Fiscal performance in monetary unions: How much austerity should be allowed?

The effectiveness of fiscal policy becomes particularly relevant in the case of the member countries of a monetary union facing a sovereign debt crisis. In that environment, fiscal policy is constrained by the need to carry out fiscal consolidation and reduce debt levels. For that reason and with the purpose of anchor fiscal discipline, the adoption of fiscal rules has become a central issue. In this paper we will analyse the management of fiscal policies in monetary unions, when the central bank and the fiscal authorities follow policy rules. The results would be related to the conservativeness of the central bank, the degree of austerity of the fiscal authorities and the initial level of public debt.

It is well known that in monetary unions, with an independent monetary authority, fiscal policy turns out to be the only available policy demand and, in some cases, monetary policy is insufficient to achieve the required stabilization.Moreover, if monetary authorities are particularly interested in controlling inflation and stabilizing output, the fiscal authorities are expected to ensure sound fiscal policies but they are also expected to help guarantee price stability.This question becomes particularly relevant in the case of the member countries of a monetary union facing a sovereign debt crisis, given that fiscal policy is constrained by the need to carry out fiscal consolidation and reduce debt levels.
For that reason and with the purpose of anchoring fiscal discipline, in the current economic environment, the adoption of fiscal rules has become a central issue.As for monetary rules, the usefulness of fiscal rules is related to the credibility of stable and announced rules.Even starting from a deficit, if fiscal discipline is credible, a fiscal contraction could have expansionary effects on output.In situations of very high public deficit, a reduction in public spending could lead to greater expansionary effects on aggregate demand than tax increases.And also, fiscal consolidations based on expenditure control, create favourable conditions for economic growth by stimulating tax revenues (Alberto Alesina and Silvia Ardagna 1998).
Keeping in mind the case of the European Monetary Union (EMU), the Maastricht Treaty stressed as basic that the member states of the EMU should avoid excessive deficits; and the reference values for deficit-to-GDP and debt-to-GDP ratios, have worked in practice as an explicit fiscal rule.But, the policy orientation of the Stability and Growth Pact (SGP) has not been fully satisfied.This opened a debate about the utility and effectiveness of fiscal rules in the EMU, and on their complementarities with discretionary fiscal policy measures and automatic stabilisers to deal with short-run fluctuations.
From the macroeconomic point of view, the EMU represents a change in the framework of economic policies, resulting in lower variability of the discretionary component of fiscal policy.And the existing different national fiscal frameworks are enforced to be consistent with the requirements of discipline at the European Union (EU) level.To ensure those objectives, in April 2011 The Pact for the Euro was signed to strengthen coordination of economic policy and to enforce member states to translate the EU budgetary rules established in the SGP into national legislations.
In an attempt to shed some light on the fiscal performance in the Eurozone, we will develop a simple model for a monetary union to analyse different combinations of policies.We will allow for a more or less conservative governor of the central bank, we will also consider both an austere and no austere fiscal policy and, finally, we will take into account the initial level of public debt of the member countries of the union.
The paper is structured as follows: in Section 1 we review some related literature; in Section 2 we comment on some considerations on the issue; next, the macroeconomic model is presented in Section 3; Section 4 shows the empirical results; and, finally, Section 5 concludes.

