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Study Finds Lack of Market Flexibility Has Undermined Stability and Growth Pact
Thursday 13th May 2004
Authors:
Andrew Hughes Hallett (Vanderbilt University and CEPR), John Lewis (Bank of Estonia) and Jürgen von Hagen (ZEI, University of Bonn and CEPR)
A new CEPR Report 'Fiscal Policy in Europe 1991-2003: An Evidence- based Analysis' examines the stance of fiscal policy in Europe since the 1980s. The study finds that some attempts to impose discipline have been successful but many have not. The authors examine the reasons for this and draw some lessons for fiscal policy-making in the future. The analysis presented in the Report shows:
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There is clear indication of fiscal weakening, on two distinct fronts: (1) the likelihood of an EU member state starting a fiscal consolidation has diminished since the launch of the euro; (2) the 'Maastricht effect' of tightening fiscal policy, which relates to the period up to 1998 when there was a threat of being excluded from participation in the single currency, has now faded.
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Since 1999, there has been relatively little attempt to run contractionary fiscal policies. Instead, the apparent decline in deficit and debt ratios is due entirely to growth effects, rather than fiscal restrictions. To date, most euro zone countries have avoided the 3% budget deficit limit of the Stability and Growth Pact (SGP) due mainly to economic growth.
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Tables 1 and 2 below show that the increase in debt in the earlier 1990s was mainly driven by increasing public sector debt ratios in the five larger states: France, Germany, the UK, Italy and Spain. But reductions post-1997 clearly come from the smaller states: Belgium, Denmark, Finland, Greece, Ireland and the intermediate states.
Table 1: Change Debt Ratios as a % of GDP in EU Member States, 1992-1997
| All EU Countries | 15.8% |
| Small Countries | 3.3% |
| Intermediate Countries | 4.1% |
| Large Countries | 18.1% |
Table 2: Country Size and Average Fiscal Stance, 1997-2002
| | Average Deficit | Change in Debt Ratio |
| All EU | -0.1% | -10.3% |
| Small Countries | +1.0% | -10.6% |
| Intermediate Countries | +0.0% | -13.0% |
| Large Countries | -1.5% | -7.7% |
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Fiscal restraint is clearly more effective in smaller states. With the SGP, larger countries may think that they are too large to be allowed to fail and will tend to flout the rules when smaller countries cannot.
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This finding has the awkward implication that fiscal discipline may only be effective in the smaller states - where it matters least. A fiscal or sustainability crisis in the smaller EU states representing just 8 - 20% of the total EU GDP is not likely to threaten the economic stability of the whole zone or its currency. A sustainability crisis in one of the larger states certainly could, however.
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The study finds evidence that electoral pressures for increased economic growth can explain some, but not all, of the observed weakening of fiscal discipline since 1999.
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The results of the study confirm the criticism that the SGP is a less effective means of discipling fiscal policy than the threat of exclusion from the euro was before the start of EMU.
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The authors show that a sufficiently strong trend growth of real GDP is a necessary condition for achieving a lasting reduction of the debt and deficit ratios. To solve a sustainability problem countries must grow out of it.
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The authors argue that the negative growth effects of a lack of labour market flexibility in the large euro zone countries may have contributed to their inability to reduce their debt burdens.
Taken together the results of the study have several key implications for policy:
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Sinners should not sit in judgement on sinners - In the current arrangements, those making a judgement on the fiscal conduct of a member state have an obvious conflict of interest. This suggests that a body without direct control or political interest in the decision should hand out fiscal policy judgements.
Incentives for fiscal consolidation must exist at the top of the economic cycle - The SGP is only binding on a member state in the event of a 3% deficit. An institutional structure must be in place with the ability to generate fiscal consolidations during upswings and periods of high growth, and so influence policy at all stages of the cycle.
Fiscal policies should be framed in terms of a debt rule - The primary role of the SGP is to address stability considerations. Stability concerns might be better addressed with a rule framed in terms of debts rather than deficits, since the value of a deficit in one particular year has little impact on the sustainability of a member states finances.
Fiscal policies need to be growth friendly - Given the existence of a debt burden, fiscal policies must not choke off economic growth over the medium term. Aside from the benefits of increasing the growth rate, policies which are more 'growth-friendly', such as a reduction of the tax burden on factor incomes and a shift of public spending from transfers to productive investments can help to ensure that a consolidation is successful.
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