Euro area fiscal stance:definition, implementation and democratic legitimacy

ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC

AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP

GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNAN

MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs S

CE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKIN

RM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFS

G UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION E

F ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs

CONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC G

ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP M

OVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANC

TO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESB

E ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMI

R EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP

IC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERN

AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SS

ANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BAN

M SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NC

KING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNIO

As NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AG

N ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOMIC GOVERNANCE BANKING UNION ECONOM

S DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MT

O SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM

MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ES

M ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EF

SM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP

CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA E

WG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR C

SRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP

EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NR

As SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS

EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP E

SAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MT

SM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EF

SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs

NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS D

GS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO S

CP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MI

P MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM

ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM

EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CR

D SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EW

G NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSR

s AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP MTO SCP ESAs EFSM EDP AMR CSRs AGS DGS EFSF ESM ESBR EBA EWG NCAs NRAs SRM MIP MTO NRP CRD SSM SGP EIP

DIRECTORATE-GENERAL FOR INTERNAL POLICIES

ECONOMIC GOVERNANCE SUPPORT UNIT

I N -DEPTH A NALYSIS

Provided at the request of the

Economic and Monetary Affairs Committee

ECON

IPOL

EGOV

Euro-area fiscal stance:

definition, implementation and democratic legitimacy

External authors: Esther Ademmer

Claire Boeing-Reicher

Jens Boysen-Hogrefe

Klaus-Jürgen Gern

Ulrich Stolzenburg

Kiel Institute for the World Economy

July 2016

IPOL

EGOV

DIRECTORATE-GENERAL FOR INTERNAL POLICIES

ECONOMIC GOVERNANCE SUPPORT UNIT

PE 574.425

IN-DEPTH ANALYSIS

Euro area fiscal stance:

definition, implementation and democratic legitimacy

External authors: Esther Ademmer

Claire Boeing-Reicher

Jens Boysen-Hogrefe

Klaus-Jürgen Gern

Ulrich Stolzenburg

Kiel Institute for the World Economy

Provided in advance of the Economic Dialogue with the President of the Eurogroup

in autumn 2016

Abstract

In its current approach to achieve an appropriate euro area fiscal stance, the EU Commission

asks countries with fiscal space to provide extra stimulus in order to compensate for countries

that are constrained by debt sustainability considerations. However, the aggregate fiscal

stance is not a particularly useful concept since it abstracts from too much relevant

information at the country level. In particular, excessive stimulus in one country is likely to

generate welfare losses there, since this may compromise fiscal sustainability and/or cause

its economy to overheat. Additional spending in one country can help other countries only

if (1) there are significant trade spillovers and (2) monetary policy does not respond to the

increase in economic activity. Even then, the composition of national fiscal policies may be

inappropriate, since additional spending may be called for in countries where it is not needed.

To overcome these problems would entail moving towards a fiscal union (e.g. by

implementing a cyclical risk-sharing mechanism), which can potentially loosen fiscal

restrictions, but introduces risks of moral hazard and persistent one-sided transfers.

June 2016

ECON EN

PE 574.425

This paper was requested by the European Parliament's Economic and Monetary Affairs Committee.

AUTHOR(S)

Esther Ademmer

Claire Boeing-Reicher

Jens Boysen-Hogrefe

Klaus-Jürgen Gern

Ulrich Stolzenburg

Kiel Institute for the World Economy

RESPONSIBLE ADMINISTRATOR(S)

Jost Angerer

Economic Governance Support Unit

Directorate for Economic and Scientific Policies

Directorate-General for the Internal Policies of the Union

European Parliament

B-1047 Brussels

LANGUAGE VERSION

Original: EN

ABOUT THE EDITOR

Economic Governance Support Unit provides in-house and external expertise to support EP

committees and other parliamentary bodies in playing an effective role within the European Union

framework for coordination and surveillance of economic and fiscal policies.

E-mail: [email protected]

This document is also available on Economic and Monetary Affairs Committee homepage at:

http://www.europarl.europa.eu/committees/en/ECON/home.html

Manuscript completed in June 2016

DISCLAIMER

The opinions expressed in this document are the sole responsibility of the authors and do not

necessarily represent the official position of the European Parliament.

Reproduction and translation for non-commercial purposes are authorised, provided the source is

acknowledged and the publisher is given prior notice and sent a copy.

PE 574.425

CONTENTS

List of abbreviations.............................................................................................................................4

List of tables.........................................................................................................................................4

List of figures.......................................................................................................................................4

Executive summary..............................................................................................................................5

1. Introduction...................................................................................................................................7

2. Measuring and evaluating the fiscal stance ..................................................................................9

2.1 Measurement: How is the fiscal stance defined and calculated?............................................9

2.2 Evaluating the fiscal stance: Business cycle stabilisation and debt sustainability ...........11

2.3 How is aggregation done and is the procedure appropriate?............................................12

3. Implementation by means of fiscal coordination........................................................................14

3.1 The current fiscal framework ............................................................................................14

3.2 Using fiscal space at the country level to target euro area aggregates .............................15

3.3 The size of spillovers: Does spending in one country help other countries? ...................16

3.4 Should fiscal policy target external imbalances? ............................................................17

3.5 Interim conclusion: The current approach to fiscal coordination has its limits ................17

4. Democratic legitimacy and the aggregate fiscal stance ..............................................................19

5. What else can be done?...............................................................................................................21

5.1 Relaxing fiscal rules ..........................................................................................................21

5.2 A macroeconomic stabilisation function..........................................................................21

5.3 Fiscal union: The way forward?........................................................................................24

6. Conclusions.................................................................................................................................26

References..........................................................................................................................................27

PE 574.425 4

LIST OF ABBREVIATIONS

EA Euro Area

ECB European Central Bank

EMU European Monetary Union

EFSI European Fund for Strategic Investments

EP European Parliament

ESM European Stability Mechanism

EU European Union

GDP Gross Domestic Product

LIST OF TABLES

Table 1: Total and cyclically-adjusted balance, euro area, in percent of GDP, different vintages.

.................................................................................................................................... 11

LIST OF FIGURES

Figure 1: Euro area fiscal stance and output gap, 2005-2015...................................................... 8

Figure 2: Composition of the budget balance in selected countries, 2015................................ 10

Figure 3: Output gap estimates in selected countries, 1999-2015............................................. 12

5 PE 574.425

EXECUTIVE SUMMARY

 The fiscal stance is defined according to business cycle stabilisation criteria, but it is judged

according to both business cycle stabilisation criteria and fiscal sustainability criteria. Fiscal

(i.e. debt) sustainability is a national responsibility and, so far, only national authorities can

conduct fiscal policies.

 Therefore, the joint fiscal stance is not a useful concept, since this abstracts from too much

relevant information at the country level.

 If debt sustainability at the country level were no problem, then all Member States could

conduct fiscal policy according to their own cyclical needs. If all countries had the same view

on this, and if spillovers were small, then the desired joint fiscal stance would arise without

additional measures.

 However, some countries are restricted in their ability to react counter-cyclically to economic

downturns, since debt sustainability concerns and fiscal rules do not allow for a more

expansionary fiscal stance. The extent of this problem can be measured by looking at the

aggregation of national fiscal stances, which became restrictive during the euro area recession

of 2012 and 2013.

The current EU approach:

 The EU Commission asks countries with sound debt positions to provide extra fiscal stimulus

(currently the case with Germany). This stimulus is intended to loosen the joint fiscal stance

and to indirectly help countries that cannot afford a more expansionary fiscal stance. However,

the EU Commission has no budgetary power to accomplish this directly.

 However, countries with sound debt positions have little incentive to do this. This is because

additional stimulus in a country beyond its own business cycle needs is likely to generate

welfare losses there, by compromising fiscal sustainability and/or causing the economy to

overheat. Pushing the economy into a state of overheating could set the seed for a future crisis,

while at the same time reducing the future fiscal space needed to help smooth the adjustment

process. Furthermore, requiring boom countries to engage in more fiscal stimulus will induce

more business cycle divergence among euro area members.

 Does this approach at least help other countries? This depends on the size of spillovers and

the responsiveness of monetary policy, the latter of which affects all euro area members. If

trade spillovers are low, but monetary policy is responsive, then stimulus in one country may

even extert a contractionary effect on other countries due to tighter monetary policy.

 Additional spending in one country can help other countries in a narrow environment: if

(1) there are significant trade spillovers and (2) monetary policy does not respond

substantially to the increase in economic activity. Moreover, (3) such a policy appears

reasonable only in a situation where monetary policy does not successfully stabilise euro area

output. Even if these conditions are fulfilled, the composition of national fiscal policies may

still be inappropriate, if additional stimulus is carried out in countries where it is not needed.

 As a result, targeting an aggregate fiscal stance will be politically contested in some euro area

members and is unlikely to become legitimated by simply claiming to represent a more

efficient approach to euro area fiscal policy-making. The current and proposed approaches to

euro area fiscal policy-making are not transparent and do not strongly involve bodies that are

directly legitimated, (such as the European Parliament). As a result, there are substantial

concerns about democratic legitimacy.

