Deficit Bias and Moral Hazard on the Road to the EMU: The Political Dimension of Fiscal Policy in Hungary

The obligation to introduce the euro is widely assumed to provide incentives for fiscal consolidation in the new member states of the European Union. Without questioning the general validity of this thesis this article calls attention to the potential for an opposite effect and the possibility of exacerbating rather than reducing the deficit bias in these countries. The argument proceeds in three steps. First, it shows that, given a weaker institutional environment in emerging economies, the new member states of the EU are particularly prone to deficit bias. Second, the incentives from the EMU are analysed and the potential moral hazard problem is identified for the current members as well as the candidate states. Third, a closer examination of Hungarian fiscal policy developments between 2002 and 2005 illustrates how weak institutions and strong market confidence can result in excessive deficits. The main implication of the article is that without complementing the EMU fiscal framework with mandatory procedural rules at the national level the deficit bias is unlikely to be eliminated in the new member states, which could result in considerable imbalances after these countries join the euro zone.