Literature Survey
In parallel to the current economic crisis, the debate on the role of economic policies has recovered a renewed interest.There seems to be a consensus on the view that the success of economic policies depends on the macroeconomic conditions, and that severe fiscal consolidations are needed (see, for instance, Casimir Dadak 2011; J. Bradford DeLong and Lawrence H. Summers 2012, among others).And as mentioned in the Introduction, the success of fiscal consolidations becomes relevant for monetary unions facing a sovereign debt crisis, since they do not have control over money and they must borrow before they can spend.Particularly, in the Eurozone the problem could be dramatic since the European Central Bank (ECB) does not act as a lender of last resort (see Stephanie Kelton 2011, for details).
At the EU level the fiscal limitations imposed by the Maastricht Treaty and, later, by the SGP, should be interpreted as a way to assure a Ricardian regime in terms of the literature on the Fiscal Theory of the Price Level (see Christopher A. Sims 1994;Charles T. Carlstrom and Timothy S. Fuerst 2000, among others).In such a regime, monetary policy is "active", price determination being the nominal anchor; while fiscal policy adjusts in a "passive" way, i.e., the government spending path is endogenous.In this line, Michael Woodford (1998Woodford ( , 2001)), showed that a central bank charged with maintaining price stability cannot be indifferent as to how fiscal policy is determined.And as Lawrence J. Christiano and Terry J. Fitzgerald (2000), addressed, "…governments adjust fiscal policy when the debt gets too far… [and] members of the EU adjust fiscal policy in the event their debts grow too large…".On the one hand, according to Public Economics and Macroeconomic Theories, fiscal policy is viewed as an effective tool for achieving stabilization, as has been recently addressed by Philip Arestis and Malcolm Sawyer (2010), Arestis (2011Arestis ( , 2012)), Yiannis Kitromilides (2011), Alan J. Auerbach and Yuriyi Y. Gorodnichenko (2012), or Eckhard Hein and Achim Truger (2012), for example.Questions such the coordination of fiscal and monetary policy; the deficit and debt reduction, the measurement of output responses to fiscal policies, and a more active role for fiscal policy have been recommended as ways of contributing to improve fiscal policy effectiveness.
On the other hand, the high levels of government deficits and debts have forced the implementation of austerity-policy packages in most of the developed economies.Genaro Zezza (2012), Roberto Perotti (2013), and Arestis and Theodore Pelagidis ( 2014), advise on the potential danger of austerity on economic growth.In a recent study based on fiscal multipliers, Pablo García Sanchez and Miguel Sebastián (2013), find that austerity may be counterproductive.From their study, they conclude that policies of deficit reduction may be self-defeating in south-European countries like Spain.In contrast, for the German case they found that austerity works.
In such an environment, where fiscal policies are the only available stabilization tool but the implementation of fiscal measures are constrained by fiscal discipline, fiscal rules have been considered a useful way of combining the achievement of policy aims with discipline and control over economic variables.In academic circles, the studies that have explicitly considered the needed of fiscal rules are scarce.Fernando Ballabriga and Carlos Martínez-Mongay (2003) estimated monetary and fiscal rules for the Eurozone, concluding that monetary policy rules should be accompanied by an explicit public deficit objective.Xavier Debrun et al. (2008) found that fiscal rules lead to more stable budget policies and less pro-cyclical fiscal policies.Michał Brzozowski and Joanna Siwińska-Gorzelak (2010) analysed the impact of fiscal rules on fiscal policy volatility, concluding that rules based on deficit control are more destabilizing than those based on imposing a limit on public debt.From another point of view, Carmen Díaz-Roldán and Alberto Montero-Soler (2009, 2011) and more recently Díaz-Roldán (2013) analyze the convenience of using fiscal rules for different subsets of countries of the EMU.They found that the success of fiscal policy decisions depend on the symmetric or asymmetric nature of the shocks to be deal with, and also on the particular economic conditions of each country.
But, recently, after the financial and economic crisis fiscal rules have recovered a new interest due to the potential usefulness that they could provide in helping to recover economies.Andrea Schaechter et al. (2012) present details about the rules' key design elements, particularly in support of their enforcement, and conclude that the "next generation" fiscal rules are increasingly complex as they should combine the objectives of sustainability with the need for flexibility in response to shocks, thereby creating new challenges for implementation, communication, and monitoring.From another point of view, and with the EMU debt crisis in mind, Charles Wyplosz (2013) has asserted that solving the fiscal discipline problem requires adequate institutions or rules, or both.
PANOECONOMICUS, 2017, Vol.64, Issue 1, pp. 61-76 Keeping in mind the above considerations along the lines addressed by the literature, in this paper we will study the management of fiscal policies in monetary unions, where the central bank and the fiscal authorities follow policy rules.When analysing different combinations of policies, we will allow for a more or less conservative governor of the central bank, for both an austere and no austere fiscal policy measures and, finally, we will also take into account the initial level of public debt of the member countries of the union.

