By Douglas Clement
Looser fiscal limits in Europe could create a severe trial for its central bank, according to V.V. Chari and Pat Kehoe.
The European Union is in disarray. In France and the Netherlands earlier this year, voters adamantly refused to ratify the EU constitution, and tiny (if rich) Luxembourg's recent vote in favor seemed to damn with faint praise. The Economist has declared the constitution dead, if not buried, and EU policymakers have been feuding in public. While disagreements are many, the main issues are economic, and at their core rests the Stability and G rowth Pact, an accord little known to the public but the focus of intense scrutiny by two University economists, V.V. Chari and Patrick Kehoe.
The pact was adopted in 1997 to create economic harmony among the EU's elite: the twelve nations of the Economic and Monetary Union (EMU). Convinced of the benefits of economic integration, these dozen countries agreed to adopt the euro and turn over their monetary policy to a common authority, the European Central Bank (ECB). The pact carefully spelled out the fiscal requirements for EMU members: Nations cannot run an annual deficit greater than 3 percent of gross domestic product or incur overall national debt greater than 60 percent of GDP.
By all accounts, however, the pact isn't working. In 2004, four of the 12 EMU nations went beyond the deficit threshold and seven surpassed the debt limit. For France and Germany, which represent half the EMU economy, it was the third straight year of deficit limit violation. [Refresher course: A fiscal deficit occurs when a government spends more in a year than it receives. The national debt is the accumulation of past deficits (and surpluses).]
Clearly chafing at the pact's constraints, some European leaders have said it needs to be seriously revamped. Indeed, at one point the official in charge of its implementation, Romano Prodi, famously called the pact "stupid" because of its inflexibility. And the question Europeans and economists are now asking is, was Prodi right? Do tight fiscal constraints not make sense in a monetary union?
Chari and Kehoe, having analyzed the intricate interplay of fiscal and monetary policy, suggest that, on the contrary, those who framed the pact showed great foresight. And if they're right, it isn't the pact, but rather its critics, whose wisdom should be doubted.
Time inconsistency and free riding"We now run the risk that, in the words of the old Chinese curse, we'll live in interesting times," said V.V. Chari in a recent interview. Chari, a professor of economics at the U of M and adviser to the Federal Reserve Bank of Minneapolis, is coauthor of a November 2003 analysis of the theoretical foundations of monetary unions like the EMU, and he suggests that loosening the Union's fiscal constraints could create a severe trial for Europe's central bank. "If fiscal policy becomes profligate over the next few years, that's when the ECB's credibility will really be tested."
If EMU nations no longer feel strong pressure from fellow members to balance their budgets, suggests Chari, some may increase their national expenditures--and debt--substantially. Pressure will then grow on the ECB to lower member nations' debt burdens through inflation--that is, by increasing the Union's money supply so that each euro is worth less and the real value of nominal debts will decline. But of course, creating inflation contradicts the ECB's primary objective: price stability.
"It is not that the central bank does not have good intentions," notes Patrick Kehoe, Chari's coauthor and also an economics professor at the U of M and an adviser to the Minneapolis Fed. "It's just representing the people on a day-byday basis. But in these kinds of situations, representing the people on a day-by-day basis leads to bad outcomes, because once a member nation prints the debt, the bank inflates. Nations realize that will happen so they issue too much debt. The result: You get high inflation, high debt. Bad outcome."
The reason for constraintAccording to Chari and Kehoe, the rationale for fiscal constraints in a monetary union has to do with a complex interplay between multiple fiscal authorities and a single monetary authority, where each watches the others and gauges the likely impact of its actions. Because decisions are taken sequentially--fiscal authorities make spending decisions, then the monetary authority sets the interest rate, and so on--time plays an important role in their analysis. The central bankers, making decisions day by day, ask, "What is the best I can do today?" But they end up with bad outcomes because their shifting policy is anticipated by rational onlookers. It's a phenomenon that economists call "the inconsistency of optimal plans."
And because a monetary union has just one central bank but many fiscal decision makers, free riding also plays a critical role. That is, individual nations will be tempted to enjoy the benefits of the union without paying their full share of the costs--riding in the rowboat but not pulling their weight.
It is this relationship between the potential for free riding and the day-to-day nature of decision making that can lead to bad outcomes if constraints aren't in place. More specifically, explain Chari and Kehoe, monetary authorities are naturally prone to change policy from one meeting to the next, responding to conditions current and anticipated. That policy inconsistency, observed by union members, leads nations to free ride--spending beyond their means, incurring national debts whose full costs they won't pay because the union's central bank will be motivated to inflate the debts away, a day-by-day monetary policy decision that spreads one nation's fiscal costs to all members of the union.
"The driving force behind our results is that a time inconsistency problem in monetary policy leads to a free-rider problem in fiscal policy," write Chari and Kehoe in "On the Desirability of Fiscal Constraints in a Monetary Union," a Minneapolis Federal Reserve Bank staff report. "The time inconsistency problem arises because the monetary authority has an incentive to inflate away nominal debt."
State of the unionChari and Kehoe's prognosis for Europe's monetary union is guarded. If EMU policymakers loosen the Stability and Growth Pact, the effect on the union will depend on the central bank's ability to commit to price stability, a commitment that Chari and Kehoe contend has yet to face a difficult test.
"What our theory says is, if you think that the ECB has not attained complete commitment, then you're going to see bad outcomes," says Chari. "If the ECB has attained that commitment, then they shouldn't restrain fiscal policy."
Kehoe is concerned that loosening the pact's constraints might begin a gradual process of weakening. "It could be the kind of thing where constraint slips away slowly, but there's no big test immediately," he says. "If the constraints are abused a little bit, not tremendously, and then five years down the road there's some massively bad recession, debt starts flying, well, that's when the central bank will get tested."
So while the current situation might not be dire, relaxing fiscal constraints without certainty of monetary commitment would be unwise, suggest the economists. "They might be sowing the seeds today for a disaster a decade from now," says Kehoe.
"I don't know whether ECB credibility is a real problem or not. We're going to find out," says Chari. "ECB policymakers haven't really been tested. We'll see what happens when they are."