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Journal of Financial Regulation, 2016, 2, 114129

doi: 10.1093/jfr/fjw003
Advance Access Publication Date: 15 April 2016

Fiscal Governance: How Can the Eurozone Get

What It Needs?
David Vines*
Within the Eurozones macroeconomic policy framework, scal policy was assigned the
task of managing the level of scal decits, and ensuring that the level of public debt was
not too high. Within this framework, monetary policy was to stabilize the macroeconomy,

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wage and price setting was to ensure that countries remained sufciently competitive in re-
lation to each other, and nancial liberalization was undertaken to enable integration of the
peripheral European economies with their northern neighbours, thereby generating an in-
crease in well-being. But, even before the onset of the global nancial crisis, the competitive
position of the GIIPS countries had become unsustainable, and nancial liberalization had
been grossly mismanaged. The onset of the global nancial crisis has meant that interest
rates have reached the zero bound so that monetary policy is no longer able to stabilize the
Eurozone economy effectively. In these circumstances, scal policy needs to both help
stabilize the economy, in a way not allowed by the Stability and Growth Pact, and also
needs to play a part in ensuring the resolution of imbalances within Europe. For this to be
possible, some of the sovereign debt of countries will need to be written down.


The Five Presidents Report on Completing Economic and Monetary Union was
released in June 2015. It raised a number of important questions about the govern-
ance of fiscal policy within the Eurozone policy system.
The Report focuses on the process of policymaking: considering who is respon-
sible for what, how responsibilities are to be enforced, when decisions are to be
made, and who is to be held accountable. The focus in subsequent discussions of the
Report has been similar.1 Such discussions have required a subtle and detailed under-
standing of European political economy.

* David Vines, Economics Department, Balliol College, St Antonys College, and Institute for New Economic
Thinking (INET) at the Oxford Martin School, University of Oxford; Crawford School of Public Policy,
Australian National University; and Centre for Economic Policy Research. Email:
I am grateful to Christopher Allsopp, Olivier Blanchard, Lukas Freund, Wendy Carlin, Russell Kincaid, Klaus
Regling, Andre Sapir, Peter Temin, and Guntram Wolff for helpful discussions. I am especially indebted to the
late Max Watson who, over many years, helped me to think more clearly about European issues.
1 See the discussion which took place at the Bruegel Think-tank in Brussels on 3 November 2015 with the
title Economic governance of the EU: Quo Vadis? Presentations from this discussion are available at
<> accessed 15 February 2016.

C The Author 2016. Published by Oxford University Press. All rights reserved.
For permissions, please e-mail:

Fiscal Governance  115

However, there are also important questions about the content of economic pol-
icy: how the policy system in the Eurozone is meant to work; how it actually works;
and what we can expect the outcomes of policies to beas distinct from what we
hope they might be. A discussion of these issues is strangely lacking in the Report,
and it has not emerged in subsequent considerations of the Report.2 Such discus-
sions require a thorough understanding of macroeconomic theory.
What macroeconomists have learned since the 1980s is that, although effective
macroeconomic governance requires both good process and good content, content
comes first. Roughly speaking, a policymaker cannot be held accountable for a policy
system until he or she understands both how that system works, and what policy ac-
tions would be required to deliver good outcomes in particular contexts.3 This article
will concentrate on these questions of content.
I write with a UK perspective. The UK has a clear interest in improving the func-

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tioning of the European Monetary Union (EMU), and in obtaining evidence about
whether progress is being madeor not madein the reforms which are necessary to
improve macroeconomic policymaking in the Eurozone. This evidence will have an im-
portant influence on the political choices about whether the UK will remain within the
European Union.


The founders of the Eurozone put in place what I will call the Eurozone
Macroeconomic Policy System, or EMPS. This had a clear conception of the process
of macroeconomic policymaking. There were four policy instruments: monetary pol-
icy, fiscal policy, wage and price setting, and financial regulation. These were assigned
to four policy targetsmacroeconomic stabilization, the level of public debt, the
relative competitive position of the countries within the Eurozone, and the integra-
tion of the European financial system. One instrument was assigned to each object-
ive. There was also a clear understanding of the content of policy. Economic theory
was used to understand the way in which this assignment of policy instruments
would enable the desired outcome for each of the four policy targets.
In more detail, the four parts of the EMPS were as follows.