What else could be done?

 Less restrictive fiscal rules could help only to a limited extent as they would not remove

restrictions of national fiscal policies caused by concerns over debt sustainability, which are

at the heart of the asymmetries.

 A joint budget to support fiscal stabilization policies could be created, to be financed by

member state contributions. Support would be granted to countries hit by asymmetric shocks.

PE 574.425 6

The activities of such a central fiscal authority could both involve redistribution between

Member States (net transfers) and redistribution over time (net lending).

 Resources from this joint budget could either be used directly (centralized spending

decisions), or acquired funds could simply be redirected to Member States (national spending

decisions). The latter is preferable in our view.

 In theory, a stabilization fund that allows for net transfers could help to partly loosen the fiscal

restrictions faced by some Member States during crises and to better synchronize business

cycles, since transfers constitute an additional source of spillovers. Moreover, a fiscal

authority that redistributes funds intertemporally in response to euro-area-wide recessions

might be considered useful in an environment where monetary policy is ineffective at

stabilizing output. However, several problems arise:

1. The stabilization mechanism would have to address only genuine cyclical risks,

despite the fact that output gaps are poorly measured, and assessment of cyclical needs

would become an even more contentious issue;

2. Asymmetric shocks can be the result of bad policies, which might trigger net transfer

inflows (moral hazard).

3. Net transfers to crisis countries run the risk of reducing the pressure to conduct

appropriate structural reforms to address the fundamental causes of the crisis.

Transfers also weaken market forces that help to overcome macroeconomic

imbalances. Therefore, a risk-sharing mechanism may perpetuate structural problems

and trigger permanent transfers in one direction.

4. A stabilization fund reduces the need for national policymakers to cushion

macroeconomic shocks themselves. Therefore, incentives to reduce high debt levels

(and to seek fiscal space) could be damaged.

 In a fiscal framework that gives more responsibilities to the euro area level, the assessment,

determination, and implementation of an appropriate aggregate fiscal stance would require a

process that is transparent and responsive to euro area wide political preferences. Such a

process is unlikely to be achieved in the current fiscal coordination framework; instead it

would require an encompassing institutional reform of the EU.

7 PE 574.425

1. INTRODUCTION

Of the three textbook functions of fiscal policy – allocation, distribution, and stabilization,

stabilization gives the main justification for considering fiscal policy at the euro area level.

Traditionally the objective of fiscal policy in a state is threefold (Musgrave, 1959): providing public

goods (allocation), organizing transfers between individuals or regions to implement a desired

secondary income distribution and to foster economic cohesion (distribution), and smoothing

economic activity over the business cycle (stabilization). However, the unique and complex

institutional structure of the European Union complicates the interpretation and conduct of fiscal

policy along these lines. With respect to allocation, the euro area represents only a part of the

European Union and most public goods are not specific for this group of countries. Obvious

candidates for European public goods relate either to the whole EU (such as infrastructure, research,

and diplomacy), or to a different subset of countries (such as expenditures associated with security,

border controls, and refugee policy for countries in the Schengen area).

Financial stability, which

could be considered an EMU-specific public good, is handled by the ESM and by the ECB.

Meanwhile, with respect to distribution, fiscal systems that redistribute personal income are provided

at the national level, and there already exist European-wide interregional transfers to make up for

geographical or historical disadvantages and improve convergence. These transfers are organized by

the European Union as a whole using structural funds, regional funds, or cohesion funds. What

remains is the issue of stabilization.

There may be demand for active stabilization policies throughout the euro area, when euro area

monetary policy is ineffective. Normally, monetary policy should be expected to be the main

instrument of aggregate stabilization policies for the euro area, at least as long as counter-cyclical

monetary policy is consistent with the ECB’s mission to achieve price stability in the medium term.

Meanwhile, national fiscal policies would be responsible for smoothing country-specific business

cycles, either through automatic stabilizers or discretionary anti-cyclical policies. This would imply

expansionary fiscal policies in countries facing a downturn relative to the euro area aggregate but

restrictive policies in countries facing an upturn. This pattern would automatically deliver an

appropriate aggregate fiscal stance in the euro area. However, there may be situations in which

monetary policy is ineffective or is otherwise unable to provide sufficient stimulus to get the

aggregate euro area economy out of a slump, such as in recent years with interest rates at the zero

lower bound (Gern et al. 2015a). Then fiscal policy would have to step in.

If some countries are restricted in their ability to react counter-cyclically to economic

downturns, this will prevent an appropriate fiscal stance from emerging. Debt sustainability

considerations and fiscal rules may not allow for the appropriate expansionary fiscal policy stance at

the national level; and may even prevent automatic stabilizers from operating properly. This has been

the case during the recent sovereign debt crises. In 2012 and 2013, financial markets pushed the crisis

countries into pro-cyclical fiscal tightening in order to promote fiscal sustainability.

At the same

time, the non-crisis countries have not engaged in an offsetting fiscal expansion. As a result, the

aggregate fiscal stance became contractionary and pro-cyclical (see Figure 1).

This uneven fiscal contraction has motivated the debate about how (or if) to enforce an

“aggregate fiscal stance” in the euro area. Since 2012, the European Semester’s recommendations

have included a recommendation on the aggregate fiscal stance, although there is no specification as

to what this would look like (Darvas and Leandro 2015: 11). The notion of the aggregate fiscal stance

has been introduced into the regulation on monitoring and assessing national draft budgetary plans in

the European Semester cycle (Article 7). This notion has also been addressed in the annual growth

survey of 2016 (annual policy priority report by the EU Commission), and has been emphasized by

ECB president Mario Draghi (2014). In addition, advising on the appropriate aggregate fiscal stance

is one of the main tasks assigned to the newly established Advisory European Fiscal Board.

The categorization of defense expenditures is complicated by the fact that not all EU countries are NATO members.

The perceived lack of sustainability of public finances in part induced a reassessment of potential output as a

consequence of the crisis.

PE 574.425 8

Figure 1: Euro area fiscal stance and output gap, 2005-2015.

Source: IMF, World Economic Outlook, 2016. We use IMF data since EU Commission estimates

(Economic and Financial Affairs) for the structural balance are available only from 2010 onwards.

We argue that the joint fiscal stance is not a reasonable measure of fiscal policy in the euro area.

This is the case because business cycle needs as well as fiscal sustainability are primarily relevant at

the national level. As long as heterogeneity in the business cycle between Member States is large,

while spillovers are low, it makes more sense to look at national fiscal stances. Additional fiscal

stimulus in one country beyond its cyclical needs can be expected to generate welfare losses in that

country, while effects on euro area-wide welfare depend on the size of total spillovers. Only

sufficiently large spillovers would make it reasonable to discuss the euro area aggregate fiscal stance.

However, even then, the composition of fiscal policies may be inappropriate, since additional

spending may be called for in countries where it is not needed.

We discuss the following main points: a meaningful application of the concept of a euro area

aggregate fiscal stance would require (1) that the aggregate fiscal stance is a reasonable measure

of fiscal policy in the euro area, (2) spillovers of national fiscal policies on economic activity of

other countries that are large enough to justify systematically intervening in national fiscal

policies, (3) and that implementation is possible and democratically legitimate. In Section 2, we

evaluate how the fiscal stance is measured and evaluated, and we discuss problems of measurement

and aggregation. In Section 3 we review the current fiscal framework and current efforts to implement

an appropriate aggregate fiscal stance. In particular, we discuss whether and under what

circumstances it is useful to push countries with fiscally sound positions to engage in fiscal expansion

to target euro area aggregates. In Section 4, we discuss how an aggregate fiscal stance (as a policy

objective) would achieve (or not achieve) democratic legitimacy. Section 5 covers other potential

ways to address perceived weaknesses in the current coordination efforts of euro area fiscal policies.

-4

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2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Change in struct. balance (pp)

Output Gap

Yearly data, in relation to potential GDP.

Percent, pp

9 PE 574.425

2. MEASURING AND EVALUATING THE FISCAL STANCE

2.1 Measurement: How is the fiscal stance defined and calculated?

The fiscal stance answers by and large the question whether current fiscal policy positively or

negatively affects economic activity. Looking at the effects on economic activity, the fiscal stance

can be measured as the change in the structural budget balance, where a decrease in the structural

budget balance is expected to be expansionary, while an increase is expected to be contractionary.

The structural budget balance is used instead of the total budget balance because the latter measures

an accounting quantity rather than an economic policy instrument.

The total budget balance is not

an instrument for discretionary stabilization because it contains several elements that are not

amenable to policy, at least in the short run. These main elements are the cyclical portion of the budget

balance, interest payments, and one-offs. The budget balance has a cyclical portion because tax

revenues are highly procyclical, while government consumption and gross investment tend to be

acyclical, and social transfer payments (especially unemployment insurance payments) are

countercyclical. Therefore, during recessions, the budget balance deteriorates (due to a fall in

revenues and an increase in expenditures), even though this reflects neither short-term changes in

policy nor long-term changes in fiscal sustainability (since the cyclical component disappears after

the output gap returns to zero).

