Fiscal Policy and EMU

This article considers the role of fiscal policy within a European Monetary Union. There are two quite different issues. The first is the medium-term problem of deficits and debt. The Maastricht fiscal convergence criteria are usually seen as an imperfect response to the need to contain potentially 'irresponsible' fiscal authorities. It is argued here that they should be seen as reflecting a coordinated response to the generalised objective of fiscal consolidation and restraint in Europe: similar rules are likely to be a feature of Stage 3. There is a danger that governments are underestimating the difficulties of fiscal consolidation in a large area such as Europe. In practice, success would require a sustained rise in private sector investment and growth (or reduced private savings). The monetary coordination to go with generalised fiscal restraint appears to be lacking and we suggest a preemptive cut in interest rates. A more complete view of the causes of rising debt stocks in Europe is needed, and we suggest that a reframing of the problem of deficits and debt in terms of the needed (counterpart) private sector responses would be helpful in highlighting the coordination problems and avoiding adverse dynamic reactions. The medium-term problems interract unfavourably with the second set of issues-the need for fiscal policy to be used more actively for short-term stabilisation in a future common currency area. Fiscal offsets are an appropriate response to domestic demand shocks, but not to others, such as those requiring a change in the real exchange rate. Contrary to the 'fiscal federalist' position, such stabilisation need not involve centralisation. But there are serious difficulties. Without care, needed stabilisation will be prevented by the Maastricht criteria or the rules likely to follow them. And without coordination, independent stabilisation of common shocks will tend towards too little fiscal activism rather than too much.