Macroeconomic Policy Coordination in EMU

Contents

List of Figures

List of Tables

List of Abbreviations

1 Introduction

2 Macroeconomic policy coordination under the Stability and Growth Pact before the crisis
2.1 Stability and Growth Pact content: numerical constraints
2.1.1 Economic rationale: the role of debts and deficits as the background of the Stability and Growth Pact content
2.1.2 Critical assessment: the need for country-specific constraints
2.2 Stability and Growth Pact objective: fiscal discipline
2.2.1 Economic rationale: negative externalities and the reasons of fiscal laxity
2.2.2 Critical assessment: the need for discretion and flexibility
2.3 Stability and Growth Pact governance: coordination through rules and mechanisms
2.3.1 Rule-based architecture and mechanism design
2.3.2 Economic rationale: The reasons for and the consequences of a rule-based framework
2.3.3 Critical assessment: credibility issues with the Stability and Growth Pact

3 Macroeconomic policy coordination during and after the crisis
3.1 The Stability and Growth Pact during the crisis
3.2 Reforms regarding macroeconomic policy coordination
3.3 Comparison of ante-crisis propositions and reforms
3.3.1 Dimensions and trade-offs of the Stability and Growth Pact design
3.3.2 Requested dimensional changes compared to actual developments of the SGP

4 Conclusion

A Appendix A - Relevant Legislation

B Appendix B - Full Tables

C Appendix C - Supplementary Figures

References

List of Figures

1 Deficit to GDP ratio (in %) of EURO-12 area from 1995 to 2004

Source: Eurostat

List of Tables

1 Gross public debt (in % of GDP), budget deficit (in % of GDP) and nominal growth rate (in %) of EC12 countries in 1991

Source: Buiter et al. (1993, p. 70)

2 Budget deficit to GDP ratio (in %) of EURO-12 countries from 1995 to 2004

Source: Eurostat

3 Procyclical and countercyclical fiscal policy in EMU countries from 1996 to 2006

Source: Dullien and Schwarzer (2009, p. 500)

4 Average cyclicality, output gap (in % of potential GDP) and government deficit (in % of GDP) of EURO-11 countries from 1996 to 2006

Source: Cyclicality: Dullien and Schwarzer (2009, p. 500); output gap: IMF; deficit: Eurostat

5 Theoretically possible scenarios for the excessive deficit procedure in case of non-compliance (time until first fine) according to reformed (2005) Stability and Growth Pact

Source: Calmfors (2005, p. 64)

6 Deficit to GDP ratios (in %) in the EURO-12 countries from 2007 to 2014

Source: Eurostat

7 Debt to GDP ratios (in %) on aggregate at the EURO-11 and EURO-12 level from 2007 to 2014

Source: Eurostat

List of Abbreviations

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1 Introduction

The financial crisis and the subsequent European sovereign debt crisis have highlighted the high degree of interdependence among EMU member states. The crisis period made much more clear that a macroeconomic policy coordination framework is indispensable as there is great sensibility and high risk for contagion effects. It is more obvious than ever that supranational frameworks affect policy making on a national level and, inversely, that national fiscal policies affect all other member states and EMU as a whole.

This bachelor thesis addresses the fundamental need for macroeconomic policy coordination in a monetary union environment. Since EMU does not represent a fiscal union with a large enough federal budget to stabilise the overall economy, the functioning of EMU relies mainly on national policies. The structure of EMU in its highest level of integration with one common currency as of one monetary authority vis-à-vis many fiscal authorities brings about several specific aspects regarding coordination and collaboration. In order to achieve and ensure economic stability in such a unique constellation there have been established several measures and frameworks. In particular, the Stability and Growth Pact (SGP) builds the centre point in this regard as it rep- resents the only legally binding and rule-based governance framwework. The in 1997 established pact is designed on the grounds of and motivated by the objectives to stabilise the overall EMU economy by promoting fiscal discipline.

There are multiple strong theoretical arguments in favour of the pact, however, since the archi- tecture involves trade-offs in the fields of specific content, objectives and design, these rationales require comprehensive analysis and bring forward criticism and corresponding propositions in opposite directions.