Furthermore, interest payments and one-offs are not the result of

current policy, but instead are the result of past debt levels and (in the case of most one-offs)

accounting decisions which do not reflect the current operations of the government.

In order to remove the effects of output fluctuations on the budget balance, the European

Commission performs a cyclical adjustment procedure. This involves two steps: first, developing

a measure of the business cycle, and then removing the influence of the business cycle from the

budget balance. The business cycle is measured by decomposing GDP into potential GDP and the

output gap, following a production function approach as documented in Havik et al. (2014). This

approach involves calculating statistical trends in productivity, labor input, etc., and then seeing how

current output deviates from its implied trend (which is treated as representing potential GDP). On

this basis, the cyclical component of the budget balance is calculated by applying semi-elasticities of

the budget on the measured output gap as documented by Mourre et al. (2014). Semi-elasticities are

estimated by a disaggregated approach for certain revenues and expenditures, which are then re-

aggregated. The procedure does not adjust with respect to interest payments, since interest payments

typically do not fluctuate strongly from year to year, except for extreme situations.

The resulting

concept of the fiscal stance is thus based on the structural budget balance and not the structural

primary budget balance.

In addition to the cyclical adjustment, so-called one-offs are subtracted. One-off measures have

a transitory effect on the budget balance and do not change the fiscal position permanently. Examples

of one-offs include extra revenues that occur in just one year and cannot be expected to be repeated,

such as revenues from auctions of mobile phone licenses. An important one-off in recent years was

government spending for bank rescue packages. Such spending was substantial in some countries, to

the point that they had an indirect effect on the structural budget balance, because these one-offs have

led to sharply higher debt levels, and higher debt levels have resulted in higher interest payments. An

important element in the definition of one-offs is that they are not at the discretion of governments;

the EU Commission does generally not regard discretionary policies that decrease the budget balance

as one-offs. Otherwise, this would give room for policymakers to engage in persistent discretionary,

expansionary policies without this showing up in the structural budget balance. The structural budget

The focus on the structural budget balance was introduced into the European fiscal framework with the 2005 reform of

the Stability and Growth Pact.

It should be noted, however, that the extent of automatic stabilization over the cycle (achieved through the fiscal system)

is at the choice of the government and may vary from country to country.

At least for the euro area as a whole, one may also argue that interest payments are also a component of government

spending that increases the disposable income of private households and enterprises. From this perspective it can make

sense to include interest payments in the definition of the fiscal stance, if these interest payments are then spent rather

than saved.

PE 574.425 10

balance itself is a typical measure for the fiscal position and plays an important role for the

surveillance of fiscal policy in the EU. The components of the total budget balance are shown for a

selected set of countries for 2015 in Figure 2; the structural budget balance is defined as the sum of

the structural primary balance and interest payments (add blue and grey bars).

Figure 2: Composition of the budget balance in selected countries, 2015.

Source: European Commission 2016, authors’ calculations.

However, there are technical and conceptual problems related to estimating and evaluating the

structural budget balance, and in making policy based on that balance. First, it is difficult to

measure the current position of the business cycle. It is common knowledge that output gap estimates

sometimes experience substantial revisions; recent experiences for EU countries are documented by

Kempkes (2014). However, to judge the fiscal position, some measure for the business cycle is needed

to disentangle short-run fluctuations from medium- to long-run developments. Otherwise, short-run

fluctuations will tend to dominate the measurement of fiscal policy. Secondly, raw data get revised

on a regular basis. The issue of revisions can be seen by looking at Table 1, which shows the total

balance and cyclically adjusted balance for the euro area for 2005 through 2009, as measured in spring

2016, in autumn 2009, and in spring 2008. While revisions to the total budget have been small for

actual data

, cyclically adjusted figures have been revised substantially and continuously. In

particular, the estimates for the cyclically adjusted balance in 2005 through 2007 were reduced

substantially from spring 2008 to autumn 2009 and afterwards, reflecting the reassessment of

potential output after the Great Recession that led to a substantial upward revision of the estimate for

the output gap for the years before the crisis.

The huge revisions to the forecast values for 2008 and 2009 reflect the impact of the surprise recession in those years.

It is worth noting that measurement problems of potential output (and potential growth) affect almost all concepts for

fiscal surveillance as these usually rely on the idea of potential output or, similarly, medium run to long run projections.

-12

-10

-8

-6

-4

-2

Structural primary balance

Interest payments

One-Offs

Cyclical Component

Total budget balance

Total structural balance

Yearly data, in relation to GDP.

Percent

11 PE 574.425

Table 1: Total and cyclically-adjusted balance, euro area, in percent of GDP, different vintages.

Total

Cyc. Adj.

Year\vintage

2016

2009

2008

2016

2009

2008

2005

-2.6

-2.5

-2.6

-2.5

-2.0

2006

-1.5

-1.3

-2.3

-1.9

-1.2

2007

-0.6

-2.1

-1.8

-0.7

2008

-2.2

-2.0

-1.0

-3.1

-2.9

-1.0

2009

-6.3

-6.4

-1.1

-4.3

-5.0

-0.8

Source: European Commission (Economic and Financial Affairs), authors’ calculations, calculated

using spring 2016, autumn 2009, and spring 2008 vintage data. Highlighted items are forecasts.

Another conceptual problem is that cyclical adjustment, by design, wipes out the effects of

automatic stabilizers, which can lead to different judgments about the behaviour of fiscal policy

over the cycle. For example, one country may systematically and predictably adjust its tax code

during a recession to stimulate the economy, while another country may have a progressive tax code

that automatically adjusts. Abstracting from the problem in the former case of getting the timing right,

the effects of both setups on the economy should be expected to be very similar. However, in one

case, the fall in tax rates during a recession would show up as a change in the structural balance, while

in the other case, it would not. As a result, the cyclical adjustment process may not automatically

deliver a true cyclical adjustment from the perspective of a person who has rational expectations about

the way that fiscal policymakers behave.

2.2 Evaluating the fiscal stance: Business cycle stabilisation and debt sustainability

While the fiscal stance is measured purely against cyclical considerations, the evaluation of its

appropriateness has to take into account the issue of sustainability of public finances and

involves making normative judgments about how to balance the effects of fiscal policy on

economic activity (business cycle stabilization) against the effects on debt sustainability. This is

one major source of tension. With respect to judging appropriateness in terms of cyclical stabilisation,

a common view is that automatic stabilizers constitute a desirable, predictable counter-cyclical

response to normal shocks, while additional discretionary measures are a weak stabilisation tool due

to inherent problems to get their timing and size right (ECB 2016: 73). Therefore, only exceptional

circumstances and deep swings of the cycle may require additional discretionary measures. With

respect to debt sustainability, Boeing-Reicher (2016) shows that if the structural total balance is

bounded, then this is sufficient to keep the public debt from exploding over the long run. However,

the EU cares about more than keeping the debt from exploding; it also wants debt levels to drop below

the 60 per cent threshold contained within the Stability and Growth Pact.

In order to keep track of debt levels in the long term, the EU Commission monitors an indicator

called S1. This indicator is based on debt projections, and it gives the structural primary balance

needed to reach a debt level of 60 per cent relative to GDP in 2030. Therefore, since public debt-to-

GDP ratios are above 90 per cent in the euro area on average, considerations on debt sustainability

would require respective countries to run more restrictive fiscal policies compared to a situation

where debt levels were still in line with the Stability and Growth Pact’s requirement of less than 60

per cent.

The indicator S1 also explicitly accounts for the fiscal pressures exerted by an aging

population in the debt projections. Details about the calculation of S1 can be found in European

Commission (2016a, Annex A2). It is also shown how the figures for S1 are highly sensitive to long-

run projections for economic activity – a problem that all debt sustainability analyses face.

In this context, we would like to stress that according to the EU fiscal rules, the 60 per cent debt-to-GDP ratio is not a

target but an upper limit of tolerable debt.

See Wyplosz (2011) and Plödt and Reicher (2014) for other examples where this matters.

PE 574.425 12

It might be unrealistic to expect countries to target specific paths for their debt-GDP ratios,

since this can actually destabilize output and debt levels, as shown by Boeing-Reicher (2016).

More generally, this can run afoul of the tradeoff between business cycle stabilisation and debt

sustainability. In the specific case of the indicator S1, it is not clear whether macroeconomic

repercussions are taken into account, or how this tradeoff should be expected to be made. Instead, we

argue that it might make sense to allow for a time-varying deficit target that varies with both the

output gap and the level of debt, following Plödt and Reicher (2015), such that automatic stabilizers

and policy mechanisms are allowed to operate in the short run while ensuring a strong degree of debt

stabilization in the long run. This is a modified version of the fiscal reaction function of Boeing-

Reicher (2016), Plödt and Reicher (2015), and Snower et al. (2011). Further work could help to

explore the effects of different calibrations – our own internal simulations suggest that a “structural

debt brake” rule of this type might strike a good balance.