Monetary policy: inflation targeting undertaken by the ECB

Within the EMPS, monetary policy was given the task of macroeconomic
stabilizationie the task of managing aggregate demandwithin the Eurozone as a
whole. This task was to be carried out by the European Central Bank (ECB), which
was to operate an inflation-targeting regime.

2 See the discussion referred to in the previous footnote, and the discussion which took place at the Bruegel
Think-tank in Brussels on 19 January 2015 with the title Deepening Economic and Monetary Union:
European Macroeconomics and Governance. Presentations from this discussion are available at <http://> accessed 15 February 2016. Further, see
David Vines, Impossible Macroeconomic Trinity: The Challenge to Economic Governance in the
Eurozone (2015) 37 Journal of European Integration 861.
3 The establishment of inflation targeting regimes, in which independent central banks have been held ac-
countable for the management of the economy, is a case in point.
116  Journal of Financial Regulation

The operation of such an inflation-targeting regime was well understood by the

time that the EMU was launched in 1999, since such regimes were already in place
elsewhere. These regimes wereof coursevery different from those constructed
by Keynesian economic policymakers in the 1950s and 1960s, operating within the
Bretton Woods international system. But, the global macroeconomic crisis of the
1970s had blown up those Keynesian regimes. To replace them, inflation targeting
regimes had been put in place during the 1980s and 1990s, with some difficulty, in
the USA, the UK, Australia, Canada, and New Zealand. This kind of new Keynesian
approach to macroeconomic policymaking was already well understood in 1999.4
The workings of these new regimes were well set out in what became a classic text-
book, drafts of which were already circulating at the time that the Monetary Union
was formed.5
In the inflation targeting regime, the ECB was to raise the interest rate when infla-

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tion was above target, or when aggregate demand was excessive, and vice versa when
inflation fell below target or aggregate demand became too low. Such an assignment
of a particular instrumentthe interest rateto a particular targetthe rate of infla-
tionover which it had clear influence made the governance of central banks much
better focussed than it had once been, and these lessons were learned in the design
of the constitution of the European Central Bank. In carrying out its task the ECB
was to operate in a rules-based way, like other central banks, following a feedback
procedure like a Taylor Rule. Such a new-Keynesian system is one in which, subject
to inflation being under control, the interest rate is used to regulate aggregate de-
mand, to ensure that the economy operates at a close to full employment. Such a
two-for-one feature results from the fact that the trade-off between inflation and un-
employment is only a short run trade-off.

Fiscal policy: control of public debt to be administered nationally

The fact that the ECB was to carry out macroeconomic management of the
Eurozone economy meant that, within the EMPS, fiscal policy was not required to
play a significant part in the stabilization of the Eurozone economy. Even so, govern-
ment expenditure, or tax rates, could have been used as active policy instruments
within the inflation-targeting regime, either instead of interest rate policy or as a par-
tial substitute. But this was not done.
The rest of the world had already decided not to pursue this course, using ideas
about the importance of monetary policy coming originally from Milton Friedman.6
One reason not to use fiscal policy is that it is subject to time lags, both in decision-
making and in implementation. A less important reason is that put forward by Barro
who argued that when, for example, taxes are cut, then individuals will know that

4 For an exposition of these ideas as they were understood at the time, see Christopher Allsopp and David
Vines, The Assessment: Macroeconomic Policy (2000) 16 Oxford Review of Economic Policy 1.
Christopher Allsopp and David Vines, Monetary and Fiscal Policy in the Great Moderation and the Great
Recession (2015) 31 Oxford Review of Economic Policy 134, discuss what was needed to get from the
earlier Keynesian policy regimes to the inflation-targeting regimes which emerged.
5 Michael Woodford, Interest and Prices (Princeton UP 2003).
6 Friedman, M. The Role of Monetary Policy (1968) 58 American Economic Review 1, 17.
Fiscal Governance  117

they will need to be raised in the future and so will not change their expenditure.7
Another more important reason was also identified: monetary policy can be dele-
gated to an independent central bank, free from political influence.8 This was of par-
ticular concern to Europe, where the obvious difficulty of coordinating an activist
fiscal policy across a number of countries presented a potential nightmare.
The role found for fiscal policy was, instead, that it would be used as the instru-
ment for ensuring fiscal disciplineie for managing the levels of public-sector def-
icits and debt.9 Nevertheless, the necessary movements in the fiscal position were
allowed to be gradual. In particular, fiscal policy continued to allow automatic
stabilizers to operate over the economic cycle. The reasons that this was done were
partly microeconomicbecause tax smoothing is a good idea; partly macroeco-
nomicbecause allowing the automatic stabilizers to operate would make it easier
for the monetary authority to control the economy; and partly practicalbalancing

