Fiscal Challanges on the Road to Euro: The Maastricht Fiscal Rule and the SGP from the Perspective of the

New Member States

György SzapáryMagyar Nemzeti BankMagyar Nemzeti Bank

Seminar on „EMU and the New Member States: A Year After Accession” organized by the Bulgarian National Bank,

Sofia, October 3-4, 2005

2

I. Outline

• The fiscal position of the New Member States vis-à-vis Maastricht

• Are Maastricht and the SGP inconsistent with the Optimal Currency Area (OCA) properties?

3

II. Central Banks and Fiscal Policy

“Central Banks are often accused of being obsessed with inflation. This is untrue. If they are obsessed with anything, it is with fiscal policy.”

Mervyn KingGovernorBank of England

4

III. Fiscal Position of the NMS vis-à-vis Maastricht*

• Initial budgetary conditions: deficits and debt

• Yield convergence

• Implicit liabilities due to ageing

*Based on a paper by Gábor Orbán and György Szapáry: “The Stability and Growth Pact From the Perspective of the New Member States”, Journal of Policy Modeling, Vol. 26 Issue 7 (2004), pp. 839-864.

5

Budgetary Balance as a Ratio of GDP: Distance from the 3% reference value in the run-up to the

euro

* Distance from the deficit reference value in 1994 for the EU-11, in 1996 for Greece and in 2004 for the other countries. A negative sign indicates that the deficit exceeds the 3% limit.

As regards initial distance from the reference value, the NMS on the whole are in a slightly better position than were today’s euro area member countries prior to euro adoption.

Deviation from the deficit criterion in the run-up to euro adoption*

-1.9 -2-2.7-2.5

0.6

-4.4

1

-6.3

5.7

-3.6-3.6

-0.5-1.2

0

4.8

-2.4

2.2

0.5

-2.2

-3.8

-0.3

1.1

4.3

1.6

-8

-6

-4

-2

0

2

4

6

8

% o

f G

DP

6

Debt GDP Ratios: in 2004 and in the run-up to the euro

0 20 40 60 80 100 120 140

% of GDP

AustriaBelgiumFinlandFrance

GermanyGreeceIreland

ItalyLuxembourg

PortugalSpain

NetherlandsCyprusCzech

EstoniaHungary

LatviaLithuania

MaltaPoland

SlovakiaSloveniaBulgariaRomania

5 years prior to EMU

2004

The same is true for debt ratios.

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Yield Convergence

-2 -1 0 1 2 3 4 5 6 7

percentage points

AustriaBelgiumFinlandFrance

GermanyGreeceIreland

ItalyLuxembourg

PortugalSpain

NetherlandsCyprusCzech

EstoniaHungary

LatviaLithuania

MaltaPoland

SlovakiaSlovenia

Bulgaria*

The long term bond yield criterion 3 years prior to assessment (12-month averages)

With the exception of Poland and Hungary, most countries already more than satisfy the bond yield criterion. This was not the case 3 years prior to assessment in euro area countries.

For the EU-11 the figure shows the distance from the March 1998 Maastricht interest rate criterion in March 1995, for Greece the distance from the March 2000 criterion in March 1997 and for the other countries the distance from the March 2005 criterion in March 2005.

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Fiscal Gains from Yield Convergence as percent of GDP

-0,5 0,0 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0

percent of GDP

BulgariaCzech

LuxembourgEstoniaLatvia

LithuaniaSlovakia

MaltaCyprus

SloveniaFrance

TheIrelandPolandAustria

GermanyHungaryFinland

SpainBelgium

ItalyGreece

Portugal

Fiscal gains from yield convergence are small compared with euro area countries

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Required Adjustment in Primary Balance

2,98 2,78

1,90 1,861,30

0,84 0,81 0,780,48 0,29 0,05 0,02

-0,26-0,67

-0,98-1,27

-1,59 -1,69 -1,78-2,34

-4,60 -4,81

-5,69

-7

-6

-5

-4

-3

-2

-1

0

1

2

3

4

Italy

Polan

dMalt

a

Fran

ce

Hungary

Austria

Cyprus

Spain

Greece

Finlan

d

Czech R

epub

lic

Slovakia

The N

etherl

ands

Lithu

ania

Belgi

um

Portu

gal

Slovenia

German

y

Irelan

dLa

tvia

Bulga

ria

Eston

ia

Luxembo

urg

perc

ent o

f GD

P

Necessary adjustment in primary balance important for high debt countries.

A positive value means the reduction of the primary deficit is required.

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Ageing is a threat in NMS

2000 2050 2003EU-15 25.95 51.40 1.57

Austria 25.20 58.20 1.40Belgium 28.10 49.50 1.62Denmark 24.20 40.30 1.72Finland 25.90 50.60 1.72France 27.20 50.80 1.89Germany 26.60 53.20 1.31Greece n.a. n.a. 1.25Ireland 19.70 45.70 1.97Italy 28.80 66.80 1.26Luxembourg n.a. n.a. 1.63Netherlands 21.90 44.90 1.73Portugal 26.70 50.90 1.47Spain 27.10 65.70 1.25Sweden 29.40 46.30 1.65United Kingdom 26.60 45.30 1.64

Czech Republic 21.90 57.50 1.17Hungary 23.70 47.20 1.30Poland 20.40 55.20 1.24

Old-age Dependency Ratios (in percent)

Total Fertility Rate

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IV. Maastricht and SGP inconsistent with Optimal

Currency Area?

Preserve public credit:

„As a very important source of strength and security, cherish public credit. One method of preserving it is to use it as sparingly as possible by cultivating peace (.. and) avoiding likewise the accumulation of debt, not only by shunning occasions of expense, but by vigorous exertions in time of peace to discharge the debt that wars have occasioned, not ungenerously throwing upon posterity the burden that we ourselves ought to bear.”