2.3 How is aggregation done and is the procedure appropriate?

Generally, the structural budget balance (as well as the primary budget balance) is measured

in euros, thus making aggregation easy. This holds for the fiscal stance, too, as it is measured as

the change in the structural budget balance. Likewise, it is possible to come up with a business cycle

position for the euro area as a whole; the European Commission regularly produces euro area output

gap estimates, which have the same benefits and drawbacks as country-level output gap estimates.

Figure 3: Output gap estimates in selected euro area countries, 1999-2015.

Source: European Commission, Economic and Financial Affairs, 2016.

But, business cycle fluctuations across Member States are far from perfectly correlated, thus

making aggregation and assessment of cyclical needs for the euro area as a whole problematic.

To see this, Figure 3 shows how the output gaps of the original euro area countries have varied since

the introduction of the EMU. For the most part, these output gaps exhibit a positive correlation with

each other, but this correlation is far from perfect. More precisely, the timing of cyclical up- and

downturns is fairly similar across countries, but the amplitude differs significantly. The ex-post

-14

-12

-10

-8

-6

-4

-2

1999 2001 2003 2005 2007 2009 2011 2013 2015

GER FRA

ITA ESP

NED BEL

AUT FIN

GRE POR

IRE

Yearly data, in relation to potential GDP.

Percent

13 PE 574.425

evaluation shows rather small variations in many euro area countries, but larger variations in Spain,

Ireland, Greece, and also Finland. Arriving at an aggregate fiscal stance (analogous to the ECB’s

aggregate monetary stance) implies abstracting from the fiscal conditions and business cycle

conditions in individual countries. Consequently important information is lost when looking at euro

area aggregates. Moreover, the example of some of the countries mentioned above shows that the

very focus on the fiscal stance may be misleading as it distracts from the problems that are at the root

of the country-specific developments. These are predominantly at the micro level and need structural

reform rather than macroeconomic demand management.

Additionally, the other main criterion, debt sustainability, is not in the domain of euro area

policymakers, but is instead in the domain of the member countries. Debt levels and structural

deficits too are far from perfectly correlated. This imperfect correlation matters – if a country runs

too high a deficit and endangers its own debt sustainability, this “mistake” cannot be counterbalanced

by a higher surplus in another member country, since this does nothing to alleviate the deficit

country’s loss in creditworthiness. As argued by the ECB (2016: 78), the aggregate fiscal stance “can

only be deemed appropriate if it safeguards the sustainability needs of all euro area countries.”

Counterbalancing would only work if the euro area as a whole would bear each member country’s

default risk, e.g. via a euro bond mechanism or some other risk-sharing mechanism. This is also

recognized by the EU Commission. In its recent assessment, the EU Commission concludes that the

fiscal stance in the euro area for 2016 is consistent with moderate stabilization and is less restrictive

than that implied by sustainability needs (European Commission 2015b: 10). Furthermore, the EU

commission regularly includes cyclically adjusted data for the euro area and for the EU as a whole;

these data currently indicate (for 2015) a small cyclically-adjusted deficit for the euro area as a whole

(see Figure 2).

Altogether, we find that the joint fiscal stance is a concept of limited relevance. Business cycle

stabilization needs as well as debt sustainability considerations are first of all measured and relevant

at the national level. Ensuring debt sustainability is a national responsibility and, so far, only national

authorities have the means to conduct fiscal policies.

PE 574.425 14

3. IMPLEMENTATION BY MEANS OF FISCAL COORDINATION

3.1 The current fiscal framework

The current set of fiscal rules and surveillance mechanisms constitutes a legal framework in

which national fiscal policies are coordinated, however weakly. Governments are to some extent

disciplined to comply with established rules in their budgetary plans by way of peer pressure and by

the threat of possible sanctions. For instance, draft budgets need approval by the European

Commission, and Member States that deviate from established fiscal rules are obliged to commit to

a reasonable path of adjustment. However, the current debate on the aggregate fiscal stance

demonstrates that the outcomes of this process are controversial. Moreover, the willingness or ability

to comply with the existing set of rules is weak among many Member States, as demonstrated by a

large number of countries recently violating the fiscal rules.

If all countries had sound public finances, the current set of fiscal rules would likely result in a

countercyclical (i.e. business-cycle stabilizing) aggregate fiscal stance. Under the rules of the

fiscal compact and the current interpretation of the European Commission (2015c), each country with

sufficient fiscal space is free to conduct discretionary counter-cyclical demand smoothing on its own.

This way, the resulting joint fiscal stance would be counter-cyclical as long as countries run counter-

cyclical policies “on average”. As Claeys et al (2016) argue, the current set of fiscal rules actually

does not prevent Member States from this type of behaviour. Indeed, wide-ranging flexibility clauses

enable the European Commission to interpret the rules with discretion.

However, some countries are restricted in their ability to react countercyclically in response to

economic downturns due to debt sustainability considerations enshrined in the fiscal rules. In

these cases, “sound public finances” present a constraint, and these constraints may require countries

facing a large, protracted crisis to tighten their fiscal stance. This constraint operates asymmetrically

in practice, since fiscal restrictions become binding mainly in the course of economic downturns, and

due to the fact that ensuring debt sustainability is a one-sided issue. This asymmetry implies that

binding fiscal restrictions in a subset of member countries can push the aggregate of country-level

fiscal stances toward a too tight, potentially even procyclical policy, in comparison with a world

where sound public finances are not a constraint. In this context, the ongoing debate on an appropriate

aggregate fiscal stance is about the possibility of overcoming this asymmetry by encouraging

additional coordinated spending in countries where fiscal restrictions do not bind. However, even if

this would be successful, in a situation where the aggregate euro area fiscal position is not in

compliance with the medium-term fiscal goals (of a structural deficit not higher than 0.5 per cent and

the debt-to-GDP ratio below 60 per cent), the appropriate fiscal stance would have to be more

restrictive than purely cyclical considerations would suggest (see ECB 2016).

Even when fiscal coordination might be desirable, fiscal coordination is difficult to achieve. The

EU and the euro area itself have had difficulties in enforcing fiscal rules. Additionally targeting a

euro-area-wide fiscal stance is even more difficult. The situation may be uniquely difficult because a

fiscal entity on euro area level would try to steer the aggregate fiscal stance, while that entity would

have little direct budgetary power. In most federal systems (like the USA or Germany), a large

proportion of the general government budget is steered by the federal government directly, and the

federal government has the sovereign right to issue new debt. Even in countries with rather high

expenditure shares for regional governments, coordination between regions and the central

government is typically not designed to steer the fiscal stance (Kirkegaard 2015). In fact, attempts to

do this have not worked well; in Spain, for instance, the central government has tried to impose deficit

targets for the autonomous regions, but the regions have not met these targets (Romero 2016). In

Germany, the “debt brake” will be binding for all states from 2020 onwards; however, so far, there is

no strong coordinating mechanism. While it is complicated enough to maintain debt sustainability

and prudent fiscal policy in a federal system, there is little evidence for macroeconomic stabilization

policies that have been conducted jointly by federal states. Instead, stimulus packages are rolled out

by central governments. To this extent, coordination to target the joint fiscal stance in the euro area

would move the euro area into uncharted territory, since the euro area is not a federal state.

15 PE 574.425

3.2 Using fiscal space at the country level to target euro area aggregates

In the EU Commission’s current approach to fiscal coordination, the Commission asks

countries with sound debt positions to provide extra fiscal stimulus. Currently, this is the case

with Germany (European Commission 2016b). The idea of the EU Commission is that additional

stimulus from Germany can generate positive demand spillovers for the other euro area (or EU)

Member States, and this can allow the fiscal policies of the other Member States to be tighter without

damaging the fragile recovery in the euro area. This extra stimulus should improve – in the current

case, loosen – the joint fiscal stance and help those countries that cannot afford a more expansionary

fiscal stance.

However, using fiscal space in one country to address euro area aggregates could destabilize

the euro area on disaggregated level. A country with fiscal space that at the same time operates at

normal capacity utilization levels may be asked to increase expenditures (i.e. Germany). For that

country, however, such a policy of additional stimulus beyond its own business cycle needs may

generate welfare losses. This would be because that country is asked to engage in (from its perspective

undesirable) pro-cyclical fiscal policies, which might push its economy into a state of “overheating”.

Meanwhile, the benefits of these policies are assumed to accrue to other countries, and the degree to

which these policies accrue depends on the size of cross-border spillovers. So, even if the joint fiscal

stance resulting from this procedure appears appropriate for the euro area as a whole, it can be

destabilizing at the individual country level. This is the case because additional fiscal stimulus mainly

takes effect in the economy where the money is actually spent. Such a policy (of spending money

where it is not needed) would generate more divergence in cyclical fluctuations between Member

States. Additional cyclical divergence, in turn, would make it even more difficult for the European

Central Bank to conduct monetary policy that fits the different needs of member state economies.

