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doi: 10.1093/jfr/fjw003
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* David Vines, Economics Department, Balliol College, St Antonys College, and Institute for New Economic
Thinking (INET) at the Oxford Martin School, University of Oxford; Crawford School of Public Policy,
Australian National University; and Centre for Economic Policy Research. Email: david.vines@economics.ox.ac.uk.
I am grateful to Christopher Allsopp, Olivier Blanchard, Lukas Freund, Wendy Carlin, Russell Kincaid, Klaus
Regling, Andre Sapir, Peter Temin, and Guntram Wolff for helpful discussions. I am especially indebted to the
late Max Watson who, over many years, helped me to think more clearly about European issues.
1 See the discussion which took place at the Bruegel Think-tank in Brussels on 3 November 2015 with the
title Economic governance of the EU: Quo Vadis? Presentations from this discussion are available at
<http://bruegel.org/events/economic-governance-of-the-eu-quo-vadis/> accessed 15 February 2016.
C The Author 2016. Published by Oxford University Press. All rights reserved.
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Fiscal Governance 115
However, there are also important questions about the content of economic pol-
icy: how the policy system in the Eurozone is meant to work; how it actually works;
and what we can expect the outcomes of policies to beas distinct from what we
hope they might be. A discussion of these issues is strangely lacking in the Report,
and it has not emerged in subsequent considerations of the Report.2 Such discus-
sions require a thorough understanding of macroeconomic theory.
What macroeconomists have learned since the 1980s is that, although effective
macroeconomic governance requires both good process and good content, content
comes first. Roughly speaking, a policymaker cannot be held accountable for a policy
system until he or she understands both how that system works, and what policy ac-
tions would be required to deliver good outcomes in particular contexts.3 This article
will concentrate on these questions of content.
I write with a UK perspective. The UK has a clear interest in improving the func-
2 See the discussion referred to in the previous footnote, and the discussion which took place at the Bruegel
Think-tank in Brussels on 19 January 2015 with the title Deepening Economic and Monetary Union:
European Macroeconomics and Governance. Presentations from this discussion are available at <http://
bruegel.org/events/deepening-economic-and-monetary-union/> accessed 15 February 2016. Further, see
David Vines, Impossible Macroeconomic Trinity: The Challenge to Economic Governance in the
Eurozone (2015) 37 Journal of European Integration 861.
3 The establishment of inflation targeting regimes, in which independent central banks have been held ac-
countable for the management of the economy, is a case in point.
116 Journal of Financial Regulation
4 For an exposition of these ideas as they were understood at the time, see Christopher Allsopp and David
Vines, The Assessment: Macroeconomic Policy (2000) 16 Oxford Review of Economic Policy 1.
Christopher Allsopp and David Vines, Monetary and Fiscal Policy in the Great Moderation and the Great
Recession (2015) 31 Oxford Review of Economic Policy 134, discuss what was needed to get from the
earlier Keynesian policy regimes to the inflation-targeting regimes which emerged.
5 Michael Woodford, Interest and Prices (Princeton UP 2003).
6 Friedman, M. The Role of Monetary Policy (1968) 58 American Economic Review 1, 17.
Fiscal Governance 117
they will need to be raised in the future and so will not change their expenditure.7
Another more important reason was also identified: monetary policy can be dele-
gated to an independent central bank, free from political influence.8 This was of par-
ticular concern to Europe, where the obvious difficulty of coordinating an activist
fiscal policy across a number of countries presented a potential nightmare.
The role found for fiscal policy was, instead, that it would be used as the instru-
ment for ensuring fiscal disciplineie for managing the levels of public-sector def-
icits and debt.9 Nevertheless, the necessary movements in the fiscal position were
allowed to be gradual. In particular, fiscal policy continued to allow automatic
stabilizers to operate over the economic cycle. The reasons that this was done were
partly microeconomicbecause tax smoothing is a good idea; partly macroeco-
nomicbecause allowing the automatic stabilizers to operate would make it easier
for the monetary authority to control the economy; and partly practicalbalancing
7 Barro, R. J. The Ricardian Approach to Budget Deficits (1989) 3 Journal of Economic Perspectives
37, 54.
8 Christopher Allsopp and David Vines, The Macroeconomic Role of Fiscal Policy (2005) 21 Oxford
Review of Economic Policy 485.
