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Fiscal policies in monetary unions

Q: Why may risk of default increase in a MU?

Two default ways: outright default (stopping payment of interest on debt) & implicit default creating surprise inflation and devaluation, reducing the real value of debt. In a MU, a country cannot create surprise inflation and devaluation (no own currency anymore) > pressure on the government to organize outright default may increase In MU: liquidity crises easily > solvency crises : since CB can raise the interest rates to such high levels that government find themselves unable to service their debt

6 important questions on Fiscal policies in monetary unions

How do fiscal policies in MU reduce fragility?

European consumers shift from demanding French products to German products. The national budget has been centralized to the central European authority. Income taxes and social security contributions collected in France decrease, whereas unemployment payments increase. The reverse happens in Germany. Tax revenues collected by European government in Germany increase and are transfered to France.

Without a centralized government budget, the French government budget deficit increases.

How does the theory of OCAs affect fiscal policies in MUs?

1. it is desirable to centralize a significant part of the national budgets to the EU level,allowing countries facing a negative shock to receive automatic transfers
2. if such a centralization of the national government budgets in a MU is not possible, then national fiscal policies should be used in a flexible way. That is, when countries are hit by a shock, they should be allowed to let the budget deficit increase

Fiscal policy is only policy left when entering a MU

Explain the sustainability problem of government budget deficits

A budget deficit leads to an increase in government debt, which has to be serviced in the future. If the interest rate on the government debt exceeds the gorwth rate of the economy, a debt dynamic is set in motion that leads to an ever increasing government debt relative to GDP > becomes unsustainable, requiring collective action

Name three aspects of the Stability and Growth Pact that show the sustainability principles

1. countries have to aim to achieve balanced budgets in the medium run
2. countries with budget deficits over 3% will be subject to fines
3. fines will not be applied if the countries in question experience circumstances such as natural disasters

Why may risk of default increase in a MU?

Two default ways: outright default (stopping payment of interest on debt) & implicit default creating surprise inflation and devaluation, reducing the real value of debt.
In a MU, a country cannot create surprise inflation and devaluation (no own currency anymore) > pressure on the government to organize outright default may increase

In MU: liquidity crises easily > solvency crises: since CB can raise the interest rates to such high levels that government find themselves unable to service their debt

Explain how a joint issue of common bonds work and what problems might arise

By issuing Eurobonds, the members jointly are reliable for the debt they have issued.

problems:
- creates incentive for countries to rely on this insurance and issue too much debt (moral hazard)
- countries with a better debt rating have to pay higher interest rate on their debt

> tackle by different type of bonds:
blue bonds: for those with debt level up to 60% of GDP - low r
red bonds: for levels of debt above 60% of GDP - high r

The question on the page originate from the summary of the following study material:

Economics of Monetary Union | 9780199684441 | Paul De Grauwe

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