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EU Leaders Struggle to Fix Fiscal Policy Rules

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Ed Dolan
Ed Dolan

EU leaders met in late 2010 to discuss changes to the fiscal policy rules for eurozone countries in response to debt crises. The existing 3% deficit and 60% debt rules did not prevent crises and failed to provide early warnings. Proposals for a permanent bailout fund, increased penalties for rule violations, and imposing "haircuts" on bondholders faced objections and were not adopted. The leaders agreed new rules were needed but did not yet find a solution that would adequately address the underlying problem of countries acting as fiscal free riders within the eurozone.

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Free Slides from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ EU Leaders Struggle to Fix Fiscal Policy Rules Post prepared November 1, 2010 Terms of Use: These slides are made available under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics , from BVT Publishers.
EU Leaders Meet on Fiscal Policy Rules At a summit meeting in late October, EU leaders unanimously agreed that changes are needed in the fiscal policy rules that apply to all members, including those that use the euro The current “3/60” rules limit budget deficits to 3 percent of GDP and government debt to 60 percent of GDP The rules are needed to overcome the free rider problem that is inherent in common-currency areas Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The European Union consists of 27 member countries, 16 of which use the euro as their common currency. In 2011, Estonia, already an EU member, will become the 17 th member of the euro area Map source; http://commons.wikimedia.org/wiki/File:Eurozone_map-2009.svg
What is the Free Rider Problem? A familiar example of the free rider problem occurs when you meet with a group of friends for a meal in a restaurant If you agree in advance that everyone will get separate checks, you order a beer and a hamburger If you agree that everyone will pay an equal share of the entire bill, you are more likely to order steak and champagne. Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Photo: http://commons.wikimedia.org/wiki/File:Caprice_Restaurant.JPG
Countries with their own currencies Countries with their own currencies can’t play fiscal free rider They can please their voters by cutting taxes or increasing spending ahead of elections . . . but if they do so, they must later bear the costs, which may include higher interest rates, unwanted exchange rate movements, and even the possibility of default on the government’s debt Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Sweden is a member of the EU but retains its own currency, the kronor Photo by Emil Frisk, http://en.wikipedia.org/wiki/File:Svenska_hundrakronorssedlar.JPG
Countries with shared currencies Countries with shared currencies are in a different position They, too, can please their voters by cutting taxes or increasing spending ahead of elections However, the costs (higher interest rates, exchange rate changes, default risk) are spread among all members of the currency area Because they get all the benefits and share the costs, they have an incentive to play the free rider Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The euro is an example of a common currency shared by several independent countries
The 3/60 rules have not Worked Well Even in good years like 2007, fewer than half of the 16 euro area members have been safely within the 3/60 limits. When the global crisis hit, all but two members missed either the debt or deficit targets, or both Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
The 3/60 rules do not give good early warning Also, the 3/60 rules do not give good early warning. Ireland and Spain went from full compliance to full-blown solvency crisis in just two years Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Proposal: Establish a Permanent Bailout Fund In May 2010, in response to the Greek budget crisis, the EU established a temporary European Financial Stability Fund to provide loans to member countries in an emergency At the October summit, it was proposed to make the fund permanent Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Objections: A permanent fund might violate the “no-bailout” clause of the EU’s founding Maastricht treaty A bailout fund could increase moral hazard. Knowing a fund is available, member countries might take bigger risks in managing their budgets
Proposal: Increase Penalties for Violating Budget Rules The EU already has authority to impose fines on members who do not comply with the 3/60 fiscal policy rules At the summit, proposals were made to increase monetary fines or introduce administrative penalties, like temporary loss of voting rights Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Objections: Imposing monetary fines on countries in crisis only makes the crisis worse It is politically hard to impose fines on the biggest member countries. In the past, France and Germany have violated the budget rules without fines Administrative penalties were rejected as too controversial
Proposal: Force Bondholders to Share the Cost of Bailouts A proposal was made at the summit that bondholders should be subjected to haircuts as a way of sharing the cost of future bailouts. Imposing a haircut would mean holders of bonds of an insolvent or near-insolvent euro member country would receive only part payment on the debts they were owed Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Objections: The threat of haircuts would spook bondholders and send borrowing costs even higher for countries whose budgets are already weak European banks are major holders of the bonds. Subjecting them to losses might reduce the cost of country bailouts only at the risk of having to bail out the banks, instead
What the Summit Decided to Do At the October summit, EU leaders unaniously agreed that a new set of fiscal rules was needed An attempt will be made to draft new rules that will include a permanent mechanism to deal with fiscal crises and a strengthening of the current budget rules Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Objections: Any proposal would probably require amendment of the EU’s founding treaty Any major modification would require formal ratification by all member countries, including referendums in some countries—an almost impossible task Minor technical modifications could be possible without formal ratification but might be too weak to do much good
The Bottom Line: Problem Not Yet Solved The summit was a small step forward in that there was unanimous agreement that current rules are inadequate The strongest proposals were rejected, and any final rule changes will probably be too weak to solve the problem permanently The bottom line: The euro area cannot yet declare victory in its struggle with fiscal policy free riders Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