The SGP in particular focuses fiscal discipline through limiting government deficits and debts. The justification is that in the absence of such criteria, adverse fiscal spillover effects and freeriding behaviour of national fiscal authorities could risk price and overall macroeconomic stability of the common currency area. This however brings about a limitation for governments to discretionary react to national economic needs and conditions which is highly criticised. The pact is further accused to only present a superficial coordination.

The main goals of this thesis are: to examine the main arguments in favour and against the pact under the areas of content, objectives and enforcement design; to highlight the resulting trade-offs; and to link these to developments of the pact that were introduced through reforms but also to economic outcomes in different situations, namely the time period before and the time period during and after the crisis.

The main finding is that the reforms regarding macroeconomic policy coordination and the SGP which were introduced after the beginning of the crisis period do not represent a rearrangement of the framework and address the same debate on economic trade-offs only with a changed set of conditions and experiences. The reforms regarding SGP can be rather described as developments refocusing on the core of the pact while still shifting it in the directions of some propositions along with criticism which had been made before the financial and subsequent Eurozone crisis.

The structure is as follows: section 2 deals with the debate on the SGP as the main frame- work for economic policy coordination. In three subsections both, the economic rationale as well as oppositional arguments, are highlighted regarding the corresponding aspect of the SGP. The first area is the pact content and the numerical rules as of the constraints of 3% of deficit to GDP and 60% of debt to GDP. The trade-off is inter alia uniformity vs. country-specific de- sign. The second subsection highlights the objective and economic rationale of fiscal discipline while weighing it against the need for flexibility. The third subsection addresses the design and architecture as of rules and mechanisms. The corresponding critical assessment will focus on enforcement issues and institutional forms of coordination. This analysis will then be extended under section 3 with a changed set of conditions due to the post-2007 crisis and will address the reforms motivated by the negative economic consequences. The thesis will conclude under section 4 after comparing the reforms with the ex ante crisis proposals and the in section 2 examined debate.

2 Macroeconomic policy coordination under the Stability and Growth Pact before the crisis

Since the publication of the Report on economic and monetary union in the European Community published in 1989, commonly known as Delors Report, the coordination of national fiscal policies has been an intensively debated issue. The report states that due to an increasing interdependence and the existence of externalities of national decisions, an effective monetary union required binding rules and mechanisms (Delors, 1989, p. 14). The framework under which national fiscal policy authorities are operating, in particular the Stability and Growth Pact (SGP), seems to have built the centre point of this debate since its adoption in 1997 due to a high number of literature that addresses and criticises the framework.

The Stability and Growth Pact is the only legally binding policy coordination framework regard- ing macroeconomic policies in EMU and, therefore, represents the strongest and most official way of enforcing policy coordination among member states. Although section 2.3.1 will examine the exact rule-based design including all mechanisms and procedures, the essential content and features of the pact are nevertheless important for the understanding of all other parts of this thesis as well. In short, the SGP is separated into two main parts: the preventive arm and the corrective arm. The latter calls for a compliance with two basic numerical rules: member states’ government deficit should not exceed 3% of GDP or otherwise the corrective arm foresees an Excessive Deficit Procedure (EDP) which theoretically culminates in fines if the concerned country does not correct its deficit. The second reference value is a maximum debt to GDP ratio of 60%. By contrast to breaching with the deficit constraint however, a country exceed- ing 60% of debt is not foreseen to be faced such a corrective procedure. The former focuses on so-called medium-term objectives (MTO) which should provide a path for each country to reach a budgetary position of balance or in surplus in the medium run. The design of the pact was reformed in 2005 and further developed through several reforms during and after the crisis period. However, the basic features have remained untouched and still build the centre point of the framework.

This section will concentrate on three main areas which are approached by the SGP and which are discussed in an accumulated degree in literature: (i) the background of the content of the pact and the economic indicators in particular which are highly focused on government deficits, (ii) the fiscal discipline the indicators impose on the member states in contrast to flexibility and (iii) the rule-based structure and governance mechanisms as the preliminary approach to enforce fiscal discipline. Each section will outline economic rationales for the SGP design regarding the concerned component before highlighting critical points of view and corresponding propositions. Each section will be examined by means of qualitative arguments and selected empirical data while respecting the SGP reforms of 2005. Since the SGP has been empirically tested during the crisis which have triggered some substantial reforms regarding fiscal policy coordination, these sections will focus on the time before and during this time period. Section 3 will then focus on the same issues and focus points with a changed set of conditions from the beginning of the financial crisis and the resulting European sovereign debt crisis on.

