chapter_6_ChEU
Page 1: Introduction
Challenges of the European Union
Chapter 5.1: Challenges of Fiscal Policy
Dr. Maximilian Gödl
Fall Semester 2024
Page 2: Lecture Overview
Fiscal Policy: Essential Economics
Fiscal Policy in the EU: Challenges
The Energy Crisis: How should Fiscal and Monetary Policy respond?
Page 3: Fiscal Policy: Essential Economics
Fiscal Policy in Open Economies
Definition: Changes in aggregate government spending (consumption/transfers) and taxes.
Affects aggregate demand through the equation: Y = C + I + G + X − Z.
Effects on interest rates (i), output (Y), and exchange rates (E) depend on the exchange rate regime:
Floating: New equilibrium at B (higher i, higher Y, higher E).
Fixed: New equilibrium at C (same i, same E, much higher Y).
Page 4: Fiscal Policy in a Monetary Union
Key Points
When joining a monetary union (MU), countries give up their monetary policy but keep their fiscal policy.
Fiscal policy is highly effective in a MU but has dual potential:
Stabilizes asymmetric shocks (long implementation lags).
Can be exploited to boost domestic economy, potentially harming the rest of the MU.
Page 5: Automatic Stabilizers
Countercyclical Fiscal Policy
Fiscal policy should respond counter-cyclically.
Automatic stabilizers are built into tax and transfer systems:
Tax revenues decrease automatically during recessions (e.g., income tax, sales tax).
Transfer payments increase automatically (e.g., unemployment insurance, welfare benefits).
The size of automatic stabilizers is especially large in the EU.
Page 6: Actual vs. Cyclically Adjusted Budget Balance
Budget Deficits
Automatic stabilizers necessitate distinguishing between two sources of government budget deficits:
Cyclical Deficits: Due to the business cycle and automatic stabilizers.
Structural Deficits: Result from discretionary tax cuts/spending increases independent of the business cycle.
Cyclically adjusted deficit is calculated as:
Cyclically adjusted deficit = Actual deficit − b × Output gap, where b is an unknown constant.
The estimation of b is subject to error and debate.
Page 7: Overall vs Primary Budget Balance
Government Budget Balance
The overall government budget balance consists of:
Primary Balance: Total revenue minus non-interest spending (T − G).
Interest Payments: Payments on existing debt calculated as D: r × D.
The government budget constraint indicates that debt increases when interest payments exceed the primary surplus.
Page 8: Debt Sustainability
Understanding Sustainability
Sustainability refers to maintaining a stable debt-GDP ratio.
The change in D/Y (debt-to-GDP ratio) relates to interest and growth rates:
∆(D/Y) = (r − g)(D/Y) − (T − G)/Y.
The required primary surplus depends critically on the interest-growth differential (r − g).
Example: With r = 0.03, g = 0.02, and D/Y = 0.5, a surplus of 0.5% of GDP is needed; if r falls to 0.01, stabilization can occur even with a 0.5% deficit.
Page 9: Fiscal Policy Spillovers
External Effects of Policy
A country’s fiscal policy impacts others through various channels:
Trade Channel: Increase in G leads to higher imports for foreign countries.
Borrowing Cost Channel: Rising prices lead to increased interest rates by the central bank.
Debt Sustainability Channel: Rising debt can cause a self-fulfilling debt crisis across nations.
Page 10: Lecture Overview
Fiscal Policy: Essential Economics
Fiscal Policy in the EU: Challenges
The Energy Crisis: How should Fiscal and Monetary Policy respond?
Page 11: Fiscal Policy in the EU: Deficit Bias and Collective Discipline
Deficit Bias
Fiscal policy in the EU shows a strong deficit bias due to political pressures to run deficits even in stable times.
Large spillover effects create a need for coordination at the union level; however, national governments are reluctant to surrender fiscal power.
Page 12: Fiscal Policy and Debt Sustainability
Rising Government Debt
Continuous deficits result in increasing government debt, raising issues about crowding out private investment.
The Eurozone crisis illustrated how national governments can face self-fulfilling runs on their debt.