9 Tatiana Kirsanova, Sven J Stehn and David Vines, The Interactions between Fiscal Policy and Monetary
Policy (2005) 21 Oxford Review of Economic Policy 532; Allsopp and Vines (n 4).
10 Allsopp and Vines (n 4).
118 Journal of Financial Regulation
In 1997 there was a further agreement, based on a proposal by the German gov-
ernment, to reinforce the fiscal provisions of article 104c. This additional agreement,
the Stability and Growth Pact, or SGP, had two key features. On the one hand, it
would allow the automatic stabilizers to operate, which would clearly contribute to
economic stability. But, on the other hand, it would do so only by tightening the
required extent of fiscal discipline. Countries were to enforce a commitment to a
medium-term budgetary objective of positions close to balance or in surplus. If
countries did this, then they would be permitted to deal with the normal cyclical fluc-
tuations in fiscal revenueie countries would allow the automatic stabilizers to oper-
ate, while still keeping their government deficit below the reference value of 3 per
cent of GDP, even when revenue had fallen in a recession. In essence, the SGP trans-
formed the 3 per cent reference value specified in the Maastricht Treaty, which re-
mained untouched, into a hard ceiling which countries would need to remain well
11 Swedish Government, Stabilisation Policy in the Monetary Union: Summary of the Report (The
Commission on Stabilisation Policy for Full Employment in the Event of Sweden Joining the Monetary
Union, Swedish Government Official Reports SOU 2002:16, Stockholm 2002); Jean Pisani-Ferry, Fiscal
Discipline and Policy Coordination in the Eurozone: Assessment and Proposals in Ministerie van
Financien (ed), Budgetary Policy in E(M)U (The Hague 2002); Charles Wyplosz, Fiscal Policy:
Institutions Versus Rules (2005) 191 National Institute Economic Review 64.
Fiscal Governance 119
important article published in 2006.12 It was also suggested that the Lisbon process,
which was set up after the launch of EMU, might play a part in helping to induce the
necessary behaviour. It was thought that this process might help to bring pressure on
uncompetitive regions to adjust their costs and prices in the appropriate manner.
P R E - C R I S IS V UL N ER A BI LI T I E S: I MP L I C AT IO NS
FOR F IS CAL P OL ICY
During the first nine years of the Eurozonefrom 1999 to 2008the first part of
the EMPS operated very well. The ECBs interest rate policy was of the right type,
compared with estimated reaction functions for the USA and the UK. It was rela-
tively active, more active than would be suggested by a commonly used standard of
referencethe Taylor Rule. In addition, the reaction function appears to have been
reasonably symmetric in its operation, despite the rather asymmetric specification of
the meaning which was initially given by the ECB to price stabilityless than 2 per
cent inflation over the medium term for the euro area HICP price index. That is
how the objective was originally expressed, but the more recent specification is The
ECB aims at inflation rates of below, but close to, 2% over the medium term.13
But the third and fourth parts of this policy systemto do with wage and price
setting and financial liberalizationwent badly wrong. Even before the onset of the
global financial crisis (GFC), this failure had called into question the second part of
12 Otmar Issing, The Euro: A Currency without a State, BIS Review 23/2006 <http://www.bis.org/
review/r060331e.pdf> accessed 15 February 2016.
13 ECB, Monetary Policy <https://www.ecb.europa.eu/mopo/html/index.en.html> accessed 15 February
2016.
120 Journal of Financial Regulation
the EMPS, the determination to use fiscal policy only for the management of the
level of public debt, and not to use that instrument in the management of aggregate
demand.
Two vulnerabilities
Ill-disciplined wage and price setting
Wages and prices did not remain in check in the way that Issing had said was neces-
sary. In Europe, the Great Moderation produced a Great Divergence. Real exchange
rates (ie relative unit labour costs) moved cumulatively upward in the GIIPS coun-
tries relative to those in Germany, with France in the middle. The amount of move-
ment was very largeapproximately 40 per cent in Greece, 35 per cent in Ireland,
and 30 per cent in Italy, Portugal, and Spain.14 There was a lack of appropriate re-
14 For a plot of these cumulative divergences, which remorselessly built up over a period of nearly 10 years,
see Peter Temin and David Vines, The Leaderless Economy: Why the World Economic System Fell Apart
and How to Fix It (Princeton UP 2013) ch 5.