2.1 Stability and Growth Pact content: numerical constraints

The first area addressed by the SGP design is the most obvious one, namely the economic indicators and specific constraints. Whereas section 2.3.1 will explicitly examine the functioning and mechanisms of the pact, this part rather attempts to give an explanation on why and how the content is dominated of government debts and deficits. The background of the establishment of the pact which is based on the Treaty on the Functioning of the European Union (TFEU), namely the convergence criteria which were introduced by the Maastricht Treaty and the Delors Report, establishes some understanding for the constraint of 3% for the ratio of budget deficits to GDP. This ratio is the fundamental focus point of the pact and the following sections as well as the overall understanding of this thesis. Thereafter, the economic indicators are being put to the test based upon multiple criticisms in literature among economists as well as selected empirical data.

2.1.1 Economic rationale: the role of debts and deficits as the background of the Stability and Growth Pact content

The aforementioned Delors report laid the foundation of the numerical constraints and the rule-based framework of both the Maastricht convergence criteria and the later introduced SGP. Proposal number 19 of the report states that with monetary unification "a wide range of decisions would remain the preserve of national and regional authorities. However, given their potential impact [...] implications for the conduct of a common monetary policy, such decisions would have to [...] be subject to binding procedures and rules. This would permit the determination of an overall policy stance for the Community as a whole [...] and place binding constraints on the size and the financing of budget deficits" (Delors, 1989, p. 14). Since the establishment of the EMU framework, the focus regarding rules for the functioning of a monetary union has lied on budget deficits in terms of their size and their financing. The justification is mainly based on externalities that decentralised fiscal decisions could have on the common currency union as a whole as well as price stability and effectiveness of monetary policies followed out by the single centralised monetary authority. The propositions of the report were first implemented in the Maastricht Treaty in 1992 as concrete convergence criteria. These specific numerical reference values on budget deficits and debt levels which were originally defined in the Protocol on the Excessive Deficit Procedure referred to in Article 104 TEC^[1] still apply today. The reference values are, as stated above, a maximum of 3% for government deficit to GDP and a maximum of 60% for the ratio of government debt to GDP^[2]. The SGP was built upon the Maastricht Treaty and therefore adopted its main principles as well as the convergence criteria in its preventive and corrective arm and converted the convergence criteria into general reference values for all EMU member states. However, Resolution of the European Council on the Stability and Growth Pact Amsterdam, 17 June 1997 which established the SGP in the first place focuses on budget deficits rather than government debts.

Despite the particular focus on government budget deficits, the ratio of government debt to GDP still has an important influence regarding fiscal policy in EMU as well as the SGP since debt and deficit ratios are linked to one another. The exact reference values can be generated through basic accounting and the following formula according to Buiter et al. (1993, pp. 62-63):

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with dt being the ratio for debt to GDP at the end of period t, ψ being the growth rate of nominal GDP in period t and deft the ratio for government deficit to GDP in period t. Assuming that the debt to GDP is constant, meaning that dt = dt−1, the following will apply:

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From (1) and (2) we get that nominal growth will implicate a decreasing ratio for debt to GDP dt according and furthermore that the ratios deft and dt are positively correlated meaning that a higher deficit to GDP ratio will increase the debt ratio. Equation (2) shows the particular economic link between the Maastricht criteria and later SGP constraints: with stable inflation and growth resulting in a specific nominal growth rate in the long run, not only are EMU member states theoretically able to comply with such guidelines for debts and deficits but also can these guidelines be designed in such specific numerical fashion.

With constraints of 60% for the debt and 3% for the deficit to GDP ratio the annual growth rate would require a value of approximately 5% of nominal GDP. That being said, the two fiscal reference values "seem mutually consistent" (Buiter et al., 1993, p. 63) although an annual real growth of 3% was even at that time estimated ambitious at an assumed inflation rate of about 2%. One possible explanation for the source of these specific values can be derived from empirical data in 1991 according to Buiter et al. (1993, p. 62) as of the averages of government debt as well as deficit ratios one year before the establishment of the Treaty as illustrated in Table 1: The average debt to GDP ratio in the EC12 countries (Belgium, Denmark, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, UK) was at 61.5%, only slightly above the determined 60%, and the average deficit to GDP ratio was at 4.3%.