Using available fiscal space in a country when it is not needed may compromise that country’s

fiscal sustainability and makes it difficult for that country to engage in fiscal expansion during

a possible future crisis. An inappropriately expansive fiscal stance in a country enjoying fiscal space

could not only push its economy into overheating, it also jeopardizes fiscal space that might be needed

to counter a potential future economic slump. The magnitude of fiscal resources sufficient for a

smooth adjustment during crises can be large, which was demonstrated by the cases of Spain and

Ireland in recent years, where favourable public debt ratios (well below 60 per cent of GDP) and

government balances in substantial surplus were not enough to cushion the blow of the Great

Recession. It may thus be preferable to keep the powder dry in those countries that enjoy fiscal space,

especially since using this fiscal space to excessively stimulate the economy (from the country’s

perspective) would also increase the probability of a crisis by contributing to a build-up of imbalances

that sooner or later would have to be corrected. Excessive stimulus that triggers a protracted boom

thus risks setting the seed for a future crisis.

Because of these tradeoffs at the country level, implementing a desirable aggregate fiscal policy

stance under the current framework is not workable. Attempts to coordinate the fiscal stance in

this manner run into problems with the incentives faced by individual countries, and overcoming

these problems would require a tough enforcement mechanism. In a top-down approach, a centralized

fiscal authority could be empowered to make the decision on the aggregate fiscal policy stance.

Afterwards, the centralized decision would be translated to a temporary caps and floors for the

national fiscal policy stances in each country (Benassy-Quéré 2015). This essentially would imply

that the amount of public spending (or taxes) would be determined at the euro area level, while the

decisions on the actual compositions of fiscal policies would remain at the national level. This

approach leaves unanswered a major question: How would the centralized fiscal authority push

through its optimal set of national fiscal policies? Without a means of enforcement at the central level,

such an approach is likely to remain a paper tiger. More likely, the centralized fiscal authority would

rely on moral persuasion and cajoling, which would not provide the desired results, in turn because

not all national governments would automatically share centralized fiscal institution’s view on the

optimal spending levels for their country. Therefore, enforcement measures would become necessary,

PE 574.425 16

for instance, sanctioning countries via an “Excessive Surplus Procedure”. Apparently, such a fiscal

framework is very unlikely to be implemented, because national budgetary autonomy would be

substantially undermined. Consequently, as Darvas and Leandro (2015) put it, they “see no political

possibility of countries agreeing to a binding process which may force them to have deficits larger

than what their domestic preferences deem appropriate.”

3.3 The size of spillovers: Does spending in one country help other countries?

Enforcement measures aside, whether or not additional spending (or tax cuts) in one country

would help other countries depends crucially on the size of spillovers. There are different channels

along which spillovers can work: in particular the trade channel and the monetary policy channel.

The standard argument for trade spillovers is that if (say) Germany were to increase public

investment, then this would stimulate the German economy, and in particular, this would stimulate

the demand for imports. These imports would come from Germany’s trading partners, which include

other European countries. An increase in imports from other European countries would stimulate

output and employment in those countries, thus putting less pressure on those countries to engage in

expansionary policies in the face of a fiscal and economic crisis. Clearly, the magnitude of such

spillovers depends on the trade linkages of the country that is expected to run expansionary fiscal

policies – whether the import share is rather 30 per cent of GDP (as in France), 40 per cent (Germany)

or even 100 per cent (Ireland). Additionally, the size of spillovers also depends on the extent to which

these goods and services are mainly imported from other euro area countries or from countries outside

the monetary union. Moreover, spillovers include the reaction of monetary policy, which affects all

euro area members equally. In fact, if trade spillovers are low, then stimulus in Germany may

hypothetically even damage others due to the reaction of joint monetary policy (higher interest rates

/ less quantitative easing). In an extreme case, Germany would enter a fiscally induced boom, while

recovery in Spain or Italy would be suppressed by tighter monetary policy.

The effective size of spillovers depends crucially on monetary policy reactions. In the country

report for Germany in 2015, the EU Commission reported that an increase in public investment in

Germany by 1 percentage point in terms of German GDP would result in limited spillover effects on

economic activity in the rest of the euro area (below 0.03 per cent in all years; see also Kollmann et

al., 2014). Calculations are based on the QUEST model. In calculations for the most recent country

report of 2016, spillovers reach ¼ per cent for the rest of the euro area, which is almost 9 times as

high as the estimated spillover effect of the previous years’ country report. Crucially, the reaction of

monetary policy in this simulation was switched off, and so these simulations represent the effects of

the trade channel. The importance of the reaction of monetary policy is also documented by Elekdag

and Muir (2014). According to their model, a boost in German government investment can have

negative effects on other members of the euro area in case that monetary policy reacts strongly. If,

however, monetary policy does not react in response to the German fiscal stimulus, then spillovers

could be sizeable. Sizeable spillovers are also found by In’t Veld (2013) and Blanchard et al. (2015),

when monetary policy does not react. Altogether, the theoretical evidence on spillovers seems to be

mixed, as is the empirical evidence.

Spillovers also depend on the composition of public spending and tax collection. For example, a

country with fiscal space might on the one hand increase public investment spending, which might

involve considerable demand spillovers. Even so, these spillovers might vary across categories of

public investment or public consumption – hiring teachers might have different effects than building

a bridge or repairing a pothole. With respect to other fiscal measures, spillovers could even be

negative – the government might cut taxes for companies that produce tradable goods (“beggar-thy-

neighbor”) instead of raising investment, which would also stimulate the economy but produce very

limited or even negative net impact on demand in other euro area Member States. Therefore,

dependent on the composition of public expenditure and revenues, more expansionary fiscal policies

would not necessarily have the intended effects. The size of spillovers may also depend on the cyclical

position the country is in when public investment is increased. In a situation of low capacity

utilization, a given amount of fiscal spending may translate into increases of volumes rather than price

17 PE 574.425

increases, relative to a situation when capacity utilization is high (crowding out). Any attempt to

mandate and enforce the national fiscal stance in a top-down approach would therefore run into the

problems of heterogeneity with respect to (highly uncertain) multipliers and spillovers. Further

attempts to mandate the composition of public spending would involve even further interference in

the national budgetary autonomy, and this interference may violate the principle of subsidiarity, a

main guiding principle of the European Union, which requires delegating decisions to the lowest

possible level.

Overall, effects on euro area-wide welfare depend on the size of total spillovers. Onlyif spillovers

were sufficiently large, discussing the euro area aggregate fiscal stance as a policy target would make

sense. An assessment of overall welfare effects for the euro area as a whole requires a comparison of

possible welfare losses in one set of countries and welfare gains in other countries. Even if this

assessment suggested that welfare gains in some countries outweigh welfare losses elsewhere, this

would not make such a policy desirable from an economic point of view. The allocation of scarce

fiscal resources would not be efficient and optimal, since additional spending may be called for in

countries where it is not needed. This, in turn, could generate output losses in in the longer run.

3.4 Should fiscal policy target external imbalances?

The issue of spillovers is closely related to the issue of external (current account) imbalances;

in fact, the debate on an aggregate fiscal stance might also reflect the desire to use fiscal policy

to correct these imbalances. In particular, demands for fiscal stimulus in certain countries seem to

be intended to counteract trade surpluses, particularly those of Germany and the Netherlands.

According to this logic, fiscal stimulus in the surplus countries in expected to fuel domestic demand,

thereby increasing imports, and increasing wage inflation, thereby realigning real exchange rates (e.g.

OECD 2016: 18). Even without significant spillovers in terms of short-run economic activity, more

expansionary policies in surplus countries could alleviate required adjustment processes for distressed

countries through a relative gain in price competitiveness of these countries. However, this approach

is problematic.

Fiscal policy would be overburdened with the responsibility to counteract trade imbalances.

First, this expands the scope of targets for fiscal policy (for one set of instruments). Fiscal policy

would then have to balance not only business cycle stabilisation against debt sustainability, but also

to consider the target of counterbalancing trade accounts. Secondly, these targets do not always (or

often) coincide with each other as they appear to do currently. In general, fiscal space and external

surpluses do not always coincide. In a different setting, this approach of “using available fiscal space”

might in fact trigger real exchange rate misalignments instead of counteracting them. For example,

Spain and Ireland in the pre-crisis years had not only favourable public finances, but also booming

economies and growing external deficits. The situation for Germany before 2005 was the reverse; the

German economy was in fact rather distressed. Using the available fiscal space in Spain and Ireland

to create hypothetical spillovers for the distressed German economy would have fuelled divergence

in terms of unit labour costs and trade balances, thus aggravating the imbalances that helped

contribute to the subsequent recession. This demonstrates that using fiscal space on country level to

target euro area aggregates should not be a universal approach. Finally, this line of argument obscures

the debate about what fiscal policy should be and should not be expected to accomplish. While it

should be discussed openly whether or not current account imbalances are problematic, and whether

there are reasonable policy options to tackle this set of problems, these concerns should not be made

the basis for changes in the euro area fiscal framework.

