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Fiscal policy in Euro Area

Evidence of fiscal procyclicality, excessive deficits, distorted budget composition and poor compliance with fiscal rules for 19 countries participating in the euro area over 1999–2015

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The European Union (EU) is a unique construct that cannot be described as a standard federal system. The EU is a unique entity that shares features of federal systems without properly falling under the definition. The EU lacks a number of legal and institutional elements that are present in federations. Unlike states in a federation, EU member states retain most of their sovereignty, and the national dimension of politics continues to predominate in the discussions at the European level.

Some argue that the EU construct lies between a fully federal system (such as the United States) and an intergovernmental cooperation system (such as the United Nations). Another important difference is that legislative powers are split between the European Parliament (EP) and the Council of the European Union—the latter represents the governments of the member states and is composed of national ministers. The vast majority of European laws are adopted jointly by the EP and the Council, although the EP involvement depends on which procedure the proposal is being adopted under.

Like many other advanced economies, euro area (EA) countries have faced a significant accumulation of public debt in the past three decades. The public-debt-to-GDP ratio of the EA as a whole increased from an average level of less than 60 percent of GDP in the early 1990s to more than 90 percent of GDP in 2015. The surge in debt was particularly pronounced in 2009 and 2010 at the peak of the global financial crisis. Some countries were priced out of the market and contagion set in, with fiscal stress in some member states spilling over to others.

Focusing on the fiscal area, differences are apparent in all dimensions of fiscal policy. The size of the EU budget and its staff are very small compared with standard federal budgets and civil service; risk sharing and redistribution mechanisms are less developed; the EU does not have the ability to borrow for the general budget or tax citizens directly and draws its resources from member states’ contributions; fiscal policy is subject to a very complex set of fiscal rules but enforcement mechanisms are weaker than in federations and there are no direct controls from the center on member states’ fiscal policies; and harmonization of spending and tax policies across states is very limited.

In the EA, another important aspect to consider is the existence of strong cross-country fiscal spillovers associated with trade linkages, confidence effects, the high degree of financial market integration, and the single monetary policy response. Through these channels, fiscal imbalances in a given member state may affect the fiscal positions of other member states.

Some of the fiscal challenges faced by the EA are rooted in distorted political incentives at both the national and supranational levels. The presence of national and supranational fiscal rules has not successfully alleviated these biases, which have continued to prevail following recent reforms of the fiscal framework.

The importance of distorted incentives is a very simple result, but it has far-reaching implications that have not yet been fully acknowledged in the reform of fiscal institutions. One extreme and dangerous manifestation of these distortions is the expressed perception by many analysts that European fiscal governance releases countries from their national responsibilities.

Nothing could be further from the truth: fiscal policy is, first and foremost, a national responsibility. The combination of this misperception with the predominance of the national dimension of politics constitutes a dangerous mix.

The most sophisticated improvements in the design of the framework will not bear fruit unless they also garner political and public support. By strengthening the economic basis of the rules, reform of the Stability and Growth Pact has made significant progress, but efforts should continue on two fronts right design combined with right incentives. It is possible and desirable to have a stronger system of incentives, including gradual and proportionate sanctions and clear benefits for compliers.

In the longer term, a lasting solution must combine market discipline and stronger fiscal governance. Fiscal union will, if it happens, be an aspect of a comprehensive architecture accompanying bank and capital markets unions. It would reflect political choices in Europe.

The working paper that describes the broad explanation about the fiscal policy, budget constraints and deficits, you can read HERE!

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