Implications of the new public debt rule in the 'fiscal compact' for the economic and monetary union.

Author:Menguy, Severine
Position:Report
 
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  1. INTRODUCTION

    Before the economic and financial crisis in 2008, the debt criterion of the Maastricht Treaty (a public debt smaller than 60% of GDP) has concretely not been much taken into account by European political deciders. However, as excessive indebtedness levels lead to a sovereign debt crisis affecting European countries since 2010, new rules were introduced for EMU (Economic and Monetary Union) member countries [see for example: Tamborini (2011)]. They are clarified in the 'Fiscal Compact': the fiscal part of a new 'Treaty on Stability, Coordination and Governance (TSCG)', which entered into force on 1st January 2013. The 3% of GDP limit for budgetary deficits, the medium term objective of budgetary positions in balance, and the constraint for countries running a structural deficit to cut it by at least 0.5% of GDP per year are maintained. However, the corrective part of the Stability and Growth Pact has been strongly reinforced. Countries should submit each year a Stability and Convergence Program (SCP), and reduce their budgetary deficits according to a schedule proposed by the Commission. Countries under an Excessive Deficit Procedure (EDP) should submit their budgets and structural reform programs to the Commission and to the European Council, which will give their advice and monitor budget implementation.

    Besides, countries whose indebtedness level exceeds 60% of GDP are supposed to take commitments to make it converge towards a defined target. Specifically, a debt-to-GDP ratio above 60% is to be considered sufficiently diminishing if its distance with respect to this reference value has reduced over the previous three years at a rate of the order of one-twentieth per year. Nevertheless, each Member State in EDP is granted a transitional three-year period following the correction of the excessive deficit for meeting the debt rule, in order to ensure no abrupt change in agreed consolidation paths. To avoid speculative attacks against the public debts of some European countries, a stronger European institutional framework was necessary. However, as European political deciders were still very reluctant to a formal and explicit coordination between their budgetary policies, they considered that such a coordination could only rely indirectly on the respect for fiscal discipline. Besides, in the framework of the sovereign debt crisis, this indirect coordination thanks to fiscal rules was supposed to give more weight to long term debt considerations (and not only to budgetary deficits) in European rules. Nevertheless, our paper shows that the new rule in the Fiscal Compact regarding public debt levels is currently very ambitious for some member States. It could even imply austerity measures which would be paradoxically detrimental to the coordination between economic policies and to macro-economic convergence in the EMU.

    In order to contribute to this debate, the rest of the paper is organized as follows. The second section mentions the ambiguous results of the econometrical studies regarding fiscal externalities in a monetary union. The third section presents a simple macroeconomic modeling of the dynamic evolution of the public debt of a monetary union's member country. The fourth section defines the optimal budgetary balance necessary to make the public debt decrease according to a predefined pace. The fifth section studies the sustainability of the new public debt rule for various EMU member countries. Finally, the sixth section concludes on the feasibility of this new rule for EMU member countries, and on its potential efficiency regarding economic policies coordination and macro-economic convergence in Europe.

  2. FISCAL EXTERNALITIES IN A MONETARY UNION

    We could expect that financial markets are efficient enough to regulate by themselves the budgetary policies of the member countries of a monetary union. In these conditions, a country with a too lax fiscal policy would have to bear higher interest rates and a higher cost for the refund of its public debt, which would incite this country to conduct a more virtuous budgetary policy. Nevertheless, Lane (1993) mentions that an effective market discipline requires that capital markets be open, that information on the borrower's existing liabilities be readily available, that no bailout be anticipated, and that the borrower responds to market signals. Regarding these conditions, financial markets are not perfect in Europe; therefore, there are large externalities and interdependencies between the public debts of the member countries of a monetary union, which reduce the power of financial markets to discipline efficiently the fiscal policies of these countries' governments.