3.5 Interim conclusion: The current approach to fiscal coordination has its limits

Based on the above considerations, we conclude that it is problematic for macroeconomic

stabilization policies to target euro area aggregates. Additional spending in one country may help

others, but only in a narrowly defined environment, where (1) trade spillovers are large; (2) monetary

policy does not react substantially to fiscally induced increases in economic activity; and (3) monetary

PE 574.425 18

policy is ineffective at stabilizing euro area output. More realistically, the proposed mechanisms can

destabilize output at the country level, particularly since business cycles and fiscal conditions across

euro area countries are insufficiently synchronized. This lack of synchronization implies that targeting

an aggregate involves abstracting from important information at a country level. As a result, even

with considerable positive spillovers, proposals for individual countries to bear the burden of an

aggregate euro area fiscal stance can be harmful for those countries, since such a proposal would

require those countries to put up with less fiscal space and more volatile business cycles. We conclude

that the current approach to fiscal coordination is not workable.

19 PE 574.425

4. DEMOCRATIC LEGITIMACY AND THE AGGREGATE FISCAL STANCE

In the course of the euro crisis, fiscal coordination in the euro area has been further centralized

with a shift of authority to the EU Commission, the European Council and the Council. This

process was, however, not accompanied by increased political accountability for these institutions

(Alcidi et al. 2014; Majone 2014; Scharpf 2015). In this context, the Five Presidents Report stresses

that further integration would need to “go hand in hand with greater democratic accountability,

legitimacy and institutional strengthening” (Juncker et al. 2015: 17). Against this background, we ask

whether and how an aggregate fiscal stance (as a policy objective) could be guaranteed democratic

legitimacy.

What is democratic legitimacy and how can it be assessed? The term legitimacy refers to the social

acceptance of polities or policies, and is usually assessed in two dimensions (Scharpf 2003): first, a

polity or policy needs to solve the common problems of the governed (“government for the people”,

or output legitimacy). Put simply, an institution and its policies must cater for its citizens’ needs.

Second, in order to democratically legitimate, it must also be responsive to the political preferences

of the governed (“government by the people" or input legitimacy). Such responsiveness can be

attained by including citizens in political processes, such as public debates, competition for political

office, and via “political institutions that ensure the electoral accountability of governors to the

governed.” (Scharpf 2015: 20). For a euro area fiscal stance to be legitimate, it would thus need both

to a) provide for an effective solution for some of the common problems of the citizens of the euro

area (output legitimacy) and b) to be determined in a way that accurately responds to the preferences

of those governed (input legitimacy).

In case that the assessment of an aggregate fiscal stance for the euro area was translated into

policy recommendations significantly constraining national fiscal policy-making, this would

increase concerns about legitimacy. As a rule of thumb in the EU, legitimacy concerns are the

greater, (1) the more EU-level decisions constrain national policy-making competences, (2) the more

they violate the interests of (some of) those affected, and (3) the less they are accompanied with

effective tools to hold the EU-level decision makers accountable (Alcidi et al. 2014; Scharpf 2003).

With regard to the euro area fiscal stance, concerns about legitimacy would thus be the greater, the

more fiscal coordination would restrict national budgetary autonomy, violate the interests of some

euro area members, and be enforced by a centralized fiscal authority that is not subject to democratic

checks and balances. In this vein, the current fiscal coordination framework has been strongly

criticized for accelerating a “democratic default” (Majone 2014) by increasing the discretionary

budgetary powers of the European Commission to the detriment of directly elected national

parliaments and the European parliament, despite the fact that formal budgetary autonomy still rests

with the Member States. The introduction of “reverse qualified majority voting” has also weakened

the provision of input legitimacy through national representatives in the Council (Scharpf 2015: 39).

The potential of legitimising a euro area fiscal stance by output-related efficiency gains (output

legitimacy) seems questionable. As business cycle dynamics are mainly national, and spillovers are

uncertain, targeting the euro area aggregate rather than a national fiscal stance may create welfare

losses for individual countries, or even make the attainment of a relatively undisputed common good

(price stability or debt sustainability) more difficult. Targeting such a policy objective is thus likely

to be politically controversial in a number of euro area member countries and is likely difficult to

justify as representing a euro area wide common good. Consequently, the euro area fiscal stance, as

a policy objective, is unlikely to receive its legitimacy from efficiency considerations. In addition,

the aggregate fiscal stance in the euro area currently remains the sum of national fiscal stances and

happens to be appropriate only by coincidence. Targeting the euro area fiscal stance would therefore

also depend on a stronger enforcement authority and a possible shift of fiscal competencies towards

the euro area level, which would require changes to the treaty of the European Union. In addition, if

decisions made at this level can inflict sensitive welfare losses for individual euro area members,

social acceptance of these decisions rests on whether euro area citizens perceive the issuing authority

PE 574.425 20

to be accountable and responsive to their preferences (input legitimacy), so that citizens would

tolerate temporary welfare losses in order to attain a euro area wide political objective.

Assessing and determining an appropriate aggregate fiscal stance would require a process that

is transparent and responsive to euro area wide political preferences; which is unlikely to be

achieved in the current fiscal framework. So far, the Commission assesses the euro area fiscal

stance, discusses this assessment with the Eurogroup, and makes it publicly available (European

Parliament and Council of the European Union 2013: Art.7). The European Parliament can invite the

President of the Commission or the Eurogroup to discuss their assessment in the framework of the

Economic Dialogue (European Parliament and Council of the European Union 2013: Art.15). Given

that the determination of an appropriate fiscal stance involves balancing various objectives (European

Central Bank 2016a), and eschews a solely technical assessment and decision, it is crucial to involve

democratically legitimated institutions that can represent the preferences of and that are accountable

to euro area citizens. In this vein, processes such as the Economic Dialogues and greater inter-

parliamentary cooperation between the EP and various national parliaments have previously provided

parliaments with resources to better control governments and to foster “deliberative bridges between

citizens and the EU” (Jančić 2016). Yet, they represent rather soft forms of parliamentary control and

may be ill-suited to legitimize decisions that have the potential to impact national budgeting decisions.

In addition, the Eurogroup may indirectly legitimize the determination of an appropriate fiscal stance

as it includes representatives of elected national governments. In the past, however, it has itself called

for the Commission to increase the transparency of the overall fiscal surveillance framework

(European Central Bank 2016b).

There are various ways in which the European Parliament’s involvement, for instance, could

be improved with regard to assessing an appropriate aggregate fiscal stance. Whether this

would generate more acceptance for closer fiscal policy coordination, however, remains

doubtful. First, if the Economic Dialogues were to be better timed and the Commission were to

explain how EP views are taken into account, this would make sure that EP views are accurately

represented in executive decisions (Alcidi et al. 2014). This is also true with regard to the aggregate

fiscal stance. Secondly, the EP should more efficiently monitor the Commission’s work in this regard,

and this would require clarifying the standards used to assess an appropriate aggregate fiscal stance.

Previous assessments of these standards have rather been “a value judgement [by the European

Commission] than the result of rigorous analysis” (Darvas and Leandro 2015: 11). The transparency

of this process may be increased by the newly established Advisory European Fiscal Board (EFB)

(European Parliament 2015). The EFB is supposed to advise the Commission on the aggregate fiscal

stance and, jointly with national fiscal boards, should independently and critically review the

implementation of the EU’s fiscal framework. In order to do so, however, the EFB and national fiscal

boards would need to operate transparently and fully independently from the European Commission

and national governments. Currently, in this regard the set-up of the EFB and its reporting procedures

have been criticized, e.g. for not clarifying whether the EFB can comment on the Commission’s

decisions in real time (European Central Bank 2015b; O’Reilly 2016). Likewise, the independence,

power, and involvement of national fiscal councils differs substantially among euro area members

(Angerer and Donatelli 2016; European Central Bank 2014). Even if such increases in transparency

and enforcement of the independence of national fiscal boards would be accomplished, however, it

is doubtful whether the EP’s involvement would generate more acceptance for policies that have the

potential to affect euro area Member States unevenly. After all, elections to the European Parliament

only qualify as “second order elections”, and EU citizens rarely vote for concrete party programs, but

rather along pro-European versus Eurosceptic lines (Alcidi et al. 2014). For a euro area fiscal stance,

more (output- and input-related) democratic legitimacy is thus rather unlikely to be achieved without

a substantial revision to the current fiscal and institutional framework of the EU.

21 PE 574.425

5. WHAT ELSE CAN BE DONE?

We argued that targeting an aggregate fiscal stance is likely to destabilize business cycles and

endanger fiscal sustainability for individual euro area countries. Given these concerns, we ask, can

we suggest (partial) solutions that help to alleviate some of the perceived deficiencies of the current

fiscal framework, in which highly indebted countries may be forced to engage in procyclical fiscal

tightening? To this end we discuss the potential of a number of policy tools or mechanisms to produce

a more favourable outcome in terms of macroeconomic stabilization.