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Table 1: Gross public debt (in % of GDP), budget deficit (in % of GDP) and nominal growth rate (in %) of EC12 countries in 1991

Source: Buiter et al. (1993, p. 70)

The reference values of the Maastricht Treaty which served as convergence criteria for countries that wanted to enter EMU were not changed with the adoption of the SGP, yet the focus was expanded to medium-term objectives in the preventive arm. However the time reference of the focus, the constraints were defined independently of the business cycle stage, although there can be situations and exceptional circumstances under which a country is allowed to exceed these limits. According to the definition of the term ’excessive deficit’, a country is allowed to exceed the reference value of 3% of its deficit to GDP ratio without facing a corrective procedure in case of a severe economic downturn. A severe economic downturn applies, if the reference values of a 2% economic decline as well as a minimum decline of 0.75% are met. The constraints nevertheless show a clear tendency towards fiscal discipline in order to cyclically sustain a balanced budget in order to ensure credibility of the monetary union and the common currency in contrast to fiscal discretion which can be explained historically: most EC12 countries showed high deficits from the 1970s until the early 1990s and a development towards high debt to GDP ratios until the mid 1990s (Fatás and Mihov, 2010, p. 295). Moreover, the tendency of procyclical fiscal policy behaviour of these countries in the 1970s and 1980s "contributed significantly to the general disillusionment on the desirability of discretionary stabilisation policy" (Brunila, 2002, p. 7).

2.1.2 Critical assessment: the need for country-specific constraints

After the establishment of the SGP and after the introduction of the common currency one could identify a clear reduction of deficits and debts of the concerned countries. Nevertheless, the economic slowdown in the early 2000s made several countries breach the constraints of the pact (Fatás and Mihov, 2010, p. 293). Table 2 shows the specific budget deficit (surplus) to GDP ratios of those countries that adopted the Euro first. In 1999, eleven countries qualified for the common currency and stage three of EMU integration according to the Maastricht criteria. From the original EC 12 countries all met these criteria except for Greece (Greece was included in the common currency area in 2001). Moreover, Denmark and the UK did not adopt the Euro as their currency. Out of the three countries that joined the EU in 1995 only Austria and Finland joined the Euro area while Sweden did not, although the country had no higher debts and deficits than the Maastricht criteria requested.

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Table 2: Budget deficit to GDP ratio (in %) of EURO-12 countries from 1995 to 2004 Source: Eurostat

All countries that adopted the Euro in 1999 complied with the fiscal Maastricht criteria and, therefore, the identical deficit constraint of 3% of GDP of the in 1997 introduced SGP. Compared to the historical tendency of running high budget deficits the constraint had a visible disciplining effect on these countries. Despite the balancing effects one could argue that the compliance with rules was only motivated by the inclusion in the common currency area. Many critics argue that the budget constraint took little account of economic circumstances and was too superficial and focused on results rather than performance (Morris et al., 2006, p. 18).

Eichengreen and Wyplosz (1998, pp. 99-100) for instance state that the breaches after the Euro implementation were a sign of the consequences from one-off measures followed by the governments. Instead of actually taking measures to increase economic performance and budget stability, governments were concerned about meeting the criteria and chose e.g. central bank sales of stock of gold or refundable Euro taxes as their strategy to improve their budgets. This would explain the unsustainability of some of the budget positions after 1999. With that in mind, the SGP was seen as aiming for adequate goals of fiscal discipline in general yet the economic indicators for doing so were accused of "supress[ing] the symptoms without eradicating the disease" and underlying problems of excessive deficits (Eichengreen and Wyplosz, 1998, p. 76). Hence, the actual cause of excessive deficits are not the focus point of the SGP and to a lesser extent of the governments for the sake of complying with the formal rules of the pact.

This argument is reflected by Table 2 and is illustrated in Figure 1. The figure shows the development of the average budget deficit of the EURO12 countries from 1995 to 2004. There is a clear trend from high budget deficits to more balanced budgets which resulted in an average surplus in 2000 of 0.6%. The figure however shows the short-term effect of the measures taken by the countries in order to comply with the criteria. After 2000 a clear downward trend can be identified which affirms the aforesaid malfunctioning of the concrete numerical rules.