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the budget year by year would give rise to very large administrative costs.
In other writing, we call this kind of assignment of monetary and fiscal policies the
New Consensus Assignment (NCA) and define the NCA as: the use of monetary pol-
icy to control inflation and manage demand and the use of fiscal policy to ensure fiscal
discipline.10 Within the NCA, fiscal policy emerged as a Stackelberg leader. Fiscal pol-
icy targeted deficits and debt. But it did this in the knowledge that monetary policy
would stabilize the economy, and thus in the knowledge of the interest rate which
would emerge. Within such a framework each policy can follow its own timetable, with
the control of public debts able to be much less rapid than the control of inflation.
In the design of the EMPS, the NCA presented particularly desirable possibilities,
since public debt had been severely out of control in Europe in the 1980s and 1990s.
Article 104c of the Maastricht Treaty (now Article 126 of the Treaty on the
Functioning of the European Union) imposed obligations on members of the
Eurozone which were designed to bring about fiscal discipline. It stipulated that pub-
lic deficits were not to exceed 3 per cent of GDP, except in exceptional circum-
stances, and that public debt was to be gradually brought down towards a target level
of 60 per cent of GDP. This article demanded that Member States . . . avoid exces-
sive government deficits. It called upon the Commission [to] monitor the develop-
ment of the budgetary situation and of the stock of government debt in the Member
States with a view to identifying gross errors, ie substantial excesses over reference
values (3 per cent of GDP for the deficit and 60 per cent for the debt) specified in
the protocol on the excessive deficit procedure annexed to the treaty (emphasis
added). The reference values did not amount to binding rules in the sense that their
breach would lead to automatic sanctions. Nonetheless, article 104c foresaw that the
Council could eventually impose sanctions if a Member State persisted in failing to
correct the situation.

7 Barro, R. J. The Ricardian Approach to Budget Deficits (1989) 3 Journal of Economic Perspectives
37, 54.
8 Christopher Allsopp and David Vines, The Macroeconomic Role of Fiscal Policy (2005) 21 Oxford
Review of Economic Policy 485.
9 Tatiana Kirsanova, Sven J Stehn and David Vines, The Interactions between Fiscal Policy and Monetary
Policy (2005) 21 Oxford Review of Economic Policy 532; Allsopp and Vines (n 4).
10 Allsopp and Vines (n 4).
118  Journal of Financial Regulation

In 1997 there was a further agreement, based on a proposal by the German gov-
ernment, to reinforce the fiscal provisions of article 104c. This additional agreement,
the Stability and Growth Pact, or SGP, had two key features. On the one hand, it
would allow the automatic stabilizers to operate, which would clearly contribute to
economic stability. But, on the other hand, it would do so only by tightening the
required extent of fiscal discipline. Countries were to enforce a commitment to a
medium-term budgetary objective of positions close to balance or in surplus. If
countries did this, then they would be permitted to deal with the normal cyclical fluc-
tuations in fiscal revenueie countries would allow the automatic stabilizers to oper-
ate, while still keeping their government deficit below the reference value of 3 per
cent of GDP, even when revenue had fallen in a recession. In essence, the SGP trans-
formed the 3 per cent reference value specified in the Maastricht Treaty, which re-
mained untouched, into a hard ceiling which countries would need to remain well

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It was widely understood that there is a collective action problem in including
such fiscal discipline within the rules of a monetary union.11 In a country not belong-
ing to such a union, fiscal contraction can be used to reduce public deficits, and debt,
while at the same time monetary policy can ensure that full employment of resources
is maintained, by lowering the interest rate and depreciating the exchange rate. If all
countries in a group were to do this together then the exchange rates between them
would, of course, remain largely unchanged, but their exchange rate relative to the
rest of the world would still be lower, and that factalong with the lower level of
interest rateswould stimulate demand in the necessary fashion. But within the
Eurozone each country will find it less attractive to pursue austerity, acting on its
own, since the ECB will not then lower interest rates, and the exchange rate of the
Euro will not fall, if other countries are not acting in the same way at the same time.
As a result, a country contemplating austerity on its own will face falling output and
unemployment. Furthermore, such a fall in output will reduce fiscal revenues, making
any desired fiscal consolidation more difficult. This is why the SGP was seen to be so
important for the operation of the Monetary Union. It was seen to be necessary to
have such a pact to enforce the fiscal discipline that countries would find it unattract-
ive to pursue if they were acting on their own.