Page 13: Fiscal Dominance of Monetary Policy
Risks of Fiscal Dominance
Central banks may come under pressure to manage government debt, raising concerns about inflation.
The European Central Bank (ECB) has engaged in extensive quantitative easing since 2014, buying substantial amounts of government debt.
Implications of ECB potentially raising interest rates and facing losses on its bond portfolio are currently uncertain.
Page 14: Stability and Growth Pact
Requirements
Admission to the Economic and Monetary Union (EMU) requires:
Budget deficit < 3% of GDP and public debt < 60% of GDP.
Mandated by Article 126 of the Maastricht Treaty to avoid excessive deficits, enforced by the Stability and Growth Pact.
Enforcement has been challenging, with notable violations by member states, such as France and Germany.
Page 15: Updated Stability and Growth Pact
Revamping SGP
The Stability and Growth Pact was modified in 2005 and during the Eurozone Crisis for flexibility.
Key elements include:
Definition of excessive deficit: cyclically adjusted deficit < 0.5% of GDP.
Preventive arm for encouraging deficit reduction during good times.
Corrective arm for responding to excessive deficits.
Embedding national budgets within an EU-wide framework and sanctions for non-compliance.
Page 16: Excessive Deficit Procedure
Implementation Steps
Member states are advised to avoid excessive deficits with reference values (3% deficit, 60% debt).
Excessive Deficit Procedure (EDP) includes:
Commission reports on exceeded reference values.
Council's recommendations after hearing from the member state.
A 6-month period for the member state to take corrective measures.
Fines for non-compliance.
Page 17: Current EDPs
Suspension and Reopening
From 2020 to 2024, EDPs were suspended due to the general escape clause.
In June 2024, procedures were reopened against Belgium, France, Hungary, Italy, Malta, Poland, Slovakia, and Romania.
Page 18: Lecture Overview
Fiscal Policy: Essential Economics
Fiscal Policy in the EU: Challenges
The Energy Crisis: How should Fiscal and Monetary Policy respond?
Page 19: The Energy Crisis: Overview
Background
The 2022 Energy Crisis began with significant rises in global fuel prices, worsened by the Russian attack on Ukraine in January 2022.
Gas prices surged to 1,800% relative to 2019 levels, amplifying inflation, especially in the Eurozone.
Various responses emerged from governments and central banks.
Page 20: The Energy Crisis: Continued Overview
The implications and responses to the energy crisis extended across multiple sectors, with fiscal and monetary policies being reconsidered in light of the emerging challenges.
Page 21: Energy Crisis: A Micro View
EU as a Net Importer
The EU, as a net importer of oil and gas, faces disrupted supplies due to sanctions on Russia, affecting the import supply curve and raising effective costs.
Implicit tariffs arise from sanctions, affecting trading dynamics.
Page 22: Welfare Consequences of Energy Sanctions
Impact Analysis
Energy sanctions result in complex welfare consequences:
EU energy consumers are worse off, while producers gain, unless reliant on Russian gas.
EU governments do not benefit economically from the sanctions as with traditional tariffs.
In Russia, producers may suffer unless they find alternative buyers.
Page 23: Mitigating Welfare Consequences
Government Strategy
Governments should avoid poor policy responses, such as inefficient price controls and broad energy subsidies that encourage wastage.
A better approach involves targeted transfers based on past consumption data to support the most affected households and industries.
Page 24: Energy Crisis: A Macro View
Supply Shock
The rise in energy prices constitutes a classical supply shock, shifting the Aggregate Supply (AS) curve leftwards/upwards.
The shock is asymmetric, impacting EU countries differently based on their energy dependencies.
Page 25: Policy Response
Trade-offs
Policymakers face a difficult choice between preventing recession and controlling inflation during the energy crisis.
The ability of monetary policy to counteract inflation amid rising costs is debated, evident in comparisons between Switzerland and the Eurozone.
Page 26: Optimal Policy Response
Recommendations
Ideally, monetary policy should adopt a contractionary stance as real interest rates remain low.
Fiscal policy measures should focus on targeted transfers to affected parties and invest in infrastructure to mitigate the energy shock, such as LNG terminals.