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Journal ArticleDOI

A Simple and Flexible Alternative to Stability and Growth Pact Deficit Ceilings: Is it at Hand?

TL;DR: In this article, the authors model a monetary union where fiscal discretion generates excessive debt accumulation in steady state and inefficiently delayed debt adjustment following shocks, and call for more focused supervision tasks for the European Commission and for parliamentary discussion whenever a disagreement arises between the Commission and a national government.
About: This article is published in European Journal of Political Economy.The article was published on 2012-03-01 and is currently open access. It has received 66 citations till now. The article focuses on the topics: Debt adjustment & Stability and Growth Pact.

Summary (2 min read)

1. Introduction

  • The Maastricht Treaty and the Stability and Growth Pact (SGP) provide the institutional framework that regulates fiscal policies within the European Monetary Union.
  • In this paper the authors review the working of the SGP after the 2005 reform and in the light of novel empirical evidence they advocate further reform.
  • In addition, the Greek debt buildup highlights a dramatic failure of both the surveillance framework and the pre-emptive arm of the Pact (Rehn, 2010).
  • The authors results call for the de facto demise of deficit ceilings, that cause inefficient stabilisation in the face of adverse shocks but in normal times allow countries to satisfy the ceiling even if policies are relatively undisciplined.
  • The European Commission would act as the “sound fiscal conscience” for national governments, and public debates in national Parliaments would trigger media coverage sufficient to provide adequate information to voters.

2. From the old to the new Pact

  • The Maastricht Treaty specifies that EU fiscal policies are run nationally, following EU-wide objectives defined for a three year period by the Council of Economic and Finance Ministers in the Broad Economic Policy Guidelines2 , and within the limits set by the SGP.
  • The MTO is expected to vary according to a country’s own initial debt-to-GDP ratio and to potential growth.
  • Hence the key commitment of the original SGP was to set the "… medium-term objective of budgetary positions close to balance or in surplus…" which "… will allow all Member States to deal with normal cyclical fluctuations while keeping the government deficit within the reference value of 3% of GDP".
  • The sanctions for breaking the 3% upper ceiling are detailed in the Excessive Deficit Procedure (EDP) which is specified by Council Regulation 1467/97 included in the SGP.
  • Several contributions pointed out that the old ‘corrective arm’ could not discipline procyclical fiscal in good times (Bean, 1998; CESifo, 2002; Canzoneri and Diba, 2001).

3. EMU fiscal policies in practice

  • There seems to be a general consensus that “a counter-cyclical response of discretionary fiscal policies seems to be the exception rather than the rule.”.
  • Estimates of changes in CAPB run separately for good and bad times reveal a pro-cyclical bias in good times and no bias in bad times.
  • The improvement of the overall balance for EMU countries since the adoption of the SGP actually masks unchanged (small countries) or deteriorating (large countries) cyclically adjusted primary balances with respect to the early post-Maastricht years.
  • Unlike the studies quoted above, the authors do not consider the pre-1999 period.
  • In Table 2 the authors present some basic correlations, confirming this analysis.

4. Theoretical underpinnings of a flexible debt targeting approach

  • The authors consider here a version of Jensen’s (1994) model of debt accumulation, extended to account for both supply shocks and the loss of monetary sovereignty that characterizes EMU membership.
  • In each country, the social welfare function is11 ststististi s sti s ti kGGkyL LW (3) where * is the discount factor, *, ~GG sti and *~ st denote public expenditure and inflation deviations from the socially optimal levels respectively.
  • The combination of idiosyncratic shocks and inflation targeting implies that sst *~ and allows to sharpen the analysis of fiscal policy12.
  • For sake of simplicity the authors therefore neglect this component of the budget constraint.
  • Thus, the term DDk sti ~,3 may be interpreted as follows: i) the target D~ defines the level of debt which would emerge if non-distortionary taxes were available in a world where bequest-constrained individuals affect politico-economic equilibria; ii) 3k represents the political cost of tolerating debt deviations from D~ 16.