Monetary and Fiscal Policies in a Monetary Union
The management of fiscal policy becomes an issue of special relevance in monetary unions, given that the particular macroeconomic framework that the union represents is not trivial.The single monetary policy is the exclusive competence of an independent and supranational central bank, whilst other economic policies generally remain the responsibility of the member states.Therefore, the fiscal discipline imposed by the monetary agreements limit the scope of stabilizing fiscal policies, and their implications on economic growth.In general, the success of fiscal consolidation depends not only on the improvement of the primary fiscal balances, but also on the macroeconomic conditions such as the monetary policy regime, the exchange rate system, and the external position.In a monetary union, the degree and the mechanism for the coordination of national economic policies differ according to how convincing the economic rationale for coordination is in the particular policy area.
Although in principle the renunciation of an independent monetary policy would be a disadvantage for a country, it would be more dangerous if the asymmetric shocks that the economy could suffer were more important.In other words, the member states of a monetary union would face special difficulties when dealing with external shocks.The reason is simply that a common monetary policy is not the appropriate instrument to deal with an asymmetric disturbance, so the cost of the loss of monetary policy would be smaller if the economies of the countries forming the monetary union were more integrated.Within integrated countries the evolution of their economies would be much more synchronized, and therefore the occurrence of asymmetric shocks would be less likely.Added to that, a monetary union represents a novel framework since, in general, a monetary union lacks of a supranational budget of a proper size to incorporate the insurance function of fiscal policy.That is the case of the EMU, where there are no federal taxes at the EU level, and shifting some taxes to the EU is not envisaged, because it would mean reinforcing fiscal competencies at the EU level.
Currently, the Eurozone stabilization policies can be broadly described by (i) a monetary policy rule followed by the ECB, aimed to achieve the only objective of price stability (inflation targeting); and (ii) the adoption of fiscal rules targeting the budget balance, public debt or government expenditure (including expenditure ceilings).In this environment, the success of a monetary-fiscal policy mix relies on the proper combination of those rules.
Regarding monetary policy, both theoretical and empirical works seem to provide sufficient evidence that the granting of independence to the central bank can reduce inflation without having a negative impact on real economic variables.The independence of the central bank is based on the assumption that the inflationary bias resulting from the application of discretionary monetary policy could be avoided by establishing some kind of strict monetary rule (Robert J. Barro and David B. Gordon 1983).But the strict rules-based solutions have two serious drawbacks: the credibility of maintenance over time, and the rigidity that monetary rules can introduce in the conduct of monetary policy.According to Kenneth Rogoff (1985) the delegation of monetary policy to an independent central bank is seen as a way to avoid the limitations of the rules.Under the discretionary or legislative approach of central bank independence, reducing the problem of inflationary bias in monetary policy is achieved by the appointment of a governor to the central bank so that it is more conservative than the rest of society.In terms of a Taylor-type monetary policy rule, a governor would be conservative if the nominal interest rate is sensitive enough to changes on inflation.
When the central bank follows a common monetary rule, fiscal policy would have the same effect as a disturbance that has affected the goods market.A common fiscal policy (or any real common disturbance) would only be effective in the short term.In other words, the total income of the union would not be altered, but there would be a redistribution of income in each member country of the union.
Taking those considerations into account, the management of fiscal policy within the Eurozone is constrained basically by two elements: the degree of conservativeness of the ECB and the particular national fiscal frameworks.Given the inflation targeting goal of the ECB, European fiscal policy aims not only to fulfil the intertemporal budget constraint, but also to guarantee price stability.Added to this, the current environment of sovereign debt crisis has forced the need to reconsider the method of fiscal policy adjustments.Therefore, the recent EU reforms are aimed to strengthen national fiscal frameworks, focusing on the adoption of numerical fiscal rules and budget coordination between different levels of government (ECB 2013).

