Free Slides from Ed Dolan’s Econ Blog http://dolanecon.blog spot.com/ EU Leaders Struggle to Fix Fiscal Policy Rules Post prepared November 1, 2010 Terms of Use: These slides are made available under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics , from BVT Publishers.
EU Leaders Struggle to Fix Fiscal Policy Rules
Dec 23, 2014
This slideshow discusses options available to EU leaders as they struggle to fix fiscal policy rules in the euro area
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Free Slides fromEd Dolan’s Econ Blog
http://dolanecon.blogspot.com/
EU Leaders Struggle to Fix Fiscal Policy Rules
Post prepared November 1, 2010
Terms of Use: These slides are made available under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics
classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishers.
Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
EU Leaders Meet on Fiscal Policy Rules
At a summit meeting in late October, EU leaders unanimously agreed that changes are needed in the fiscal policy rules that apply to all members, including those that use the euro
The current “3/60” rules limit budget deficits to 3 percent of GDP and government debt to 60 percent of GDP
The rules are needed to overcome the free rider problem that is inherent in common-currency areas
The European Union consists of 27 member countries, 16 of which use the euro as their common currency. In 2011, Estonia, already an EU member, will become the 17th member of the euro areaMap source; http://commons.wikimedia.org/wiki/File:Eurozone_map-2009.svg
Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
What is the Free Rider Problem?
A familiar example of the free rider problem occurs when you meet with a group of friends for a meal in a restaurant
If you agree in advance that everyone will get separate checks, you order a beer and a hamburger
If you agree that everyone will pay an equal share of the entire bill, you are more likely to order steak and champagne.
Photo: http://commons.wikimedia.org/wiki/File:Caprice_Restaurant.JPG
Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Countries with their own currencies
Countries with their own currencies can’t play fiscal free rider
They can please their voters by cutting taxes or increasing spending ahead of elections . . .
but if they do so, they must later bear the costs, which may include higher interest rates, unwanted exchange rate movements, and even the possibility of default on the government’s debt
Sweden is a member of the EU but retains its own currency, the kronorPhoto by Emil Frisk, http://en.wikipedia.org/wiki/File:Svenska_hundrakronorssedlar.JPG
Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Countries with shared currencies
Countries with shared currencies are in a different position
They, too, can please their voters by cutting taxes or increasing spending ahead of elections
However, the costs (higher interest rates, exchange rate changes, default risk) are spread among all members of the currency area
Because they get all the benefits and share the costs, they have an incentive to play the free rider
The euro is an example of a common currency shared by several independent countries
Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
The 3/60 rules have not Worked Well
Even in good years like 2007, fewer than half of the 16 euro area members have been safely within the 3/60 limits. When the global crisis hit, all but two members missed either the debt or deficit targets, or both
Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
The 3/60 rules do not give good early warning
Also, the 3/60 rules do not give good early warning. Ireland and Spain went from full compliance to full-blown solvency crisis in just two years
Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Proposal: Establish a Permanent Bailout Fund
In May 2010, in response to the Greek budget crisis, the EU established a temporary European Financial Stability Fund to provide loans to member countries in an emergency
At the October summit, it was proposed to make the fund permanent
Objections:
A permanent fund might violate the “no-bailout” clause of the EU’s founding Maastricht treaty A bailout fund could increase moral hazard. Knowing a fund is available, member countries might take bigger risks in managing their budgets
Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Proposal: Increase Penalties for Violating Budget Rules
The EU already has authority to impose fines on members who do not comply with the 3/60 fiscal policy rules
At the summit, proposals were made to increase monetary fines or introduce administrative penalties, like temporary loss of voting rights
Objections:
Imposing monetary fines on countries in crisis only makes the crisis worseIt is politically hard to impose fines on the biggest member countries. In the past, France and Germany have violated the budget rules without finesAdministrative penalties were rejected as too controversial
Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Proposal: Force Bondholders to Share the Cost of Bailouts
A proposal was made at the summit that bondholders should be subjected to haircuts as a way of sharing the cost of future bailouts.
Imposing a haircut would mean holders of bonds of an insolvent or near-insolvent euro member country would receive only part payment on the debts they were owed
Objections:The threat of haircuts would spook bondholders and send borrowing costs even higher for countries whose budgets are already weakEuropean banks are major holders of the bonds. Subjecting them to losses might reduce the cost of country bailouts only at the risk of having to bail out the banks, instead
Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
What the Summit Decided to Do
At the October summit, EU leaders unaniously agreed that a new set of fiscal rules was needed
An attempt will be made to draft new rules that will include a permanent mechanism to deal with fiscal crises and a strengthening of the current budget rules
Objections:Any proposal would probably require amendment of the EU’s founding treatyAny major modification would require formal ratification by all member countries, including referendums in some countries—an almost impossible taskMinor technical modifications could be possible without formal ratification but might be too weak to do much good
Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
The Bottom Line: Problem Not Yet Solved
The summit was a small step forward in that there was unanimous agreement that current rules are inadequate
The strongest proposals were rejected, and any final rule changes will probably be too weak to solve the problem permanently
The bottom line: The euro area cannot yet declare victory in its struggle with fiscal policy free riders
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