4.3 The fiscal policy problem under a debt targeting rule

  • Furthermore, the model has a clear policy prescription, linking national deficits to country-specific cyclical conditions and to country-specific accumulation of debt.
  • In the next section the authors shall discuss how, in principle, EMU institutions could deliver that.

5. Turning the SGP into a flexible debt targeting regime

  • Taken at face value, the new SGP is consistent with their proposal of endorsing a long-term debt target.
  • Third, the new SGP acknowledges the role of past debt in assessing a country’s budgetary objectives ex-ante, but fails to condition deficits on past debt: deviations from MTOs are corrected in a fixed proportion of GDP and faster adjustment is typically enforced on countries characterized by relatively low debt ratios (see their discussion in section 3 above).
  • The Commission’s recommendation was certainly consistent with the SGP provisions.
  • To obtain this, new provisions should require that, in case of disagreement with the Commission, the government would then be required to report to national Parliament, publicly motivating its decisions.
  • In New Zealand the government chooses the inflation target.

6. Conclusions

  • Compared to the SGP, even in its ‘new’ post-2005 form, their proposal scores better with respect to the twin goals of long-term public finance sustainability and economic stabilization in the face of adverse shocks.
  • In their view, their comparison with fiscal policies implemented in non-EMU countries once more confirms that the SGP binds when it should not.
  • The sensitivity of expenditures to the current debt burden (equation 13) may be interpreted as follows.
  • The policymaker’s reluctance to tolerate debt deviations from the target works in the opposite direction: the larger is coefficient 3k , the less sensitive is the deficit to shock.
  • The authors wish to thank for very useful comments Enzo Dia and Jacques Melitz.

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Citations
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Abstract: How the tax system might affect the individual’s educational level is well studied. But the question of how the tax system affects the individual’s choice of educational type is mostly ignored. This is an important issue, since the educational choice of today’s young generation determines the skill composition of tomorrow’s labor force and hence the future production possibilities of the country. This paper studies the problem in a partial model. A progressive tax system might in fact introduce distortions in the individuals’s educational choice and induce him to choose more of the educational type with the higher consumption value. If he also puts more weight on the present than on the future, this effect is strengthened further. JEL-classifications: H25; I21; I29.

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References
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Journal ArticleDOI
TL;DR: In this paper, a simple quantitative model of output, interest rate and inflation determination in the United States, and uses it to evaluate alternative rules by which the Fed may set interest rates.
Abstract: This paper considers a simple quantitative model of output, interest rate and inflation determination in the United States, and uses it to evaluate alternative rules by which the Fed may set interest rates. The model is derived from optimizing behavior under rational expectations, both on the part of the purchasers of goods (who choose quantities to purchase given the expected path of real interest rates), and upon that of the sellers of goods (who set prices on the basis of the expected evolution of demand). Numerical parameter values are obtained in part by seeking to match the actual responses of the economy to a monetary shock to the responses predicted by the model. The resulting model matches the empirical responses quite well and, once due account is taken of its structural disturbances, can account for our data nearly as well as an unrestricted VAR. The monetary policy rule that most reduces inflation variability (and is best on this account) requires very variable interest rates, which in turn is...

2,210 citations


"A Simple and Flexible Alternative t..." refers background in this paper

  • ...With this justification, the policymaker’s loss functions is assumed to be quadratic even in models that explicitly model the representative agent’s preferences (Rotemberg and Woodford, 1997, 1999; Dixit and Lambertini, 2000)....

    [...]

  • ...With this justification, the policymaker’s loss functions is assumed to be quadratic even in models that explicitly model the representative agent’s preferences ( Rotemberg and Woodford, 1997, 1999; Dixit and Lambertini, 2000)....

    [...]

