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

1. Fiscal Policy: Essential Economics

2. Fiscal Policy in the EU: Challenges

3. 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

1. Fiscal Policy: Essential Economics

2. Fiscal Policy in the EU: Challenges

3. 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:

  1. Commission reports on exceeded reference values.

  2. Council's recommendations after hearing from the member state.

  3. A 6-month period for the member state to take corrective measures.

  4. 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

1. Fiscal Policy: Essential Economics

2. Fiscal Policy in the EU: Challenges

3. 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.