Introduction
5
fiscal constraints introduced in the SGP respect the solvency constraint? Are there any
economic reasons for introducing some fiscal constraints into the monetary union? Are
these economic reasons more relevant if the members of this monetary union do not have
the same fiscal policy
1
? The last question that we are going to discuss is related to the role
of the public sector in capital accumulation (given the existence of fiscal constraints). The
SGP has recommended that Member States should set the medium term budgetary targets
which should be close-to-balance or in surplus. Governments will thus normally fund
capital expenditure out of current revenue. This has two main consequences: a) tax
financing of investment may create a disincentive to spend on public capital; b) the switch
from deficit to tax financing of investment affects the distribution of welfare across
generations as it entails a double burden for current generations. In this work we will try
to discuss if the rules set up for the EMU can permanently reduce the public sector
contribution to capital accumulation.
This structure of this thesis is as follows. In section 2 we are going to introduce the
institutional framework of fiscal roles in the EMU, we will present and critically analyse
the Maastricht Treaty and the so called Stability and Growth Pact. In section 3, after a
brief review of the literature on the pros and cons of fiscal constraints, we are going to
discuss a model relating to the need for fiscal constraints in the presence of a monetary
union and in the absence of a common fiscal policy among countries. After that we will
compare the SGP constraint with the solvency constraint. Based on this analysis, it will be
1
This seems to be the case of EMU. So far there does not exist any agreement between the members of
EMU in term of fiscal federalism mechanisms.
Introduction
6
possible to observe that there are some situations in which even meeting the SGP
constraint does not necessarily entail meeting the solvency constraint as well.
In section 4 we will focus our analysis on the relationship existing between public
investment and fiscal constraints. We briefly introduce the Golden Rule and the way
this rule is applied in Britain.
2
After that we will discuss a model where we will show
how the introduction of a deficit ceiling, like the one imposed by SGP, can imply a
reduction in public investment in a two-period model. We will also discuss the possibility
of abiding by the Golden Rule via an increase of private investment.
In section 5 after we have briefly analysed what we have discussed previously, we present
some suggestions for future research in the conclusions.
2
See A code for fiscal Stability HM Treasury, 1997
Institutional Framework
7
2. Institutional Framework
To partially understand why budgetary discipline has been introduced we have to
consider the point of view of the European Commission. In a landmark report of the
European Commission we read: Solid budgetary discipline is considered to be an
essential condition for the success of EMU
3
. It is with this condition in mind that
budgetary discipline has been introduced. The requirements for achieving a sound
budgetary position in order to join the single currency and for maintaining budgetary
prudence, once a country is in the EMU, are at the core of the Maastricht Treaty. The
general principles and procedures of the Treaty have been spelled out in detail in
secondary legislation, which forms the so-called Stability and Growth Pact .
2.1 The Maastricht Treaty
In the Treaty of Maastricht (1992) two general fiscal rules have been established.
According to the first requirement, the general government deficit should not exceed 3%
of GDP (deficit constraint). The second requirement is that the ratio of general
government gross debt to GDP should be lower than 60 per cent (stock constraint) or, if it
is higher, it should be diminishing sufficiently and approaching that threshold at
satisfactory pace . The maximum deficit level consistent with a diminishing debt ratio
may be lower or higher than 3% of GDP, depending on the debt level and the GDP
3
See European Commission 1997 Achieving budgetary discipline page 69.
Institutional Framework
8
growth rate. The 3% threshold can be exceeded causing an excessive deficit, but only
under a restrictive set of conditions. In particular, three conditions must be met:
• exceptionality: the origin of the excess has to be outside of the normal range of
situations;
• temporariness: the deficit is allowed to remain above 3% of GDP only for a limited
period of time;
• closeness: the deficit must remain close to the reference value.
These three conditions need to apply simultaneously. In practice, the Treaty prescribes
that the original cause of the rise of the deficit above the 3% ceiling must be exceptional,
that the deficit must not, in any case, exceed this threshold by too much, and must return
promptly below it once the initial driving force is over. The Treaty, however, does not
specify the exact content of the these constraints.