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Figure 1: Deficit to GDP ratio (in %) of EURO-12 area from 1995 to 2004 Source: Eurostat

Fitoussi and Creel (2002, p. 42) focus on this development and highlight the fact that the rules of the SGP have disguised underlying problems such as the institutional imbalances of the eurozone. The plurality of fiscal authorities implies differences in the level of economic competitiveness, foreign trade openness, production structure and (un-)employment which leads to different optimal fiscal policy approaches. "The co-existence of a single, independent and politically unaccountable central bank, and a plurality of fiscal authorities all constrained by the same rules, creates a major institutional imbalance" (Fitoussi and Creel, 2002, p. 42) representing a one-size-fits-all fiscal policy which only little considers economic situations and country specific needs especially for countries wanting to enter the eurozone.

The on-size-fits-all criticism was popular before as well as after the reforms of the SGP in 2005. Although the preventive arm as well as the corrective arm were extended taking into consider- ation country-specific issues and economic conditions, the base of the EDP as well as the MTO as of 3% for the deficit to GDP ratio remained unchanged and stayed the benchmark for EMU countries. Therefore, the reforms regarding numerical constraints were seen as a weakening of the effectiveness of the pact in seeking fiscal discipline and a strengthening of the design taking into consideration country-specific factors such as structural reforms. Therefore, the proposi- tions before the reforms and even, in some cases, before the introduction of the SGP, continued to be suggested afterwards as well. Two of the most discussed and recognized are:

Proposition 1: Stronger focus on debts instead of/ in equal measure as deficits

Although the Maastricht Treaty included debts in its EMU entrance criteria, this approach to fiscal sustainability was not pursued in the strict manner with the SGP as budget deficits were. Moreover, the set debt targets represent "an accident of history"(Wyplosz, 2005, p. 73) because of the average debt rate of about 60% when the Maastricht Treaty was defined: "applying a unified target to countries whose debts range from 5 per cent to 120 per cent of GDP is clearly senseless". The argumentation against the focus on budget deficits is, that a focus on debts would increase sustainability and effectiveness of a pact aiming fiscal discipline. Buiter and Grafe (2004, p. 76) for instance suggest a Permanent Balance Rule: "The Permanent Balance Rule implies that, as long as the growth rate of nominal GDP is positive, a higher ratio of the stock of debt-GDP would imply, other things being equal, that the government would be able to run a larger financial deficit" aiming for a permanent tax rate to achieve government solvency (Buiter and Grafe, 2004, p. 78). It takes into consideration the primary surplus to GDP ratio, the long-run real interest rate and the long-run real growth rate as well as the net debt to GDP ratio.

Pisani-Ferry (2007, p. 8) even suggests a total shift from deficits to debts in guise of a "Debt Sustainability Pact". This would include the publication of public finance accounts "that allow to assess the potential future impact of off-balance sheet liabilities". By keeping the debt to GDP ratio at or below a specified maximum and by agreeing on a medium term ratio objective in order to assess budgetary policies on that basis, the SGP would be less superficial and more focused on the fundamental source of economic instability.

Proposition 2: Focus on the quality of public finances

Another suggestion addresses the way of accounting which should reflect the actual quality of public finances including debts and deficits. According to Blanchard and Giavazzi (2004, p. 3-5) the SGP fails to adequately take investment expenditures into account and should be correctly applied as of including nominal interest payments and capital depreciation to the budget but excluding net investment. This would promote long-term growth and sustainability while keeping budgets under control. The SGP with such a feature would imply "instead of a cut in demand, [...] a substitution of current expenditure with an equivalent amount of public investment". Instead of bearing the costs of a breach with the original design of the pact or the costs of a fiscal fatigue due to spending cuts, financing investment projects with a sufficiently high social rate of return would shift SGP economic outcomes to sustainability and long-term growth.

This argumentation was brought up even before the introduction of the SGP, right after the Macroeconomic policy coordination under the Stability and Growth Pact before the crisis establishment of the Maastricht Treaty: Buiter et al. (1993, pp. 87-88) suggested a shift of focus to structural deficits which would even in times of economic upturns allow for higher current spending. "Given the importance of public investment for growth, Europe’s fiscal framework could be based on the ‘golden rule’ of public finances, which stipulates that over the course of the economic cycle current public spending - excluding investment - should not exceed revenue" (Fitoussi and Creel, 2002, p. 64).