15 See European Commission, EMU@10: Successes and Challenges after Ten Years of Economic and
Monetary Union, European Economy 2/2008; and Andre Sapir, Europe after the Crisis: Less or More
Role for Nation States in Money and Finance? (2011) 27 Oxford Review of Economic Policy 608.
16 See Temin and Vines (n 14) for a plot of these divergences in real interest rates, which remained remark-
ably constant over time. A similar plot can be made for the other GIIPS countries.
Fiscal Governance 121
assured if wage-and-price setters looked forward in the way that Issing has suggested
is necessary.17
The facts show that this did not happen in the period from 1999 to 2008. It is
quite possible that, in the absence of the GFC, and given a long enough period of
time, such forward-lookingness might have begun to dominate. But by the onset of
the GFC this had not happened, and the cost-positions of peripheral countries in the
Eurozone were well out of line with each other.
17 See Christopher Allsopp and David Vines, Fiscal Policy, Labour Markets, and the Difficulties of
Intercountry Adjustment within EMU in David Cobham (ed), The Travails of the Eurozone (Palgrave
2007) 95; Tatiana Kirsanova and others, Optimal Fiscal Policy Rules in a Monetary Union (2007) 39
Journal of Money, Credit and Banking 1759.
18 Carmen Reinhart and Kenneth Rogoff, This Time is Different: Eight Centuries of Financial Folly (Princeton
UP 2009).
19 European Commission Adjustment Dynamics in the Euro Area, European Economy 6/2006. Watson
was then Economic Adviser to the Director General for Economic and Financial Affairs (DG-ECFIN).
122 Journal of Financial Regulation
the recommendations of this group were ignored. The opportunity to use fiscal pol-
icy in a stabilizing manner was not taken up.
More than this, the SGP acted in a positively destabilizing manner.20 It did this
because the automatic stabilizers were not actually allowed to operate. The effect of
the SGP was to encourage spending in the Southern European periphery, at the time
that this region was experiencing a boom. This can be seen from a description of
what happened in Spain. High growth in domestic demand in Spain led to inflation
and to a worsening current account position. But it was not allowed, at the same
time, to lead to a greater fiscal surplus so as to dampen the boom. Instead, most of
the extra revenues were spent, meaning that fiscal policy actually supported the
boom, augmenting the destabilizing effects outlined in the Walters critique, rather
than seeking to dampen it. The SGP positively encouraged such pro-cyclical
behaviour.
T H E IM P L I C A T I O N S OF TH E G F C A N D T H E E U R O P E A N C R I S I S
F O R TH E E U R O Z O N E M A C R O E C O N O M I C PO L I CY S Y S T E M
The GFC and the zero bound for monetary policy
When the GFC struck at the end of 2008, the effects appeared at first to be relatively
smallfor example, relative to the Latin American debt crisis of the 1980s. But the
crisis soon spread rapidly around the world. The reason for the speed of contagion
appears to have been the quite extraordinary degree of leverage that had been built
up during the Great Moderation. In Europe, as everywhere, there was a massive
downturn in aggregate demand.
The policy response was immediate. First, as was to be expected from the infla-
tion-targeting framework within the NCA, interest rates were slashed. In the USA,
they reached the lower bound by the end of 2008; the Eurozone was not far behind.
Once the lower bound was reached, no further offset could be provided by
conventional monetary policy. Second, there were massive financial bailouts. Third,
turning to fiscal policy, in most advanced countries the automatic stabilizers were
allowed to operate as the economy fell into recession. This, too, was in line with the
framework of the NCA, in which fiscal objectives had typically been formulated to
apply over the cycle. Importantly, there was a cooperative agreement to do this at
the G20 Washington summit in November 2008.
At the London summit of the G20 which followed in April 2009, there was a sig-
nificant departure from the fiscal framework of the NCA. Policymakers adopted a
significant discretionary expansion of their fiscal policies, as a demand-stabilizing
measure, to an extent which amounted to perhaps as much as 2 per cent of global
GDP over a period of up to three years. This discretionary expansion was important,
coming on top of the operation of the automatic stabilizers. But, the effects of the
automatic stabilizers were much larger; putting these two effects together the overall
21 Christopher Adam, Paola Subacchi and David Vines, International Macroeconomic Policy Coordination:
An Overview (2012) 28 Oxford Review of Economic Policy 395; Creon Butler, The G20 Framework
for Strong, Sustainable, and Balanced Growth: Glass Half Empty or Half Full? (2012) 28 Oxford Review
of Economic Policy 469.