2.2 The Stability and growth pact
One post-Maastricht element to clarify the meaning of the Maastricht Treaty provision is
the Pact for Stability and Growth
4
(SGP). The pact consists of two Council regulations
5
:
one involves the excessive deficit procedure, and the other the surveillance mechanism in
the application of the pact. The SGP confirms the deficit constraint (Deficit/GNP ≤ 3%)
and the stock one (Debt/GNP ≤ 60%) defined in the Maastricht Treaty. For this reason in
our future analysis the expressions Maastricht Treaty budget and/or stock constraint and
SGP budget and/or stock constraint are interchangeable; both of them refer to the same
4
In the Eichengreen point of view, the growth part was added at the request of the French authorities as a
face-saving exercise after they were forced to soften their previous opposition.
Institutional Framework
9
budget/stock constraint (Deficit/GNP ≤ 3% and Debt/GNP ≤ 60% ). The SGP gives also
a more precise interpretation of the conditions of exceptionality and temporariness given
in the Maastricht treaty, providing details of the circumstances under which the 3%
reference value for the general government deficit can be exceeded without incurring a
fine. The SGP does not give many indications about the stock constraint introduced by the
Maastricht treaty.
The European council adopted the Stability and Growth Pact in Amsterdam in June 1997.
The starting point of the Pact is that EMU members should set medium-term budgetary
targets which are close-to-balance or in surplus , thus allowing them to abide by the 3%
ceiling even during economic downturns.
The core elements of the Pact are:
• the definition in terms of setting time limits to the various steps of the Excessive
Deficit Procedure so as to speed it up and, where appropriate, impose sanctions within
the calendar year during which the decision on the existence of the excessive deficit is
taken;
• defining the meaning of exceptionality and temporary conditions;
• specifying the sanctions for the countries which do not meet these criteria
2.2.1 The exceptionality condition
According to the SGP the exceptionality clause can become operative when the excess of
the deficit is a result of an unusual event outside the control of the Member state.
5
These two regulation have the force of law.
Institutional Framework
10
Alternatively the exceptionality condition can apply if the deficit overshooting takes place
in times of severe economic downturn. The SGP considers as a severe economic
downturn a decline in GDP by at least 2% in the year in question. In addition, a recession
in which real GDP declines by less than 2% but more than 0.75% may qualify with the
concurrence of the Council. In this case the country has to show that its recession was
exceptional in terms of its abruptness or in relation to past output trends. Countries with
an annual output decline smaller than 0.75% will not be able to claim exceptional
circumstances. In a severe economic downturn, as defined above, the SGP recognises that
the budgetary room for manoeuvre between a deficit close to balance and a deficit of 3%
of GDP may not be sufficient to cushion the negative effects of the shock on the
economic activity.
2.2.2 The temporary condition
In its attempt to clarify the Maastricht Treaty s clause, the SGP gives also some indication
of the timing for which the deficit is allowed to remain above 3% of GDP
6
. At a general
level, countries are obliged to correct excessive deficits as quickly as possible after their
emergence .
In more precise terms, the SGP means that if a country s deficit exceeded the 3% in year t
it has to communicate to the Commission by March of year t+1. By May of the year t+1
the Commission has to issue a recommendation for eliminating that excess. The country
has to undertake corrective action, such that the excess deficit is eliminated by the year
Institutional Framework
11
t+2. If no corrective actions are taken by the end of year t+1, financial sanctions will be
imposed
7
. It is the Commission which evaluates the degree of corrective action
undertaken by counties. If the Commission indicates that the deficit would not fall below
the reference value in the year t+2 , the country would also be put into a position of
excessive deficit in the year of the recession because it has violated the temporariness
clause.
In fig 2.1 we illustrate the five relevant paths for the deficit during and after an
exceptionally severe recession, by indicating for each of them whether or not there is an
excessive deficit position. Into this picture we also introduce the closeness condition that
is represented by the ∆. However in relation to the closeness condition there is just a
theoretical mention in the Maastricht Treaty and in the SGP, it does not mention in the
Treaty the maximum amount by which the deficit could exceeded the threshold of 3%
(closeness condition).
