneous theoretical views, considered it necessary to reform the institutional organization of the coordination process itself. For Wyplosz, the organization of fiscal policy should resemble that of monetary policy. He proposed the establishment of independent “Fiscal policy committees” similar to “Monetary policy committees”, arguing that they can generate better results than rigid numerical rules. The committees can fix the deficit – GDP ratios, but not the composition of the revenues and expenditures of the national budgets, which are reserved to elected bodies (Blinder). Pisani-Ferry proposed instead to transform the Eurogroup into the fiscal agency of the area, making its role analogous to that of the Eurosystem.

The introduction of a European fiscal committee or agency can facilitate the use of fiscal policy enhancing growth and avoid the adoption of measures that cause recession and intensify structural disequilibria (Panico and Suarez Vazquez). The agency must describe the economic situation of the area, the needs of each economy, the common targets and the structural policies required. Its institution must be accompanied by a set of arrangements providing incentives for all actors to enter binding commitments on policy coordination. The arrangements can foresee, for instance, the possibility of transferring the implementation of specific programmes to a super-national authority when the local authorities fail to respect the agreements subscribed at the European level. In this way, unlike what happens today, misconduct of the political authorities will end up punishing the politicians, rather than the citizens.

The 2005 reform of the SGP disregarded the proposals of the second group of authors and focussed on the content of its rules. It introduced flexibility, but was criticized by the first group of authors too for making the rules less transparent and relaxing enforcement to such a point as to make it irrelevant. The reform also caused concerns about the working of coordination during a recession. Unfortunately, the defects of the new rules emerged even before the crisis of 2007. Some Governments immediately considered them irrelevant. The Greek coalition let the deficit-GDP ratio to rise again after 2005. At the same time, the coalition magnified the accounting tricks in its balance sheets in order to avoid the negative consequences of the European multilateral surveillance on its political consensus at home.

The solution to the debt problem requires mending the coordination process. Our plan is a good example of how policy can be led by reason, rather than by fears and ideologies.


1. Panico C. and Purificato F., 2012, Policy coordination, conflicting national interests and the European debt crisis, Cambridge Journal of Economics, waiting for response

2. Wyplosz C., 2005, Fiscal policy: Institutions versus rules, National Institute Economic Review, 191, 70-84

3. Blinder A.S., 1997, Is Government too political?, Foreign Affairs, 76(6), Nov-Dec, 115-26

4. Pisani-Ferry J., 2002, Fiscal discipline and policy coordination in the Eurozone: assessment and proposals, in Budgetary Policy in EMU, Design and Challenges, Proceedings of a seminar held at the Dutch ministry of Finance

5. Panico and Suarez Vazquez, Panico C. and Suarez Vazquez M., 2008, Policy coordination in the Euro Area, Studi Economici, 96 (3), 5-31

One Response to “Restoring Fiscal Policy in the Monetary Union”

  1. Excellent article and some solid points. Although I think some of the guidelines might be fairly difficult to implement, anything that can go some way to reducing the interest rates on sovereign securities must be aimed for and every effort made to achieve it.