    In a monetary union, one can rightfully expect the bailout of a country by other member countries [see for example: Demertzis and Viegi (2011) or Landon and Smith (2007)]. In the event of a too lax and unsustainable fiscal policy in one member country, the risk premium to pay and the yields on public bonds will then increase in all member countries of the monetary union, and not only in the faulting country. Another transmission mechanism of public debt externalities in a monetary union is the monetization of the public debt. An increase in the public indebtedness of one member country can incite the common central bank to conduct a more accommodative monetary policy and to increase the global inflation rate, in order to reduce the weight of the public indebtedness [see: Landon and Smith (2007)]. This would then increase the yields on public debts of all member countries in the monetary union. Nevertheless, what is the width of these fiscal externalities in a monetary union?

    Econometrical analyses usually confirm the following relationship at the national level: budgetary deficits or public debts increase national long term interest rates. However, as regards the fundamental question of fiscal externalities in a monetary union, empirical studies in the European context are today, unfortunately, very seldom, in particular because the short existence of the EMU implies a lack of long term data. However, it would be very useful to know whether the budgetary policy in a given country mainly affects its own long-term interest rates, or whether it has also consequences on yields of its partners. Do national fiscal policies affect mainly country spreads, or do they have a substantial effect on the average level of Euro area interest rates and on other governments' borrowing costs? On the one hand, some studies [Fremont et al. (2000), Schiavo (2008), Chinn and Frankel (2003, 2007) among others] underline the persistent dominance of national budgetary factors on long-term interest rates of the member countries of the EMU. On the other hand, some studies [De Santis and Gerard (2006), Bolton and Jeanne (2011), Bernoth et al. (2004), etc.] shed light on the fiscal interdependencies and externalities in a monetary union.

    For example, Caporale and Girardi (2011) analyze, thanks to a dynamic multi-country VAR model over the period 1999-2010, the dynamic effects of fiscal imbalances in a given EMU member state on the borrowing costs for other member countries. Then, they find that euro-denominated government bonds yields are strongly linked with each other (except in the case of Greece). Faini (2006) also finds that for the first EMU member countries, on the period 1979-2002, an expansionary fiscal policy or a high indebtedness level in one country is not seen much in the level of its spreads, but has a definite and more substantial impact on the average level of EMU interest rates. Therefore, fiscal spillovers would be non-negligible in an integrated monetary area such as the European Economic and Monetary Union. In the same way, Clays et al. (2008) use a spatial panel data model for 16 OECD countries on the period 1990-2005. They find that the increase in national interest rates due to a fiscal expansion is significant, but is reduced by spillover effects across borders. Besides, these spillovers would be important in periods of major crises, in periods of coordinated policy actions, or among EU countries with a great financial and commercial integration.

    Therefore, in the economic literature, empirical studies regarding the width of fiscal externalities in a monetary union and in EMU provide mitigated conclusions. On the contrary, theoretical results about budgetary and fiscal interdependencies are more clear-cut, even if such studies are much less numerous. For example, Tamborini (2011) underlines the interdependencies and strong fiscal and budgetary externalities between EMU member countries. However, these countries are still strongly structurally heterogeneous: divergences in initial indebtedness levels and in growth rates are striking between them, without real fiscal and political cooperation to mitigate these divergences. In this framework, the aim of this paper is to analyze the theoretical implications of a binding rule regarding public indebtedness, like the one mentioned in the 'Fiscal Compact', to cope with the recent sovereign debt crisis and the difficulties encountered by the European countries. Is such a rule currently sustainable for EMU member countries, and is it appropriate to provide the necessary coordination between their fiscal policies?

  3. THE MODEL

    Let's suppose a monetary union made of (k+1) member countries. We analyze the situation of one member country (i), in comparison with the situation of the (k) other partner member countries. We will express the dynamic evolution of the public debt in this country (i), according to the behavior of a representative investor maximizing his utility.

    3.1 DYNAMIC EVOLUTION OF THE PUBLIC DEBT

    In the country (i), the dynamic evolution of the nominal public debt is the following:

    [D.sub.i,t] = [Def.sub.i,t] + (1 + [i.sub.i,t])[D.sub.i,t-1] (1)

    With, for the country (i) in period (t): ([GDP.sub.i,t]): Nominal Gross...

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