6
The SGP does not provide any interpretation about the closeness condition mentioned on the Maastrick
treaty.
7
Sanctions take the form of non-remunerated deposits, which start at 0.2% of GDP and rise by one-tenth of
the excess deficit up to a maximum of 0.5% of GDP.
Institutional Framework
12
Fig 2. 1 Exceptional, temporary, and close to the reference value : an
illustration
The need of fiscal constraint in a monetary union: Is the SGP also a solvency constraint?
13
3. The need of Fiscal Constraints in a Monetary Union: Is the
SGP also a solvency constraint?
In the first paragraph of this section we will analytically assess the budget constraint (3%
Deficit/GDP) and the stock constraint (60% Debt/GDP) introduced by the Maastricht
Treaty (and confirmed in the SGP) and compare them to the solvency constraint. In our
analysis the solvency constraint represents the present and the future value of the capacity
to pay of a country. From our point of view it will be possible to observe that there are
some situations under which meeting the SGP constraint does not necessarily imply
meeting the solvency constraint. We will also show that under some circumstances
meeting the solvency constraint does not imply the complete satisfaction of the SGP
constraints.
Secondly, we will review the literature on the pros and cons of the fiscal constraint from a
theoretical point of view. The issue of fiscal constraints is a perennial argument in the
economics literature. Already in 1939 Musgrave was arguing against the introduction of
Capital budget at federal level for the US. After the literature review we will present a
two-period model on the need for a fiscal constraint in a monetary union where the
countries that joint the union share the same monetary policy, but each of them has its
own fiscal policy. This simple model is a very close representation of the European case.
In fact, under the EMU, monetary and exchange rate policies will be centralised, but
The need of fiscal constraint in a monetary union: Is the SGP also a solvency constraint?
14
fiscal policy will remain a national responsibility, in line with the subsidiarity principle
8
.
Analysing the model we will find that the desirability of imposing constraints depends
critically on the extent to which the monetary authority can commit to its future policies.
Precisely if the monetary authority can commit to its future policies there are no gains
from imposing fiscal constraints. On the other hand if the monetary authority cannot
commit, then there are some gains from imposing fiscal constraints. The intuition of this
result is very straightforward.
Without commitment the monetary authority finds it optimal to have higher inflation
when the debt level of member states is high. When a single fiscal authority in a member
state decides how much debt to issue, it recognises the incentives of the monetary
authority in the future to partially monetarize its debt, but it ignores the cost in terms of
inflation that its decision imposes on other member states. This free-rider problem leads
to inefficient outcomes in the sense that each fiscal authority issues too much debt. All the
member states can be better off if constraints are imposed on the amount of debt that each
fiscal authority can issue. With commitment by the monetary authority, this free-rider
problem disappears, so there are no gains from imposing constraints on debt.
3.1 SGP constraints and Solvency constraint a quantitative
comparison
Do the SGP constraints also respect the solvency constraint? In this section using a
discrete time model we are going to analyse the SGP budget constraints from one
8
For a complete exposition about the rule regarding the fiscal policy in EMU see Cangiano and Mottu.
(1988).
The need of fiscal constraint in a monetary union: Is the SGP also a solvency constraint?
15
quantitative point of view. We will also present the solvency constraint, and we will
compare it with the SGP.
Let introduce now the following notation:
Y
t
: GNP at end of year t
D
t
: Government level of debt at end of year t, we assume to have a fixed nominal market
value and zero maturity.
G
t
: Nominal amount of government expenditure from beginning to end of year t, this
variable includes government spending on consumption and investment.
T
t
: Nominal amount of tax revenue from beginning to end of year t.