A Macroeconomic Model for a Monetary Union
Our main purpose is to analyse the management of fiscal policies in monetary unions, where the central bank and the fiscal authorities follow policy rules.To that end, we will develop a simple model for a monetary union to analyse different combinations of monetary and fiscal policies.
Following Díaz-Roldán and Montero-Soler (2009) our starting point will be a "small" monetary union formed by two symmetric countries, where the nominal exchange rate disappears among countries.The monetary authority (the central bank), follows a common Taylor-type monetary rule to achieve the price stabilization goal (inflation targeting).Variables are defined as logarithmic deviations from their equilibrium levels (a more detailed description of the model can be found in the Appendix).The aggregate demand and the aggregate supply functions for each country are as follows: , Equations ( 1) and ( 2) represent the aggregate demand function for each member country of the monetary union, where y 1 , y 2 are the outputs, p 1 , p 2 , the inflation rates, g 1 , g 2 the budget deficits, i.e., the fiscal policy instrument, and v 1 , v 2 capture any kind of expansionary demand shock.Equations ( 3) and ( 4) represent the aggregate supply function for each member country of the monetary union, where s 1 , s 2 capture any expansionary supply side shock.
Solving (1) to (4), we obtain the reduced forms.Looking at the coefficients of the equations of the model (see Appendix), when countries are particularly concerned by inflation targeting, the "beggar-thy-neighbour" effect prevails (demand shocks are transmitted abroad in an asymmetric way, i.e., with the opposite sign).This would be the case for a monetary union following a monetary policy rule (inflation targeting).Given that in our analysis we will focus on stabilization policies aimed at dealing with demand shocks, we will neglect supply side shocks hereafter.
Equations ( 5) to (8) show the economic framework of the monetary union.This particular set of equations will constrain the policy decisions of the authorities, given that the economic framework determines the method of transmission of economic policies or any other disturbance.Besides this consideration, we will also include in our model the restriction imposed by the requirement of achieving the fiscal discipline goal.To do that, we will allow the adoption of an explicit fiscal rule to characterize the deficit path followed by fiscal authorities.
To take into account the role of fiscal rules, we will follow Ballabriga and Martínez-Mongay (2003).And therefore, we will consider a fiscal rule which relates an explicit public deficit target (in terms of the GDP), g o , with public debt deviations (in terms of the GDP) with respect to its optimal level (d -1 -d o ), and the output level y: The public deficit adjusts according to the following path, where Fiscal Performance in Monetary Unions: How Much Austerity Should Be Allowed?PANOECONOMICUS, 2017, Vol.64, Issue 1, pp. 61-76 Adding the variables that are given in period 1, we obtain the simplified fiscal rules for each member country of the union: .
then k i < 0, indicating a country with a relatively high level of debt.And the opposite holds for k i > 0, indicating a country with a relatively low level of debt.
To solve our model we will assume that fiscal authorities will try to minimize their loss function constrained by the economic framework (given by the reduced form of the macroeconomic model, Equations ( 5) to ( 8)), and the explicit fiscal rule (Equations ( 11) and ( 12)).Their goals are to minimize output changes, y i , with stabilization purposes, and to minimize public deficit changes, g i , in order to achieve fiscal discipline.Regarding inflation, since our model describes a monetary union, we assume full delegation of prices control to the monetary authority; therefore, public deficit will be the only demand policy instrument available at the national level.
In this framework, among the set of policy makers decisions, we will focus on the case of a coordinated decision allowing for the use of a fiscal rule in both countries.That optimization problem describes the current situation of EU fiscal governance, since the European Commission has recently enforced fiscal policy coordination and the use of numerical fiscal rules (see ECB 2013, for an analysis).Solving the optimization problem, we will obtain the optimal (fiscal) policy, i.e., the optimal level of public deficit compatible with the stabilization goal (see Appendix for details).
The problem of coordinated decision and fiscal rule in both countries is as follows: 5), ( 6), ( 11) and ( 12), where 2 , 1 is the loss function of the fiscal authority.
In order to describe the current situation faced by the Eurozone member states, we will consider the following scenarios: (a) The central bank (CB) could be more conservative or less conservative, i.e., it could be more or less concerned about the inflation goal.We will assume both alternatives giving different values to the coefficient of the inflation objective in the monetary rule (see Appendix).So we will assign different values to , to characterize a more conservative or less conservative CB respectively.
(b) Every country could choose a different fiscal rule depending on the initial level of public debt.In order to describe the two alternatives, we will allow for k > 0 (low level of debt) and k < 0 (high level of debt) in the fiscal rule.
(c) Finally, the national fiscal authorities could be more austere or less austere.So, we will assign different values to the weight of public deficit in the loss function, for describing the particular concern about deficit control and, therefore, the degree of austerity of the policy implemented.
In order to make an empirical application, we will adopt the following assumptions.The shocks suffered by the countries are identical in size (normalized to 1); in other words, they are perfectly symmetric in size, although the shocks may differ in their sign, i.e., expansive (+) or contractive (), so they are perfectly asymmetric in their effects.Next, we will give numerical values to the parameters of the reduced form according to the scenarios described above: (1) In the monetary rule: we will assign = 0.8 or = 0.3, to characterize a more conservative or less conservative CB.
(2) In the fiscal rules, the response of the public deficit to changes in output will be neutral (= 0.5) to underline the relevance of the debt level: higher than the target (k = -0.9)or lower (k = 0.9).
(3) In the loss function we would assume that fiscal authorities are more concerned about fiscal discipline (= 1.3) or, on the contrary, they are more concerned about output growth (= 0.7) For comparability reasons we assign the value 1 to the aggregate supply slope (t = 1).The rest of the values can be found in the Appendix (see Table 5).

