Saving Europe's Automatic Stabilizers
European policy makers have repeatedly suggested that fiscal- policy coordination and fiscal federalism will play key roles in Europe's monetary union. This paper warns that this hope is misplaced. Fiscal federalism will not be available to offset recessionary shocks for the foreseeable future. The effects of coordination designed to internalize the cross-border spillovers of fiscal policies are too weak. Freeing up fiscal policy to replace national governments' loss of monetary independence requires allowing European countries' automatic stabilizers to operate. That in turn requires a flexible application of the Excessive Deficit Procedure and the Stability Pact. The solution suggested here is that the Excessive Deficit Procedure and any fines and sanctions associated with the Stability Pact be applied to the constant- employment budget balance, not the actual deficit. Applying them to actual deficits when European countries enter EMU up against the 3 percent limit will render fiscal policy strongly procyclical, aggravating the problem of macroeconomic fragility created by the loss of monetary autonomy. Still, countries like Germany haunted by the specter of fiscal profligacy need to be reassured that member states will not abuse their fiscal discretion. Procedural and institutional reform to offset the deficit bias in national political systems is the obvious quid pro quo.
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