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EU Leaders Struggle to Fix Fiscal Policy Rules

  • 1. Free Slides from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ EU Leaders Struggle to Fix Fiscal Policy Rules Post prepared November 1, 2010 Terms of Use: These slides are made available under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics , from BVT Publishers.
  • 2. EU Leaders Meet on Fiscal Policy Rules At a summit meeting in late October, EU leaders unanimously agreed that changes are needed in the fiscal policy rules that apply to all members, including those that use the euro The current “3/60” rules limit budget deficits to 3 percent of GDP and government debt to 60 percent of GDP The rules are needed to overcome the free rider problem that is inherent in common-currency areas Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The European Union consists of 27 member countries, 16 of which use the euro as their common currency. In 2011, Estonia, already an EU member, will become the 17 th member of the euro area Map source; http://commons.wikimedia.org/wiki/File:Eurozone_map-2009.svg
  • 3. What is the Free Rider Problem? A familiar example of the free rider problem occurs when you meet with a group of friends for a meal in a restaurant If you agree in advance that everyone will get separate checks, you order a beer and a hamburger If you agree that everyone will pay an equal share of the entire bill, you are more likely to order steak and champagne. Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Photo: http://commons.wikimedia.org/wiki/File:Caprice_Restaurant.JPG
  • 4. Countries with their own currencies Countries with their own currencies can’t play fiscal free rider They can please their voters by cutting taxes or increasing spending ahead of elections . . . but if they do so, they must later bear the costs, which may include higher interest rates, unwanted exchange rate movements, and even the possibility of default on the government’s debt Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Sweden is a member of the EU but retains its own currency, the kronor Photo by Emil Frisk, http://en.wikipedia.org/wiki/File:Svenska_hundrakronorssedlar.JPG
  • 5. Countries with shared currencies Countries with shared currencies are in a different position They, too, can please their voters by cutting taxes or increasing spending ahead of elections However, the costs (higher interest rates, exchange rate changes, default risk) are spread among all members of the currency area Because they get all the benefits and share the costs, they have an incentive to play the free rider Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The euro is an example of a common currency shared by several independent countries
  • 6. The 3/60 rules have not Worked Well Even in good years like 2007, fewer than half of the 16 euro area members have been safely within the 3/60 limits. When the global crisis hit, all but two members missed either the debt or deficit targets, or both Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 7. The 3/60 rules do not give good early warning Also, the 3/60 rules do not give good early warning. Ireland and Spain went from full compliance to full-blown solvency crisis in just two years Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
  • 8. Proposal: Establish a Permanent Bailout Fund In May 2010, in response to the Greek budget crisis, the EU established a temporary European Financial Stability Fund to provide loans to member countries in an emergency At the October summit, it was proposed to make the fund permanent Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Objections: A permanent fund might violate the “no-bailout” clause of the EU’s founding Maastricht treaty A bailout fund could increase moral hazard. Knowing a fund is available, member countries might take bigger risks in managing their budgets
  • 9. Proposal: Increase Penalties for Violating Budget Rules The EU already has authority to impose fines on members who do not comply with the 3/60 fiscal policy rules At the summit, proposals were made to increase monetary fines or introduce administrative penalties, like temporary loss of voting rights Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Objections: Imposing monetary fines on countries in crisis only makes the crisis worse It is politically hard to impose fines on the biggest member countries. In the past, France and Germany have violated the budget rules without fines Administrative penalties were rejected as too controversial
  • 10. Proposal: Force Bondholders to Share the Cost of Bailouts A proposal was made at the summit that bondholders should be subjected to haircuts as a way of sharing the cost of future bailouts. Imposing a haircut would mean holders of bonds of an insolvent or near-insolvent euro member country would receive only part payment on the debts they were owed Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Objections: The threat of haircuts would spook bondholders and send borrowing costs even higher for countries whose budgets are already weak European banks are major holders of the bonds. Subjecting them to losses might reduce the cost of country bailouts only at the risk of having to bail out the banks, instead
  • 11. What the Summit Decided to Do At the October summit, EU leaders unaniously agreed that a new set of fiscal rules was needed An attempt will be made to draft new rules that will include a permanent mechanism to deal with fiscal crises and a strengthening of the current budget rules Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Objections: Any proposal would probably require amendment of the EU’s founding treaty Any major modification would require formal ratification by all member countries, including referendums in some countries—an almost impossible task Minor technical modifications could be possible without formal ratification but might be too weak to do much good
  • 12. The Bottom Line: Problem Not Yet Solved The summit was a small step forward in that there was unanimous agreement that current rules are inadequate The strongest proposals were rejected, and any final rule changes will probably be too weak to solve the problem permanently The bottom line: The euro area cannot yet declare victory in its struggle with fiscal policy free riders Post P101101 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/