Journal ArticleDOI
TL;DR: In the pure theory of electoral competition, citizens compare the platforms of the candidates and vote for the one whose platform is preferred as discussed by the authors. But these models have another feature that is quite as disturbing as their instability.
Abstract: In the pure theory of electoral competition, citizens compare the platforms of the candidates and vote for the one whose platform is preferred. Candidate strategies are identified with promises about future performance in office. Models of this sort have been developed in both static [McKelvey (1975)] and dynamic [Kramer (1977)I settings, and all appear to have the property that if the set of alternatives is "large enough" in some sense, equilibrium platforms rarely exist. But these models have another feature that is quite as disturbing as their instability. In the static setting discussed by McKelvey, little attention is paid to the possibility that, once in office, the politician's preferences may diverge from those of his constituents and that he may therefore choose policies at variance from his platform. Instead it is simply assumed that promises will be kept whether or not such behavior is congruent with the interest of the officeholder. It is sometimes argued that an "enforcement" mechanism may exist to discipline politicians for failing to keep promises, but without a specification of the mechanism it is not obvious that it would be in the interests of the

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MonographDOI
TL;DR: In this article, the authors present a co-operative research effort that allowed contributors to evaluate different policy rules using their own specific approaches, and present their findings on the potential response of interest rates to an array of variables, including alterations in the rates of inflation, unemployment and exchange.
Abstract: This volume presents late-1990s thinking on monetary policy rules and seeks to determine just what types of rules and policy guidelines function best. A co-operative research effort that allowed contributors to evaluate different policy rules using their own specific approaches, this collection presents their findings on the potential response of interest rates to an array of variables, including alterations in the rates of inflation, unemployment, and exchange. This work illustrates that simple policy rules are more robust and more efficient than complex rules with multiple variables. A state-of-the-art appraisal of the fundamental issues facing the Federal Reserve Board and other central banks, the text should be of interest for economic analysts and policymakers alike.

1,586 citations

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01 Jan 1999
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Abstract: This volume presents late-1990s thinking on monetary policy rules and seeks to determine just what types of rules and policy guidelines function best. A co-operative research effort that allowed contributors to evaluate different policy rules using their own specific approaches, this collection presents their findings on the potential response of interest rates to an array of variables, including alterations in the rates of inflation, unemployment, and exchange. This work illustrates that simple policy rules are more robust and more efficient than complex rules with multiple variables. A state-of-the-art appraisal of the fundamental issues facing the Federal Reserve Board and other central banks, the text should be of interest for economic analysts and policymakers alike.

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TL;DR: In this article, the optimal tax on capital income in general equilibrium models of the second best is analyzed and shown to be zero in the long run for a special case of additively separable utility functions and conditions that are sufficient for the local stability of the steady state.
Abstract: This paper analyzes the optimal tax on capital income in general equilibrium models of the second best. Agents have infinite lives and utility functions which are extensions from the Koopmans form. The population is heterogeneous. The important property of the models is the equality between the social and the private discount rates in the long run. I find that the optimal tax rate is zero in the long run. For a special case of additively separable utility functions, I then determine the tax rates along the dynamic path and conditions that are sufficient for the local stability of the steady state.

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Frequently Asked Questions (2)
Q1. What contributions have the authors mentioned in the paper "A simple and flexible alternative to the stability and growth pact deficit ceilings. is it at hand?" ?

The authors use a simple theoretical model of a monetary union where myopic discretionary fiscal policies generate excessive debt accumulation in steady state and inefficiently delayed debt adjustment following a shock. By setting a long-term debt target and by raising the political cost associated to deviations from the optimal pace of debt reversal following a shock ̧ institutional design induces the fiscal policymaker to implement unbiased discretionary responses to shocks. This is a completely revised version of CESifo Working Paper n. 1006. The authors wish to thank for very useful comments Enzo Dia and Jacques Melitz. 

21 Note that 0ˆ/1ˆ is a necessary condition for stability, and that the stability condition r 1ˆ can be reinterpreted as a ceiling to the proportion of adjustment shifted onto the future.