The Political Economy of the Europe’s Fiscal Union

1. The Political Economy of the Europe’s Fiscal Union Duisenberg Lecture Alberto Alesina January 11 2011

2. Delegation of Policy Prerogative • Monetary Policy: yes • Fiscal Policy: No • Why? • Monetary Policy: less “political”? More “technical”? Do we agree more about it?

3. Monetary Union without Fiscal Union • Original debate: on the one hand countries need more flexibility to purse independent fiscal polices given the constraints on monetary policy; on the other hand the common pool problem. Excessive borrowing.

4. Original sins • Borrowing binge in the periphery. • Spain Portugal Greece Ireland with CA deficit Italy without them but Italy with an already large stock of debt • Why? Low interest rates • ECB non differentiating between debts of different countries • Market asleep and waking up too suddenly

5. Systemic problem • We are in a “bad equilibrium”: markets expect default • They require high rates • They make default more likely

6. Why did we get here? • Comedy of errors starting with the Greek crisis. • Confusion about political feasibility of sharing fiscal burdens • Confusion about willingness to delegate fiscal policy to EU institutions. • Arrogance and denial. “We can do it without the IMF!” (It lasted two weeks !)

7. What to do now? • The time for financial engineering is over • ESFS is not enough to save Italy. • Eurobonds and nor enough (flow versus stock) and in any case opposed by Germany

8. Institutional reforms in Europe • Fiscal rules: which ones? • National or super national? • Delegation of fiscal policy? • Which rule work? Which don’t?

9. Which rules? • Balanced budget rule. • Cyclically balanced budget rule. • Balanced budget rule except for public investment. • Fiscal boards

10. National or super national? • Super national rules have not worked. • Stability and growth pact did not work. • Renewed of more complicated stability and growth pact unlikely to work either • Politically not palatable to delegate fiscal policy • Compare with monetary policy

11. National rules • Rules on sub national levels of government seem to work (evidence form US and Italy). • Rules on national governments? • Possibly, but big endogeneity problem: the choice of putting rules in place is endogenous

12. Between a rock and a hard place • Europe need austerity and growth. • Is it impossible? • Large ongoing debate

13. Case studies of large fiscal adjustments • Lively revival of a literature started by Giavazzi and Pagano and Alesina and Perotti in the early nineties about the possibility of expansionary fiscal adjustments. • Recent papers by Weo, (2010) Alesina Ardagna,(2010) Perotti (2011), IMF volume (2011)

14. What are the issues? • Are spending based adjustments less contractionary in the short run that tax based adjustments? • Some fiscal adjustment have been expansionary even on impact. Why? What is the channel?

15. My take • Spending based adjustments in OECD economies with close to 50 per cent of G/Y are preferable and very likely to be less costly than tax based ones (This may not hold for developing countries) • A large fiscal consolidation accompanied by appropriate policies (wage moderation, friendly monetary policy, stabilizing inflationary expectations ) can be much less costly than we normally think not only in the medium run but also in the short run

16. Why? Supply side effects of tax increases. Demand side effect (positive) effect of future lower taxation if spending goes down. Confidence credibility effects. An adjustment today eliminates the need of a bigger one tomorrow. Public sector wage moderation If you don’t stop automatic spending growth taxes can never catch up!

17. The policy package matters Major fiscal adjustments are often accompanied by other major policy reforms. The appropriate one may help a lot, their absence may hurt Forthcoming IMF Book on what make fiscal adjustment successful

18. What matters? • When the debt is very high fiscal adjustments are less costly in terms of recessions than when the debt is low. (Related to Reinhart and Rogoff) • Wage agreements help and wage agreements are helped by wage moderation in the public sector due to the fiscal adjustment • Private investment seem to react to a change of regime in which the fiscal house is on the way to adjust. • Wage moderation and sometimes devaluation help competitiveness and export booms • Credible and stable (but not restrictive) monetary policy helps

19. Fiscal deficits and elections There is not evidence that larger budget deficits increase changes of reelection. Brender and Drazen (AER 2008) find the opposite: larger deficits are (weakly) associated with less success at the polls.

20. How about large fiscal adjustments? Many large fiscal adjustments have been followed by re-election of government which implemented them. Especially when the adjustment occurred early in the term

22. Reverse causality? Could it be that only those governments which know they are strong engage in fiscal adjustment? Thus government are reelected despite not because of fiscal adjustments. Difficult to test. How do you define “strong”? No obvious evidence of this effect.

23. Social costs of fiscal adjustments We don’t know enough. Much depends on the efficiency of the welfare state.

24. Welfare systemsper cent of households at risk of poverty before and after social transfers (2003) Source: Eurostat

25. Fonte: Peter Whiteford, 2006

26. Examples Government wages: in many countries they grew more than private sector wages Pensions: retirement age has to go up everywhere Physical infrastructures: their value overestimated Taxes: expand base don’t increase rates

27. Conclusion • Europe has two key problems: • A short term one of how to move in between a rock and a hard place: growth and austerity • An institutional problem of how to achieve more fiscal union