5.1 Relaxing fiscal rules

A new set of fiscal rules could more strongly incentivise counter-cyclical fiscal policy while still

encouraging fiscal sustainability. For example, it has been suggested to temporarily exclude

incremental investment and incremental unemployment expenditures from the measure for the fiscal

deficit (e.g. Benassy-Quéré 2016). These expenditures would be booked into a separate adjustment

account – and thus not affect the Maastricht deficit – in bad economic times and gradually transferred

into the normal budget when the cycle had turned to the better. This approach would allow countries

to engage in more fiscal expansion in a recession, without compromising the established fiscal rules.

Alternatively, the excessive deficit procedure could be based on structural deficits and not total

deficits. This would be another way in which current rules could be adjusted in a simple way in order

to remove some possible sources of asymmetry. Clearly, both approaches have implementation

issues, since, for example, countries with fiscal restrictions might be tempted to book as much public

expenditure as possible as incremental investment if this did not affect the relevant deficit measure.

Similarly, focussing on structural deficits would be accompanied by a substantial loss of clarity,

because measurement of the structural deficit remains uncertain and susceptible to revisions. Overall,

it is unclear how large the effects are likely to be given that current rules already entail a large degree

of flexibility.

If fiscal rules were changed in order to loosen the current restrictions, debt sustainability would

remain an issue. The reason behind the episode of pro-cyclical tightening in 2012 and 2013 was

concern about debt sustainability, not current fiscal rules. The SGP has a general escape clause

increasing fiscal flexibility, whenever an economic event outside the control of a Member State has

a major impact of government finances, or in the case of a severe downturn on the euro area level,

although this is possible only as long as fiscal sustainability is not endangered in the medium term.

In addition, the EU Commission in practice often has tolerated temporary deviations from an

adjustment path. As a result, during the episode of 2012 and 2013, it was not compliance with rules

or pressure by the EU Commission that made countries engage in pro-cyclical fiscal tightening.

Instead, the crisis started out as a financial crisis and a large recession but then subsequently evolved

into a “sudden stop” and a sovereign debt crisis (Baldwin et al. 2015). If debt sustainability is at stake,

fiscal priorities shift from business cycle stabilization towards consolidation, especially if there is

increasing evidence that potential output of the economy has declined with a corresponding need for

fiscal adjustment. This set of problems would remain if fiscal rules were relaxed.

5.2 A macroeconomic stabilisation function

A stabilization fund could be constructed to support countries once they were hit by severe

asymmetric shocks (“rainy day fund”). Governments would be required to provide financial

contributions to a centralized fiscal authority, which redirects these resources to those member

countries hit by asymmetric shocks. To avoid permanent transfers in one direction, such a system

would need to address only genuine cyclical risks, which is a problem when output gap estimates are

highly uncertain. Therefore, the estimation of the output gap would become even more a contentious

political issue than it currently is.

PE 574.425 22

Spending decisions should be left on country level. A central fiscal authority could either be

responsible to redirect funds to Member States, without being involved in the composition of

spending, or it could be made responsible to actually carry out centralized decisions on public

expenditures. For example, spending could take place in the field of public investment, by directing

funds primarily to infrastructure projects in distressed countries, as the Five-Presidents-Report

suggests the European Fund for Strategic Investments (EFSI) to become a vehicle for implementing

a stabilisation function (Juncker et al. 2015: 15). In our view, spending should be left on national

level for several reasons. First, moving spending decisions to the supranational level conflicts with

the principle of subsidiarity as long as there is no efficiency gain involved by shifting competencies

to a higher level. Second, centralized spending would call for an economic analysis of EMU-specific

collective goods apart from providing “stabilization”. As argued above, while EU-wide collective

goods may exist (and should then be reflected in the EU budget), EMU-specific public goods are rare,

if they exist at all. Third, funding for long-run public investment projects as intended by the EFSI

(Juncker plan) can hardly be switched on and off in a discretionary manner depending on the business

cycle. Therefore, reasonable public investment projects with a considerable lead time and duration

are not suitable for targeted fiscal stimulus aimed at macroeconomic stabilisation.

Fiscal policies of a centralized authority can conceptually be decomposed into the redistribution

of available resources between countries (net transfers) and redistribution over time (net

lending). A stabilization function could involve between-country smoothing of cyclical risks, since

countries with a more positive output gap would then be required to transfer funds to countries with

a more negative output gap (IMF 2013: 19f., De Grauwe and Ji 2016). This would ameliorate the

effects of asymmetric macroeconomic shocks – an example of a transfer mechanism would be a

common unemployment (re-) insurance scheme. However, a pure transfer system is problematic

particularly once the euro area as a whole enters a recession. Then, funds would be channelled from

countries in a mild recession to countries in a deep recession, pushing the former country deeper into

recession. On aggregate, to deal with economic up- and downturns on euro area level, the fiscal

authority would have to conduct inter-temporal smoothing. This in turn would require a joint debt

instrument at the euro area level (i.e. euro bonds). Overall, a macroeconomic stabilisation function

would certainly combine both net transfers and net lending.

Permanent contributions of Member States would allow for joint debt issuance without

imposing full liability on national budgets. To this end, Member States would have to agree on

transferring relatively small financial contributions from their national budgets, but they would have

to commit to payments for a very long time span (Tabellini 2016, drawing mainly on Ubide 2015).

Thereby, a limited transfer of fiscal sovereignty to a supranational institution could be accomplished,

while the largest part of budgets would remain under the control of national parliaments. Based on a

long-run inflow of revenue, the joint fiscal authority could issue and service debt, and use this debt

to engage in area-wide fiscal stabilization policy (inter-temporal smoothing). Backing the limited

amount of jointly issued debt with full liability of national budgets is not necessarily required.

Backing it explicitly with ECB guarantees would certainly reduce risk premia and financing costs

(Corsetti et al. 2016), although it is clearly not a recognized central bank objective to provide fiscal

authorities with favourable financing conditions. To initially ensure liquidity of the new debt

instrument, Tabellini (2016) proposes to issue bonds amounting to 10 per cent of GDP at the start,

the receipts of which were simply used to retire equal amounts of circulating national debt, and to

limit the maximum amount of circulating euro bonds to 25 per cent of GDP. Such a debt instrument

would not impose joint liability on the major part of accumulated national debt. Moreover, current

crisis mechanisms could be replaced by the joint budget: Once a fiscal capacity with substantial

resources was to be introduced on euro area level, it could take on the role currently attributed to the

ESM (Tabellini 2016).

Net transfers could help to partially loosen fiscal restrictions for countries in crisis and to

improve the alignment of cyclical patterns between Member States. First, financial transfers

Tabellini (2016) and Ubide (2015) suggest that in order to create perfectly default-free assets with lowest possible risk

premia, governments need to agree on the possibility of additional payments in the case of extreme events. Moreover,

they argue that national debt should be subordinated to “stability bonds”.

23 PE 574.425

would likely reduce some of the fiscal restrictions countries can face when they are hit by a deep

recession. Still, the aggregate fiscal stance would not necessarily achieve a desirable level, since there

is still the issue of fiscal sustainability at the country level – for example, overall fiscal expenditure

could even be reduced in a euro-area-wide recession, if a country without fiscal space were required

to transfer money to a country deeper in recession. Secondly, net transfers could improve the

alignment of cyclical patterns between Member States. Countries with a relatively more positive

output gap would be required to transfer funds to countries with a more negative output gap. This

way, upswings as well as downturns are both dampened, so that business cycles are better

synchronized. Currently, the alignment of business cycles between Member States mainly depends

on trade integration and the common monetary policy. Trade integration generates positive demand

spillovers, while common monetary policy has caused business cycles to diverge: Higher economic

activity in one country induces tighter monetary policy, thus negatively affecting economic activity

in other countries. Since booming economies often exhibit higher wage and price increases,

divergence is amplified by implicitly imposing lower real interest rates in boom countries. Recent

efforts to promote a capital market union could further contribute to strengthening spillovers by

inducing higher cross-border capital income flows (both profits and losses). A possible introduction

of a transfer mechanism between countries could in principle constitute another force that supports

alignment of business cycles, which would allow monetary policy to better fit the needs of all euro

area Member States.

However, a joint stabilisation fund would likely be accompanied by moral hazard problems and

would reduce both market forces and political pressure to overcome structural causes of crises.

Unfortunately, it is difficult to make sure that transfers actually tackle genuine risks without

producing permanent cross-border transfers in one direction. In particular, the blurry notion of

“macroeconomic shocks” conceals the different nature of these shocks. Macroeconomic shocks can

be more or less symmetric to all countries (e.g. oil price shocks), as well as asymmetric so that the

shock hits only a subset of countries. Asymmetric shocks, in turn, can be due to “bad luck” or the

result of “bad policies”. As it is difficult to design a regular stabilisation mechanism that can

accurately discriminate between these two types of shocks, moral hazard problems may arise. That

is, countries might be tempted to engage in unsustainable policies or to take irresponsible risks, for

example in order to avoid unpleasant consequences of necessary reforms. Moreover, asymmetric

shocks that are actually caused by “bad luck” can be either cyclical or structural, the latter of which

implies that structural adjustment is required. In structural crises, a transfer mechanism has

detrimental side effects. While net inflows of transferred funds alleviate matters for the distressed

country, they also reduce the political pressure to conduct appropriate structural reforms that might

address the fundamental causes of the problems. Transfers also weaken market forces that help to

overcome imbalances – for example, a required internal devaluation would be suppressed if transfer

payments keep the wage level higher than overall productivity would allow for.

