Working Paper: CEPR ID: DP1351
Authors: Andrew Hughes Hallett; Peter McAdam
Abstract: Of all the institutional arrangements for monetary union in Europe, the fiscal convergence criteria have proved the most difficult to achieve and the most controversial because of their presumed deflationary impact on economies already suffering high unemployment. This paper examines what fiscal corrections would be necessary in the four largest European economies to reach the 3% deficit criterion by 1999, and to maintain that criterion thereafter. It argues that because these criteria are defined as ratios, a change in the policy mix is required ? not simply fiscal contractions. The interaction between fiscal and other policies is the crucial factor therefore. The change in policy mix might involve monetary relaxation, a currency depreciation, or perhaps most effectively, wage restraint to boost competitiveness. Certainly some action is needed to maintain (or boost) the ratio?s denominator, since fiscal cuts will otherwise cut both the numerator and denominator and leave the ratio unchanged. But, because there is also a debt criterion and it is most unlikely that the deficit and debt criteria are reached simultaneously, it is very hard to reach the deficit criterion and stay there without accompanying policies designed to maintain output. Fiscal cuts will otherwise continue to deflate the economy, and hence inflate the deficit ratio, in an attempt to reach the required debt ratio. To offset this there must be reform of the tax regime as well. These results point to growth and the design of the tax regime as being the key features of the fiscal side of a successful monetary union.
Keywords: convergence criteria; monetary union; policy mix
JEL Codes: H62; E62; E63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| fiscal contractions (E62) | achieving the 3% deficit criterion (H68) |
| change in policy mix (E63) | achieving the 3% deficit criterion (H68) |
| monetary relaxation (E49) | support fiscal adjustments (E62) |
| currency depreciation (F31) | support fiscal adjustments (E62) |
| wage restraint (E64) | enhance competitiveness (F23) |
| enhance competitiveness (F23) | reduction of the deficit ratio (H68) |
| reforms in the tax regime (H25) | ensure GNP does not decline (F52) |
| fiscal cuts (E62) | GNP does not decline (E10) |
| fiscal corrections (E62) | avoid further deflationary impacts (E31) |
| initial conditions and accompanying policies (O24) | success of fiscal restructuring (H19) |
| simultaneous satisfaction of deficit and debt criteria (H62) | coordinated efforts across countries (F53) |