Wage and price setting: competitiveness to be ensured by national actors

As noted earlier, within in the EMPS, the ECB was to carry out monetary policy so
as to achieve the appropriate level of inflation and aggregate demandbut only for
the Eurozone as a whole. Wage bargaining and price setting in each country were to-
gether given the task of ensuring that each country remained appropriately competi-
tive, relative to the other members of the Union, so as to prevent the emergence of
inter-country imbalances. Otmar Issing explained this system very clearly in an

11 Swedish Government, Stabilisation Policy in the Monetary Union: Summary of the Report (The
Commission on Stabilisation Policy for Full Employment in the Event of Sweden Joining the Monetary
Union, Swedish Government Official Reports SOU 2002:16, Stockholm 2002); Jean Pisani-Ferry, Fiscal
Discipline and Policy Coordination in the Eurozone: Assessment and Proposals in Ministerie van
Financien (ed), Budgetary Policy in E(M)U (The Hague 2002); Charles Wyplosz, Fiscal Policy:
Institutions Versus Rules (2005) 191 National Institute Economic Review 64.
Fiscal Governance  119

important article published in 2006.12 It was also suggested that the Lisbon process,
which was set up after the launch of EMU, might play a part in helping to induce the
necessary behaviour. It was thought that this process might help to bring pressure on
uncompetitive regions to adjust their costs and prices in the appropriate manner.

Financial liberalization devoted to ensuring greater

financial integration within Europe
The creation of the Euro meant that the financial integration brought about by the
single market could be carried much further, leading to a much better integrated, and
much more competitive, European financial system. It was believed, correctly, that
such an integration of financial markets would lead interest rates in the different
countries in the Eurozone to converge. That would happen both because of the ab-
sence of currency risk for the separate countries within the Eurozone, and because

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sovereign states were bound by the Stability and Growth Pact (as described earlier),
which meant that there would be a very great reduction in the default risk for the
separate sovereigns within the Eurozone. As a result of this convergence, capital
would flow to the European peripheryie the GIIPS countries (Greece, Italy,
Ireland, Portugal, and Spain). The investment of such capital in these countries
would enable more rapid growth to happen there, bringingit was thoughtgreater
welfare for Eurozone as a whole.
Nevertheless, it was thought that financial regulation could remain safely dele-
gated to policymakers in the separate nation states. They would also manage finan-
cial supervision, provide lender-of-last resort financing to banks headquartered
within their country, as and when this proved necessary, and be responsible for bail-
ing out any failing banks within their countries.

During the first nine years of the Eurozonefrom 1999 to 2008the first part of
the EMPS operated very well. The ECBs interest rate policy was of the right type,
compared with estimated reaction functions for the USA and the UK. It was rela-
tively active, more active than would be suggested by a commonly used standard of
referencethe Taylor Rule. In addition, the reaction function appears to have been
reasonably symmetric in its operation, despite the rather asymmetric specification of
the meaning which was initially given by the ECB to price stabilityless than 2 per
cent inflation over the medium term for the euro area HICP price index. That is
how the objective was originally expressed, but the more recent specification is The
ECB aims at inflation rates of below, but close to, 2% over the medium term.13
But the third and fourth parts of this policy systemto do with wage and price
setting and financial liberalizationwent badly wrong. Even before the onset of the
global financial crisis (GFC), this failure had called into question the second part of

12 Otmar Issing, The Euro: A Currency without a State, BIS Review 23/2006 <
review/r060331e.pdf> accessed 15 February 2016.
13 ECB, Monetary Policy <> accessed 15 February
120  Journal of Financial Regulation

the EMPS, the determination to use fiscal policy only for the management of the
level of public debt, and not to use that instrument in the management of aggregate

Two vulnerabilities
Ill-disciplined wage and price setting
Wages and prices did not remain in check in the way that Issing had said was neces-
sary. In Europe, the Great Moderation produced a Great Divergence. Real exchange
rates (ie relative unit labour costs) moved cumulatively upward in the GIIPS coun-
tries relative to those in Germany, with France in the middle. The amount of move-
ment was very largeapproximately 40 per cent in Greece, 35 per cent in Ireland,
and 30 per cent in Italy, Portugal, and Spain.14 There was a lack of appropriate re-