Results
In terms of a macroeconomic model, due to the problems of the financial system and the difficulty in borrowing, the current economic crisis has led to increases of the real interest rate decreasing the level of income of the economy.The attempts to deal with the crisis by implementing expansionary demand policies would result in an increase of public deficit and debt, which are already very high in most advanced countries.Particularly, in EU countries, contractive fiscal policies are being implemented to reduce the size of government deficits and to recover the confidence of financial markets, trying to avoid the risk of debt default.But it is also true that a contractive fiscal policy will tend to cause a drop in activity levels, exacerbating the recession and making further deficit reduction more difficult.
In Table 1 we offer the realized values of government deficit and public debt for EU-27, the Eurozone, Spain and Germany from the beginning of the EMU.As can be seen, after the current crisis both deficit and debt have become higher.And when comparing the Spanish and the German case, in spite of the lower debt level in the former, the Spanish fiscal policy seems to have been less austere allowing for a higher public deficit.
In order to illustrate the current situation faced by the Eurozone countries, and given that we are concerned with stabilization, in the empirical application we have computed the values for the case of a common demand contractive shock (v 1 < 0 + v 2 < 0), leading to contractive effects on output and prices.Results are reported in Tables 2, 3 and 4. Source: Author's calculations, according to the model and the scenarios described in Section 3.
According to the results reported in Tables 2 and 3, the monetary union welfare losses will be the minimum when the CB is less conservative, the fiscal authority is less austere and the countries show a relatively high debt level.In other words, expansive fiscal policies would contribute to stabilization without having a negative impact on growth.The results also hold when looking at the individual welfare losses of the member countries.Countries that are less austere have lower welfare losses.But when we allow for combining asymmetries, in Table 4, the results show that countries with low debt should apply non austere fiscal policies, while countries with high debt should be austere.
This last outcome is independent of the degree of conservativeness of the CB and could illustrate the situation faced by the European countries.In spite of the commitment to use numerical fiscal rules, countries should not apply identical fiscal rules.The design of the rules should be tightly linked to the values of the debt level.This result is in line with those obtained by Díaz-Roldán and Montero-Soler (2011) who found that the countries interested in adopting a rule would be those with a debt level higher than the objective; although, on the other hand, the fiscal rule could re-duce the scope for stabilization.More recently, Díaz-Roldán (2013), addresses that the member countries of the EMU, when deciding whether or not to adopt a fiscal rule; should not only take into account the debt levels, but also the specific features of their economies.The reason is that the characteristics of each member state determine the transmission channels of the shocks and, therefore, the optimal economic policies to deal with them.
From another point of view, García Sanchez and Sebastián (2013) found that austerity may be counterproductive.From their study, based on fiscal multipliers, they conclude that policies of deficit reduction may be self-defeating in south-European countries like Spain.In contrast, in the German case they found that austerity works.According to the data in Table 1, Spanish fiscal policy seems to have been less austere than German fiscal policy.But the effects on real GDP are not conclusive: in Spain the rate of growth has been 0.3% and in German 0.4% in 2013 (Eurostat 2014a, b).

Summary and Conclusions
In this paper we have analysed the management of fiscal policies in monetary unions, when the central bank and the fiscal authorities follow policy rules.To that end, we have developed a simple model for a monetary union to analyse different combinations of policies.We have considered the possibility of a more or less conservative governor of the central bank, both an austere and no austere fiscal policy and, finally, we have also taken into account the initial level of public debt of the member countries of the union.
In the empirical application, and in order to illustrate the current situation faced by the Eurozone countries, we have computed the values for the case of a common demand contractive shock, leading to contractive effects on output and prices.
Our results show that the monetary union welfare losses will be the minimum when the CB is less conservative, the fiscal authority is less austere and the all the countries show a relatively high debt level.Under those circumstances, expansive fiscal policies would contribute to stabilization without having a negative impact on growth.But when the countries of the union do not have similar debt levels, the results show that countries with low debt should apply non austere fiscal policies, while countries with high debt should be austere.This outcome is independent of the degree of conservativeness of the CB.In this case, that could be representative of the Eurozone member countries, the particular fiscal performance should be linked to the initial values of debt level, and they also should take into account the specific features of the involved economies.
From (1.A) to (3.A) we obtain the aggregate demand for each country: Supply side From (4.A) to (9.A) we obtain the aggregate supply for each country: The "beggar-thy-neighbour" effect prevails when countries are particularly concerned by inflation targeting and output stabilization (the coefficient , in the monetary rule − Equation (3.A) − is high enough).

Aggregate demand coefficients
, 2 (13.A) When the "beggar-thy-neighbour" effect prevails (inflation targeting): (5) Optimization problem Coordinated decision and fiscal rule in both countries: Reaction functions: where: 0 (18.A) (Symmetric for g 2 )  Source: Author's calculations, according to the model and the scenarios described in Section 3.

Table 5
Values for the Empirical Application