2.2 Stability and Growth Pact objective: fiscal discipline

The literature shows a clear tendency in favour of the fundamental need for fiscal discipline of EMU member states in general, whereas opinions differ in the way this discipline should be designed. Both, the preventive as well as the corrective arm of the SGP follow the clear objective of member states’ fiscal discipline. This section will now examine why such a great degree of importance was and still is drawn on fiscal discipline in EMU and what (disputable) consequences this discipline implies. Counteracting negative externalities resulting from a high interdependence among countries of a common currency area and especially the case of EMU represent the core justification for fiscal discipline. The motivation is to not only maintain credibility and effectiveness of the ECB but also prevent free-riding behaviour of national fiscal authorities which could result in destabilising economic outcomes through fiscal spillover effects. The high degree of discipline which is imposed on member states by the SGP, especially the corrective arm, is however criticised since it prevails flexibility through the lens of national governments.

2.2.1 Economic rationale: negative externalities and the reasons of fiscal laxity

The main reason why the SGP content and indicators target fiscal discipline in such a distinct manner is the credibility and effectiveness of the design of EMU itself as of one independent central bank and many decentralized fiscal authorities. For a well functioning of EMU and particularly the goal of price stability followed by the ECB, well balanced deficits and a limited scope of national fiscal policies are important preconditions (Buti et al., 1998, p. 95). The ECB therefore plays a key role in this regard and will be the first argument in favour of fiscal discipline. Thereafter, two more arguments requiring fiscal discipline are being highlighted: the existence of freeriding behaviour of national fiscal authorities and the fact that monetary unification increases this phenomenon and adverse fiscal spillover effects.

The role of the European Central Bank Canzoneri et al. (2002, p. 336) point out that fiscal constraints imposing fiscal discipline on monetary union member states theoretically assist in supporting an effective and sustainable monetary policy which marks one major objective of EMU creation. In this regard, the inde- pendent position of the ECB has been and still is unambiguous. Article 127 TFEU^[3] disposes monetary policy of the integrated union focusing on the primary objective of price stability. Beetsma et al. (2001, p. 64) state that this position of the ECB vis-à-vis the many fiscal author- ities induces two main problematic externalities concerning macroeconomic policy coordination: in the absence of fiscal discipline "fiscal coordination amplifies the inconsistency between what fiscal authorities jointly perceive as the appropriate policies in the various individual countries and the broader assessment made by the ECB for the aggregate level". Additionally, a central bank facing many fiscal authorities has limited ability to maintain its scope regarding macroeco- nomic policies. A successful pact imposing fiscal discipline therefore denotes the fiscal-monetary policy interaction as monetary dominance meaning that national fiscal authorities choose their fiscal strategies with regard to long-term solvency in order for the central bank to be able to choose a consistent anti inflationary policy without losing its credibility (Sutter, 2000, p. 40). According to Grilli et al. (1991, p. 365) a credibility problem of a monetary authority to ad- just to high debt and deficit ratios can be overcome by solely disconnecting monetary-fiscal interdependencies and therefore making it less promising for fiscal authorities to run excessive deficits when there is little chance of an inflationary reduction of public debts. The credibility problem Grilli et al. (1991, p. 365) refer to concerns a framework in which both fiscal as well as monetary authorities are located in one country. The incentive of a central bank to follow an expansionary monetary policy strategy aiming for inflation taxes when private agents are unable to adjust their behaviour accordingly will ex post lead to the need for a higher inflation rate on the part of the central bank to tackle augmented inflation expectations. This lack of credibility on the part of private agents leads to a dependence on seigniorage revenues and higher inflation rates. Although this concept does not apply to the EMU framework without modification, the credibility of the ECB to follow a stable low inflation rate monetary policy strategy is certainly applicable.