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sponsiveness of prices and wages, which were not adjusted smoothly across products,
sectors, and regions.15 This led to accumulated competitiveness losses.
It has become clear that a tendency for costs and prices to diverge is an intrinsic
problem in a monetary union. This has been widely understood in the UK, since the
idea was put forward by Sir Alan Walters in the late 1980s. (Walters was the eco-
nomic adviser to Prime Minister Thatcher, and was highly critical of the UKs mem-
bership of the European Monetary System at the time.) According to the Walters
critique, as the European economic system integrated, peripheral economies in the
Eurozone would become attractive places for investment because of the much lower
wage costs in those economies, leading to an investment boom and to higher infla-
tion. But, at the same time, as noted above, interest rates would move downwards
because of the reduction in policy risk, heading towards the level of rates in the more
advanced countries in the Eurozone. As a result, with both higher inflation and lower
nominal interest rates, real interest rates would fall. The data show that this is exactly
what happened in the decade after the formation of EMU. In Spain, for example, real
interest rates were around three hundred basis points lower than in Germany for a
period of nearly 10 years.16
Walters claimed that such lower real interest rates would stimulate the booming
economy, exacerbating the inflation problem. As a result, he said, the EMU system
might even become unstable, driven by the operation of the Phillips curve in the
booming economy. High aggregate demand would lead to higher inflationvia the
Phillips curveand so to lower real interest rates, and hence to higher aggregate de-
mand, leadingagainto higher inflation. It is clear that real interest rates for such
a country do not respect the Taylor principle, which requires that real interest rates
rise as inflation rises. Stability of an economy in a monetary union might only be

14 For a plot of these cumulative divergences, which remorselessly built up over a period of nearly 10 years,
see Peter Temin and David Vines, The Leaderless Economy: Why the World Economic System Fell Apart
and How to Fix It (Princeton UP 2013) ch 5.
15 See European Commission, EMU@10: Successes and Challenges after Ten Years of Economic and
Monetary Union, European Economy 2/2008; and Andre Sapir, Europe after the Crisis: Less or More
Role for Nation States in Money and Finance? (2011) 27 Oxford Review of Economic Policy 608.
16 See Temin and Vines (n 14) for a plot of these divergences in real interest rates, which remained remark-
ably constant over time. A similar plot can be made for the other GIIPS countries.
Fiscal Governance  121

assured if wage-and-price setters looked forward in the way that Issing has suggested
is necessary.17
The facts show that this did not happen in the period from 1999 to 2008. It is
quite possible that, in the absence of the GFC, and given a long enough period of
time, such forward-lookingness might have begun to dominate. But by the onset of
the GFC this had not happened, and the cost-positions of peripheral countries in the
Eurozone were well out of line with each other.

Ill-managed financial liberalization

The understanding, by those who devised the EMPS, of what would happen finan-
cially within the Eurozone, following greater financial integration within Europe, was
initially correct. However, the liberalization was not subsequently well managed.

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There was undisciplined over-lending to the GIIPS countries by banks within those
countries, by northern European banks, and by global banks. As a consequence, these
countries over-borrowed.
Experience should have been a good guide here. Something very similar had hap-
pened with the liberalization of East Asian capital markets during the East Asian
Miracle, in particular in Thailand and in Mexico, in the run-up to the East Asian fi-
nancial crisis. And it had happened before that in Mexico, just after Mexico joined
NAFTA. In each case, it seemed to players that policy risk had fallen, leading to a
very large increase in borrowing and in expenditure. But, just as in Thailand, Korea,
and Mexico, in Europe, policymakers said this time is different.18
It is quite possible that, in the absence of the shock provided by the GFC in 2008,
the investments financed by the borrowings in the GIIPS countries might well have
remained profitable, and rapid growth might have been maintained in those coun-
tries, and across the Eurozone. But this ceased to be the case once the GFC arrived.