George Washington, Farewell Address, 1796

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Public Debt/GDP Before and After Maastricht, 1960-2002

0

25

50

75

100

125

150

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002

Austria Belgium Denmark Germany

Finland France United Kingdom Greece

Ireland Italy Netherlands Portugal

Spain Sweden

%

Prior to Maastricht, the debt/GDP ratios increased in the EU countries. After Maastricht, they declined.

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Interest Rate Expenditure/GDP, 1978-2003

Interest rate expenditures as a ratio of GDP rose prior to Maastricht, but declined thereafter.

Interest rate expenditure/ GDP 1978-2003

0

2

4

6

8

10

12

14197819912003

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Interest Rate Expenditure/GDP, 2003

However, in most countries, the interest burden is still high.

Interest expenditures in EU member states and Bulgaria(as % of GDP in 2003, ESA 95)

0 1 2 3 4 5 6

GreeceBelgium

ItalyHungary

MaltaCyprusEU-15EU-25

GermanyPolandAustriaFrance

HollandPortugal

DenmarkűSlovakia

SpainSloveniaBulgaria

UKFinlandSweden

Czech RepublicIreland

LithuaniaLatvia

EstoniaLuxemburg

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V. Fiscal Rule: Mundell vs Maastricht*

• Business cycle synchronization is one of the most important Mundell OCA criteria

• Meeting the Maastricht criteria is a condition for entering the euro area

• In a currency union, fiscal policy is the sole macroeconomic tool to smooth the business cycle when a country is hit by asymmetric shock

• Striking absence of direct overlap between Mundell and Maastricht: fiscal criteria and SGP mean that fiscal policy can not play the stabilizing role

------------

* Based on a paper by Zsolt Darvas, Andrew K. Rose and György Szapáry: „Fiscal Divergence and Business Cycle Synchronization: Irresponsibility is Idiosyncratic”, NBER Working Paper, No. 11580

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V. Fiscal Rule: Mundell vs Maastricht (cont.)

• But is there an indirect connection between Mundell

and Maastricht?

• Suppose fiscal policy itself is a source of shock, not a stabilizer. In that case Maastricht is indirectly consistent with Mundell

• Everything hinges on whether fiscal policy generates or responds to shocks.

• Intuition is that fiscal irresponsibility is idiosyncratic. That is what we have tested empirically

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VI. Main results

Using panels of 21 OECD countries and 115 countries of the world for the years 1964-2003, we found:

• Fiscal divergence reduces business cycle synchronization

• Smaller deficits/larger surpluses tend to be associated with more synchronized business cycles

• Large deficits are associated with more volatile business cycles

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Business Cycle Correlation and Fiscal Divergence

-.11**(.03)

-.15**(.04)

-.11**(.03)

-.16**(.04)

IV

-.028**(.005)

-.048**(.006)

-.024**(.005)

-.036**(.006)

OLS

UnemploymentDifferenced

UnemploymentHP Filtered

GDPDifferenced

GDPHP-Filtered

-.11**(.03)

-.15**(.04)

-.11**(.03)

-.16**(.04)

IV

-.028**(.005)

-.048**(.006)

-.024**(.005)

-.036**(.006)

OLS

UnemploymentDifferenced

UnemploymentHP Filtered

GDPDifferenced

GDPHP-Filtered

Fiscal divergence reduces BSC• Sensitivity checks

– Estimation: OLS, IV– Fixed effects– Different samples: 40 yrs, 10yrs, without EMU– Other controls (trade, gravity regressors, level of deficit)– Different measures of BCS and FD (total and primary

deficit)

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Average Budget Positions and Business Cycle Synchronization

.005**(.001)

.007**(.002)

Total balance

115 countries: OLS

.02*(.01)

.03**(.01)

Primary balance OECD: OLS

.09**(.03)

.11**(.03)

Primary balance OECD: IV

GDP

Differenced

GDP

HP-Filtered

.005**(.001)

.007**(.002)

Total balance

115 countries: OLS

.02*(.01)

.03**(.01)

Primary balance OECD: OLS

.09**(.03)

.11**(.03)

Primary balance OECD: IV

GDP

Differenced

GDP

HP-Filtered

Smaller deficits/larger surpluses tend to be associated with more synchronized business cycles.

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Government Budgets and Business Cycle Volatility

Annual Panel Results (using 115 countries)

(.019)(.015)-.060**-.038**Year and Country Effects(.019)(.015)-.066**-.058**Country Effects(.017)(.014)-.072**-.038**Year Effects(.016)(.014)-.080**-.057**Common intercept

GDP DifferencedGDP HP

(.019)(.015)-.060**-.038**Year and Country Effects(.019)(.015)-.066**-.058**Country Effects(.017)(.014)-.072**-.038**Year Effects(.016)(.014)-.080**-.057**Common intercept

GDP DifferencedGDP HP

Larger deficits are associated with more volatile business cycles

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VII. Conclusion

• Maastricht imposes fiscal convergence to low levels, thus helps reduce debt

• Strong evidence that fiscal convergence is associated with business cycle synchronization

• Moreover, evidence that

– reduced deficits (or higher surpluses) increase business cycle comovements, and

– large deficits are associated with volatile cycles

• Reason: high deficits increase the likelihood that fiscal policy itself is a source of asymmetric shock: that is, irresponsibility is idiosyncratic

• Therefore, Maastricht helps synchronization

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To Sum Up

• Maastricht fiscal rule has helped to reduce debt and debt service burden and also helps to satisfy OCA criteria.

Many cheers!