124 Journal of Financial Regulation
I would argue that the global recovery would have been much faster if fiscal policy
had been allowed to take responsibility for the restoration of full employment, in an
environment that tolerated the necessary rises in public debt. The policies of auster-
ity which have been adopted, designed to reduce public debt, have slowed the global
recovery. Global growth will not be resumed until the private sector begins to invest
strongly again, creating the financial assets which the private sector wishes to hold,
thereby enabling public debt to be retired. This has not yet happened because the
private sector, correctly, does not believe that macroeconomic policy is capable of
sustaining a strong recovery.
Secondly, the sovereign debt crisis in the GIIPS countries led to an additional
reason for tightening fiscal policy. These uncompetitive countries, which had over-
borrowed, were unable to find a way to stimulate growth by currency depreciation
or in any other way. Andbecause the collapse in output in these countries had led
to a collapse in fiscal revenues, fiscal consolidation was seen to be essential, even-
though this worsened the collapse in output.
P U T T I N G T H I N G S T OG E T H E R : TH R E E I M P L I C A T I O N S
FOR F IS CAL P OL ICY IN TH E EM PS
Nevertheless, the Eurozone survived the crisis of 2010. In 2012, Mari Draghi
announced that the ECB would do whatever it takes, and by the end of 2013 there
was widespread optimism that recovery was on its way. Buttwo years laterthat
optimism has faded. It has been replaced by a belief that the revival of economic
The need for revision of the SGP and the imbalances procedure
As described earlier, the SGP forced Germany to follow excessively tight policies dur-
ing the Great Moderation but allowed excessive laxity in the GIIPS countries. Now,
however, the SGP is imposing excessive fiscal deflation across Europe. As described
earlier, there is a policy of fiscal constraint in northern Europe, following the prin-
ciples of the NCA. However, this is coupled with severe austerity in the South, as a
result of the sovereign debt crisis there. As a consequence, the SGP needs to be
reformed, for reasons which build on those set out above. But in fact it has been
tightened since the onset of the GFC in 2008. (This statement is correct even allow-
ing for the fact that there have been repeated extensions of deadlines.)
The SGP has also been accompanied by a new policy process, the Macroeconomic
Imbalances Procedure, designed to deal with the intra-European adjustment problem
described earlier. But I would argue that these adjustments to the EMPS have become
part of the problem, not part of the solution.22 This procedure imposes surveillance
on all countries with an external deficit of more than 4 per cent of GDP, forcing them
to curtail fiscal deficits, but allows countries with surpluses of up to 6 per cent to es-
cape surveillance, rather than forcing them to expand fiscally. It is very strange that
Germany, with a surplus of nearly 8 percent, is escaping pressure to expand, and that
the Netherlands is doing the same, with an even greater surplus.
This set of policies has had the effect of holding back the European recovery.
Numbers presented by the OECD suggest that the level output in Europe is 34 per
cent lower than it would have been without such fiscal austerity.23
With such a combination of discipline and asymmetry, the only way that demand
can begin to grow again in Europe is through growth in net exports. And, the only
22 These changes to the EMPS have been introduced in a set of reforms known as the Two Pack and the
Six Pack.
23 OECD, Economic Outlook Volume 2014/2 (2014).
126 Journal of Financial Regulation
24 David Vines, On Concerted Unilateralism: When Macroeconomic Policy Coordination is Helpful and
When It is Not in Tamim Bayoumi, Stephen Pickford and Paola Subacchi (eds), Managing Complexity:
Economic Policy Cooperation after the Crisis (Brookings Institution 2015) ch 2.
25 For a discussion of how this needs to be done, see Allsopp and Vines (n 17), Kirsanova and others
(n 17), Kirsanova, Stehn and Vines (n 9), Pisani-Ferry (n 11), and Wyplosz (n 11).
26 European Commission, Quarterly Report on the Euro Area, (2015) vol 14, no 4.
27 Britains overvaluation in 1925 was less than half of what was required in Europe in 2008, and yet adjust-
ment proved to be impossible.