This argument of negative correlation between the degree of independence on the part of a mon- etary policy institution and the height of public debts goes back to Tabellini (1987) where this "link of current deficits and future monetization" (Tabellini, 1987, p. 25) is demonstrated: the theory behind this argumentation is of simple dynamic game theoretic nature with three players (fiscal authority, central bank and the private sector) of which two (fiscal authority and central bank) are the decision and policy makers following different objectives. The fiscal authority will only take public expenditures into account when maximizing its utility function, whereas the central bank will care about the private sector while not considering public expenditures (Tabellini, 1987, p. 18). That is because a fiscal authority places the degree of desired inflation tax at a higher level than the central bank does. By imposing a government budget constraint on the policy authorities the question of which of the authorities will have to internalise the costs of satisfying the restriction arises.^[4] The answer will put a form of discipline on the policy freedom of the concerned authority and "depends on the institutional set-up" (Tabellini, 1987, p. 19). The indicator for the apportionment of the strategic power allocates a first mover ad- vantage in choosing an economic policy strategy on one of the authorities. The fiscal authority chooses the amount of public expenditure whereas the monetary policy instrument of the central bank is represented by the amount of domestic money supply, depending on which of them is strategically superior over the other. The first extreme outcome is defined as a condition of fiscal dominance where the fiscal authority acts as the Stackelberg leader and will choose to run a high degree of government debt since the central bank will follow an expansionary monetary policy afterwards in order to combat debts and deficits and comply with the induced constraint. By contrast, if the central bank has the strategic position to commit to a monetary policy strategy that counters debt monetization before the fiscal authority chooses the level of government debt, the latter would choose a debt level that it can fully internalise itself (Tabellini, 1987, pp. 19-20). "The larger is the degree of fiscal dominance [...], the more inflationary are the consequences of issuing public debt. In the limit, if monetary policy is dominant [...], issuing debt has no effect on prices, since the debt will not be monetized at all in the future" (Tabellini, 1987, p. 22). With that theoretical background, the linkage and interdependence between monetary and fiscal authorities is consequently in itself one form of fiscal discipline.

Freeriding behaviour of national fiscal authorities As a result of EMU design and rather strict separation of governments (fiscal authorities) and the central bank (monetary authority), a policy mix is not envisaged in the style of a coordinated and ex ante agreement (Beetsma et al., 2001, p. 10) which hinders fiscal discipline without any additional rules or mechanisms (Pisani-Ferry, 2007, p. 10).

Instead, this design brings about some important consequences in favour of the SGP objectives. Supposing an interrelation between the outcomes of fiscal policies in terms of not only govern- ment debts and deficits but also (underlying) fiscal shocks and monetary policies, a construct of many fiscal authorities having in mind different sets of national fiscal conditions and needs results. Hence, an aggregated picture of fiscal policies on the level of EMU is shaped which represents the average set of fiscal conditions and needs and, more importantly, which builds the basis for decision-making for monetary policy strategies followed by the ECB (Uhlig, 2003, pp. 32-40). In this construct the single fiscal authorities will underestimate their importance in and impact on the EMU context when evaluating their fiscal policy choices. Without an ex ante agreement among fiscal authorities this freeriding behaviour will be observed in all monetary union member states.

From an economic perspective "the ’ideal’ split of tasks is for the fiscal authorities to respond to the demand shocks and for the central bank to respond to the cost-push shocks" (Uhlig, 2003, p. 30). Demand shocks, both endogenous and exogenous, will have an effect on national output and the price level. The central bank will initiate nominal interest rate adjustments to avert inflation pressures. Here, the monetary authority of a monetary union with multiple fiscal authorities will take into consideration only the average economic variables though. The result is an unchanged inflation rate and an unchanged output gap on the European level.

In a framework with only one fiscal authority and one monetary authority, a cost-push shock will be internalised by the monetary authority by stemming higher inflation rates for the sake of price stability by raising the nominal interest rate. By contrast, the fiscal authority will not react to the cost-push shock if the central bank represents a credible institution following the objective of price stability and the instruments and power to combat shocks with adequate measures and instruments. This outcome will change with monetary unification and a rising number of fiscal authorities: the central bank of the monetary union will now react to the aver- age of cost-push shocks instead of country-specific ones. By doing so, the rise in nominal interest rates will provoke altered economic conditions in all countries of the monetary union. National fiscal authorities will find themselves enabled to prevent or counteract an economic recession by increasing their government deficit individually while exclusively taking into consideration their national economy. The central bank will notice the growing deficits in an aggregated manner and will further increase nominal interest rates due to higher inflationary pressure worsening the situation for all monetary union member states (Uhlig, 2003, pp. 37-41). The strategic position of one individual fiscal authority in fact does not have a crucial impact on the European level (Beetsma and Bovenberg, 1999, p. 305) yet when added up, many fiscal authorities behaving in the same pattern, this freeriding problem "is a classic coordination failure" (Uhlig, 2003, p. 41). The negative consequences and the effect of freeriding behaviour itself is increasing with the number of monetary union member states without an ex ante cooperative approach or fiscal discipline (Uhlig, 2003, pp. 41-42).