Therefore, a “risk-

sharing” mechanism can perpetuate structural problems.

Given that certain macroeconomic

imbalances actually trigger financial support for affected countries, and macroeconomic imbalances

do not disappear without painful reforms and adjustment processes, financial support for these

countries is doomed to be permanent – although proponents of a joint stabilization function claim to

avoid this (e.g. Juncker et al, 2015: 15).

Availability of fiscal resources for macroeconomic stabilization policies on euro area level may

also damage incentives in the fiscal surveillance framework. On the one hand, the desire of

For example, Pissarides (2016) argues that fiscal transfers are required as a corrective mechanism to substitute for

exchange rate flexibility, since internal devaluation is perceived as too costly and labour migration is not politically

feasible. In other words, whenever a country is hit by an asymmetric shock, so that productivity is not in line with the real

wage level any more, the country will receive fiscal transfers in order to avoid painful adjustment processes.

This problematic side effect also applies to highly expansionary monetary policies of the ECB, which effectively

reduces public financing costs and thereby eliminates much of the pressure for governments to engage in far-reaching

structural reforms. Nevertheless, this is not meant to deny that in certain situations, smoothing (and probably slowdown)

of macroeconomic adjustment processes can be required due to social considerations, concerns on political stability, or

in order to prevent systemic risks to materialize.

PE 574.425 24

Member States to access funds of the stabilization function in times of crisis would provide the joint

fiscal authority with leverage to enforce compliance with fiscal rules and thereby strengthen fiscal

surveillance.

On the other hand, the desire to be able to conduct counter-cyclical fiscal policies on

national level is probably a major incentive to seek for fiscal space. If a joint budget were

implemented that eliminates the need for national policymakers to cushion big macroeconomic

shocks themselves, incentives to reduce high debt levels could be severely damaged. Overall, intrinsic

motivation to reduce debt levels would to some extent be replaced by extrinsic motivation to comply

with rules in order to maintain access to joint fiscal resources.

Significant cross-border transfers as well as joint debt instruments are likely to be politically

contested. In existing transfer unions such as Germany (federal level vs. state level), by far the largest

part of redistribution between regions is “hidden” in social security contributions and taxes.

Yet

there are also direct redistributive payments between state-level budgets, which are of minor

importance (~0.3 per cent of GDP), but which cause disagreement between state-level governments

on a regular basis. So even in a single country with a common spoken language and a political union

there is dissent on “minor” direct transfers between regions, which is, however, mediated with the

help of a full-fledged democratic process. The euro area, however, lacks such processes and fiscal

risk-sharing was explicitly ruled out by law from the start (“no-bail-out” clause). A transfer system

of significant magnitude is likely to be politically highly contested; particularly in countries that likely

end up in a net payments position. Similarly, introducing joint debt instruments even on a small scale

will face strong objections. The mere existence of euro bonds would be suspected as paving the way

for the further mutualisation of accumulated national public debts and of undermining national

budgetary autonomy. Introducing a limited role for joint debt instruments would possibly raise

demands for an increase of the issuance of joint debt, for example to handle the problem of “legacy

debt” once monetary policy becomes tighter. Some commentators explicitly recommend “small

steps”, only because the final aim of a full fiscal union appears not to be currently attainable (e.g.

Bofinger 2016, De Grauwe and Ji 2016). Therefore, any limited role for a joint debt instrument is

likely to face strong objections even if it is not intended to mutualize accumulated national debt.

Overall, the creation of a joint budget and joint fiscal stabilisation policies represent far-reaching

institutional changes that would require a consensus among all Member States that advantages of a

joint stabilisation function outweigh possible disadvantages.

5.3 Fiscal union: The way forward?

The extent of fiscal integration, risk-sharing mechanisms, and also legacy-sharing could in

principle be scaled up deliberately. A centralized fiscal authority could be allowed to issue joint

debt, thereby shifting funds over time (intertemporal smoothing) and redistributing available fiscal

resources between Member States (between-country smoothing). Moreover, fiscal spending decisions

could also be partly carried out at central level, if reasonable collective goods for the euro area could

be identified. Additional steps might concern introducing euro area taxes for the joint budget (instead

of member state contributions), joint debt instruments (to remove differences in credit ratings and

refinancing costs), debt mutualisation (to remove country-specific restrictions caused by high debt

levels, i.e. “legacy sharing”), harmonized institutions and regulation (to harmonize macroeconomic

adjustment processes), a joint treasury, and a euro area finance minister. The extent of such further

steps of integration could in principle be scaled up deliberately, ranging up to a full fiscal union.

There is disagreement whether the monetary union should actually evolve in the direction of a

fiscal union. Some proposals argue that further integrative steps towards a fiscal and political union

Zuleeg (2015) suggests that a centralized fiscal authority might link availability of fiscal spending to proper

implementation of country-specific recommendations (via “contractual agreements”), so that the fiscal authority would

basically use its spending power as an instrument to pressure Member States into complying with a centralized reform

agenda.

For example, progressive income taxes as well as social security contributions are generated over-proportionately in

the industrial centers of Southern Germany, where unemployment is very low, incomes are high, and people are relatively

young. In contrast, rural areas in Eastern Germany exhibit lower incomes, higher unemployment rates, and many

pensioners, who on average cause higher health costs. There is a similar pattern across U.S. states.

25 PE 574.425

are desirable and even necessary for the survival of the monetary union (e.g. Juncker et al. 2015, de

Grauwe and Ji 2016, Bofinger 2016). In a fiscal and political union that encourages euro area wide

preference formation on fiscal-policy-making, an increasingly powerful fiscal authority could in

principle be able to increase the effectiveness of fiscal policy coordination, while – if designed

accordingly – being constrained by democratically elected institutions on the national and European

level. In addition, any decision about the establishment of a central fiscal authority (e.g. to administer

a joint macroeconomic stabilisation function) would require a transfer of competencies. This, in

return, required changes to the treaties of the European Union that need to be ratified by all Member

States and would hence be democratically legitimate. Against the background of the rise of

Eurosceptic parties, however, such further and far-reaching European integration currently seems to

be a rather distant prospect.

If a fiscal union is unattainable, strengthening resilience of the monetary union becomes

paramount. In this vein, other commentators argue that further fiscal integration is not necessarily

required, but instead that the monetary union and the financial system need to be made more resilient,

so that fiscal failure in one country does not harm the monetary union as a whole, and that the euro

area should credibly re-establish the no-bail-out principle (Baldwin et al. 2016, Feld et al 2016,

Weidmann 2016). The latter approach does not necessarily involve or require substantial further steps

towards stronger fiscal and political integration. If a fiscal union is unattainable, strengthening

resilience of the monetary union becomes paramount, especially when taking into account that

support for European integration has previously been predominantly based on efficiency

considerations (Scharpf 2015).

PE 574.425 26

6. CONCLUSIONS

Altogether, we find that the joint fiscal stance is not a useful concept, because business cycle

stabilization needs as well as debt sustainability considerations are first of all measured and relevant

at the national level. Debt sustainability is a national responsibility and, so far, only national

authorities have the means to conduct fiscal policies.

Proposals for implementing a euro area fiscal stance are highly questionable as long as this

requires countries to run more pro-cyclical fiscal policies. Such a proposal would also run into

problems with incentives, since increasing public spending in one country beyond its cyclical needs

would generate welfare losses for that country, because that country would experience less fiscal

space and more volatile business cycles. What is left is the issue of spillovers: Additional spending

in one country would help other countries under specific conditions, where (1) trade spillovers are

high, and (2) there is no (or only a small) reaction of monetary policy to a fiscally-induced increase

in economic activity. Moreover, (3) additional spending appears reasonable mainly in an environment

where monetary policy does not successfully stabilize the output gap for the euro area as a whole.

However, even when these conditions are satisfied, we argue that such a policy would still destabilize

the euro area at disaggregated level and induce more cyclical divergence across countries.

While a transfer mechanism (to address cyclical risk-sharing) can potentially improve the

alignment of business cycles between Member States and alleviate fiscal restrictions to some

extent, there are risks of moral hazard and persistent one-sided transfers. Given that the benefits

of such proposals for aggregate business cycle stabilization are highly uncertain, and given that the

consequences of such proposals are likely to shape the lives of citizens in the euro area, it is crucial

to consider the democratic legitimacy of such proposals. In a fiscal framework that gives more

responsibilities to the euro area level, assessing and determining an appropriate aggregate fiscal

stance would require a process that is transparent and responsive to euro area wide political

preferences.

27 PE 574.425

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Contact: [email protected]

For more information: http://www.europarl.europa.eu/committees/en/ECON/home.html

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ECONOMIC GOVERNANCE SUPPORT UNIT

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