X
t
: Nominal primary budget (surplus) also ability to pay
-B
t
: Overall Budget (deficit) if B
t
>0 we have an overall budget deficit
g: Rate of nominal GNP growth
i: Annual nominal interest rate
d
t
: Debt/GNP ratio at the end of period t
x
t
: Nominal primary budget / GNP
t-1
ratio
ASSUMPTIONS:
(1)B
t
>0; (2)X
t
>0; (3)i>g
3.1.1 Relations and dynamics of the variables
Government spends on consumption and investment (G
t
) and receives tax (T
t
) as
government revenue. The primary budget (X
t
) is given by the difference between tax
revenue, and government expenditure in one year.
The need of fiscal constraint in a monetary union: Is the SGP also a solvency constraint?
16
X
t
=T
t
-G
t
⇒Primary Budget or ability to pay
In this simple framework government also issues nominal debt (D
t
) and pays back i as
interest. For simplicity, all government debt is assumed to have zero maturity and fixed
nominal market value. The overall budget (-B
t
) is given by the difference between the
primary budget and the expenditure upon interest
9
.
-B
t
=X
t
iD
t-1
⇒Overall Budget
If the expenditure for interest (iD
t-1
) is bigger than the primary budget we will have an
overall budget deficit (B
t
>0) and the government has to issue more debt for the next
period to cover the overall budget deficit. In case of an overall budget surplus (B
t
<0) the
government will issue less debt for the next period. Therefore the dynamics of the debt
are:
D
t
=(1+ i)D
t-1
-T
t
+G
t
In our analysis we will assume that T
t
>G
t
so that we have a primary budget surplus
(X
t
>0); we will also assume that X
t
<iD
t-1
so we will also have an overall budget deficit
10
(B
t
>0). Under these assumptions we will have a permanent growth of the nominal debt.
The relationship between the dynamic of debt and overall deficit can be express as:
D
t
-D
t-1
=∆D=B
t
9
For simplicity in comparing this model with the SGP constraints we consider B
t
to represent the overall
budget so if B
t
>0 we are in a situation of overall budget deficit.
10
Empirically these two assumptions do not seem to be unrealistic especially if we focus on the European
countries in 1988, only in 1988 did Denmark, UK, and Luxembourg have an overall budget surplus, the rest
of EU country had a deficit. During the same year only Italy and Greece had a primary budget deficit, the
rest had a primary budget surplus. Source: European Commission.
Ballassone Franco (1998) show that the European countries during the seventies and eighties had on
average an overall budget deficit. Only Finland and Luxembourg seem to have had an overall budget
surplus.
The need of fiscal constraint in a monetary union: Is the SGP also a solvency constraint?
17
In relation to GNP we assume that it grows at a percentage trend at a constant rate so:
Y
t
-Y
t-1
=∆Y=gY
t-1
We also assume that the countries capacity to pay (the primary budget) grows at the
same percentage rate as GNP so:
∆X=gX
t-1
From an economic point of view this means that the government tax revenue and
government non interest expenditure grows at the same nominal rate GNP. In other words
the government keeps tax revenue constant with respect to GNP.
3.1.2 The Dynamic of the model
Before analysing the dynamics of the model we need to deflate all variables with respect
to GNP. We do this because, as shown in section 1, the SGP constraint refers to the
overall deficit and the debt deflated by the GNP.
d
t
=D
t
/Y
t
x
t
=X
t
/Y
t-1
The dynamic of these two variables can be expressed as follow
11
:
∆x
t
=0⇒x
t
= x =constant
∆d
t
=
g1
x
d
g1
gi
1t
+
−
+
−
−
(1)
11
See appendix for the proof
The need of fiscal constraint in a monetary union: Is the SGP also a solvency constraint?
18
Assuming a positive interest rate growth differential
12
(i>g) we can represent the
dynamics of the model. In figure 3.1, the line OS represents combinations of the primary
budget (deflated by Y
t
) and the debt/ GNP ratio according to equation 1 that keeps the
debt/GNP ratio constant.
12
See Abel and other (1989) for theoretical and empirical discussion.
Fig 3. 1 Combinations (d
t-1
, x ) that keeps constant the debt/GNP ratio
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