Complementary to this argumentation is the fact that monetary unification itself leads to an accumulation of national public debt, not only because of freeriding behaviour due to a rise in inflation biases of discretionary policymakers in the absence of binding fiscal discipline but also because of the existence of myopic governments (Beetsma and Bovenberg, 1999, pp. 309-312) (with myopic governments meaning short-sighted in the sense that they run excessive deficits that are welfare harming because of their impatience of their and their societies’ desired economic outcome for political and election cycle reasons). Myopic governments increase the freeriding behaviour phenomena: governments that are highly influenced by election cycles and that can- not be made accountable for economic outcomes if their corresponding election cycle does not match with the business cycle, the costs of running high deficit and debt ratios are rather little considered and internalised at the government level. In a monetary union to an even higher extent than in a national currency system. Beetsma and Bovenberg (1999, pp. 310-311) there- fore state that a credible and independently operating central bank must be assisted by further limitations.

At this point EMU design comes into play again: without a monetary union and a centralised monetary authority, monetary union member states would have no incentive to stick to an ex ante fiscal discipline approach (Beetsma and Uhlig, 1999, p. 548-560). In a framework in which countries with individual monetary authorities commit to an agreement of fiscal discipline there is a high probability of them deviating ex post from it and not "proceed with the punishment in case of a recalcitrant country: there is nothing at stake for the potential enforcers" (Beetsma and Uhlig, 1999, p. 548). Whereas the other countries will have an interest in maintaining the ex ante agreement when there is a common central bank imposing inflationary burdens on all member states. Beetsma and Uhlig (1999, p. 548) state in this context that it is of that reason "why we see countries entering a stability pact only after they have already agreed to join a monetary union, i.e. why we do not see a group of arbitrary countries elsewhere entertaining such a possibility".

The freeriding phenomenon is resulting from the underlying existence of club goods according to von Hagen and Mundschenk (2001, p. 2). Club goods meaning certain economic indicators that are shared among all EMU member states and that these individual member states are able to freeride on. In a monetary union there are five club goods that result from the design of one monetary authority and many fiscal authorities but also the areas in which integration is happening or has happened already: i) the first club good is represented by the price level of the currency area and the price stability as the objective of the central bank. Although member states can experience individual relative price movements, all member states share the benefits and costs of price stability induced by the ECB’s monetary policies in the long run to the same extent. This club good was up to this point of this section the centre of the issue of freeriding behaviour. ii) The second club good is the unified market for goods, services, capital and labour. The benefits of this integration is experienced by all member states equally - all countries have access to the same rights and privileges. iii) The third club good is a shared currency risk, again induced by the single currency and reflected by the common interest rate level. iv) The stability (or instability) of the banking sector and the financial markets represent another club good of EMU. v) The last club good is the equally experienced external balance resulting from the exchange rate of the common currency against other currencies and its level as well as the variability of it.

The last club good is of particular interest since it demonstrates that freeriding behaviour can happen in two different ways. The first is the one already observed as of excessive deficit behaviour under the assumption that the ECB will react and internalise the costs of these ex- cessive debts and deficits. This implies active freeriding behaviour.

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^[1] Article 104 TEC is now represented by Article 126 TFEU. The full article can be found in Appendix A.1.

^[2] Besides deficit and debt criteria, entrance requirements are an inflation slightly above those of the three members with lowest inflation, stable exchange rates and nominal interest rates converging to a level close to that achieved by the three lowest-inflation countries

^[3] Article 127 TFEU (former Article 105 TEC) can be found in Appendix A.2.

^[4] In this model the constraint is represented by a full recovery of all public debts after the end of a two period time horizon.