Fiscal Governance 127
Asia in 1997. Furthermore, during the adjustment process it will be difficult for
growth to resume. It is hard to imagine that political support for such a strategy will
be sustained throughout this period of time.
Adjustment would be easier if Germany shared the burden, allowing a much higher
rate of German inflation for a period of some years, and so bringing about a difference
in inflation rates without requiring deflation in the GIIPS countries. The behaviour of
German representatives at the ECB since 2012 has revealed their unwillingness to
allow a European monetary policy which would bring this about. This explains why, in
late 2014, the ECB was so unwilling to take decisive action to prevent inflation from
falling well below the two per cent target. German resistance to Quantitative Easing
(QE), early in 2015, can be seen in this light. The action of the ECB in carrying out
significant QE from 2015 has begun to push the process in the right direction, by gen-
erating greater Eurozone-wide inflation, through the depreciation of the Euro.
28 Vines (n 24).
29 Brett House, David Vines and W. Max Corden International Monetary Fund in Steven Durlauf and
Lawrence E Blume (eds), The New Palgrave Dictionary of Economics (2nd edn, Palgrave 2008); James M
Boughton, Tearing Down Walls: The International Monetary Fund 1990-1999 (IMF 2012).
128 Journal of Financial Regulation
of the peripheral countries of Europe if growth is to resume. This is the case because
the existence of a debt overhang of the current size is likely to go on depressing both
consumption and investment, and so to prevent a recovery.30 What is more, the fiscal
surpluses necessary to bring the debt-to-GDP level back to acceptable levels do not
appear to be politically sustainable. This has already become evident in the case of
Greece, but the point is a more general one and applies across all of Portugal,
Spain, and Italy. The necessary write-downs are being resisted by Germany. German
policymakers are acting in a way similar to what happened in the 1980s in the USA,
when the US government, acting on the behalf of US banks, prevented write-downs
of Latin American debt.
In Ireland, in late 2010, the ECB and the European Commission prevented the
Irish Government and the Irish Central Bank from imposing losses on bond holders
who had invested in Irish banks which had become bankrupt. Such debt-reliefworth
elsewhere will, in the end, become responsible for failed debts in the GIIPS coun-
tries. But, the need for the write-down is also obvious. The result that emerges will
be the result of some kind of bargaining process. And, it will be relevant to this bar-
gaining process that much of the debt was created by banks in northern Europe, who
over-lent to these countries in the first place, encouraged by the light-touch regula-
tion which went along with the financial liberalization that was part of the EMPS.
Nevertheless, writing down this debt has become much more difficult than it was
in 2010. In the intervening years, banks have been able to pass on their debt, first to
the IMF and then to the ECB and ESM. Writing down the debt held by the ESM
will be politically difficult, precisely because the burdens will end up with taxpayers,
rather than part of the burden being born by the private shareholders of those
northern European banksand US bankswho made some of the loans.
But until the necessary write-downs happen, uncertainty will cast a shadow over
C O N CL U S I O N
Within the Eurozones Macroeconomic Policy Framework, the task of monetary pol-
icy was to stabilize the macroeconomy, and fiscal policy was given the objective of
managing the level of fiscal deficits, and of ensuring that the level of public debt was
not too high. Within this framework, the wage-setting and price-setting processes
were to ensure that countries remained sufficiently competitive in relation to each
other, and policies of financial liberalization were undertaken to enable the closer in-
tegration of peripheral European economiesthe GIIPSwith their northern
neighbours, thereby generating an increase in well-being.
Even before the onset of the GFC, the process of wage and price fixing in the
GIIPs countries was ill disciplined, and the process of financial liberalization was
grossly mismanaged, creating a need for adjustment. There was a role for fiscal policy
to play a part in the adjustment process.
The onset of the GFC meant that interest rates soon reached the zero bound and
so that monetary policy was no longer able to effectively stabilize the Eurozone econ-
omy. QE, undertaken by the ECB, has helped to depreciate the Euro, and so has less-
ened the difficulties, both by stimulating demand and by raising Eurozone-wide
inflation. Nevertheless, in these circumstances fiscal policy needs to both help
stabilize the Eurozone economy in a way not allowed by the SGP, and also needs to
play a part in ensuring the resolution of imbalances within Europe. For it to be pos-
sible to carry out these two tasks, sovereign debt will need to be written down, more
than has happened to date.