Implications for fiscal policy

The failures of the third and fourth parts of the EMPSin wage and price setting
activity and in the management of financial liberalizationcalled into question the
second part of the EMPS, in which fiscal policy was dedicated to the task of
stabilizing public debt.
In the face of competitive divergences of the GIIPS countries, fiscal policy could
have played a stabilizing role. The way that this might have worked was carefully
explored in a paper reporting on the work of a team led by the late Max Watson.19
Watsons team deliberately recommended that the SGP be amended to allow fiscal
policy to play a part in correcting inter-country imbalances within the Eurozone. But

17 See Christopher Allsopp and David Vines, Fiscal Policy, Labour Markets, and the Difficulties of
Intercountry Adjustment within EMU in David Cobham (ed), The Travails of the Eurozone (Palgrave
2007) 95; Tatiana Kirsanova and others, Optimal Fiscal Policy Rules in a Monetary Union (2007) 39
Journal of Money, Credit and Banking 1759.
18 Carmen Reinhart and Kenneth Rogoff, This Time is Different: Eight Centuries of Financial Folly (Princeton
UP 2009).
19 European Commission Adjustment Dynamics in the Euro Area, European Economy 6/2006. Watson
was then Economic Adviser to the Director General for Economic and Financial Affairs (DG-ECFIN).
122  Journal of Financial Regulation

the recommendations of this group were ignored. The opportunity to use fiscal pol-
icy in a stabilizing manner was not taken up.
More than this, the SGP acted in a positively destabilizing manner.20 It did this
because the automatic stabilizers were not actually allowed to operate. The effect of
the SGP was to encourage spending in the Southern European periphery, at the time
that this region was experiencing a boom. This can be seen from a description of
what happened in Spain. High growth in domestic demand in Spain led to inflation
and to a worsening current account position. But it was not allowed, at the same
time, to lead to a greater fiscal surplus so as to dampen the boom. Instead, most of
the extra revenues were spent, meaning that fiscal policy actually supported the
boom, augmenting the destabilizing effects outlined in the Walters critique, rather
than seeking to dampen it. The SGP positively encouraged such pro-cyclical

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Conversely, the effect of the SGP in Germany was to support the tightening of
domestic spending there. Low growth of aggregate demand in Germany during this
period led to lower fiscal revenues, and the effect of this was supported by further fis-
cal consolidation, under the influence of the SGP. The tighter fiscal position further
dampened German demand. This destabilizing effect was imposed on top of the ef-
fects identified by the Walters critique: higher real interest rates than in Spain caused
German growth to lag. But fiscal tightening augmented this effect, rather than seek-
ing to offset it. It is often observed that Germany violated the SGP at this time, by
not carrying out sufficient fiscal consolidation. But if Germany had fully observed the
SGP, the resulting macroeconomic problems would have been even worse.
A general point can be made from this discussion. Even before the arrival of GFC,
parts of the European Macroeconomic Policy System in Europe were not function-
ing well. The outcomes of wage and price setting were leading, cumulatively, to di-
vergences in competitiveness, and financial liberalization was having asymmetric
effects on demand. These facts should have ledeven before the onset of the
GFCto a reconsideration of the role of fiscal policy, but they did not.

The GFC and the zero bound for monetary policy
When the GFC struck at the end of 2008, the effects appeared at first to be relatively
smallfor example, relative to the Latin American debt crisis of the 1980s. But the
crisis soon spread rapidly around the world. The reason for the speed of contagion
appears to have been the quite extraordinary degree of leverage that had been built
up during the Great Moderation. In Europe, as everywhere, there was a massive
downturn in aggregate demand.
The policy response was immediate. First, as was to be expected from the infla-
tion-targeting framework within the NCA, interest rates were slashed. In the USA,
they reached the lower bound by the end of 2008; the Eurozone was not far behind.
Once the lower bound was reached, no further offset could be provided by

20 Temin and Vines (n 14); Kirsanova and others (n 17).

Fiscal Governance  123

conventional monetary policy. Second, there were massive financial bailouts. Third,
turning to fiscal policy, in most advanced countries the automatic stabilizers were
allowed to operate as the economy fell into recession. This, too, was in line with the
framework of the NCA, in which fiscal objectives had typically been formulated to
apply over the cycle. Importantly, there was a cooperative agreement to do this at
the G20 Washington summit in November 2008.
At the London summit of the G20 which followed in April 2009, there was a sig-
nificant departure from the fiscal framework of the NCA. Policymakers adopted a
significant discretionary expansion of their fiscal policies, as a demand-stabilizing
measure, to an extent which amounted to perhaps as much as 2 per cent of global
GDP over a period of up to three years. This discretionary expansion was important,
coming on top of the operation of the automatic stabilizers. But, the effects of the
automatic stabilizers were much larger; putting these two effects together the overall

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budget deficits in the USA, and in some other countries, rose to around 10 per cent
At the next G20 Summit, held at Pittsburgh in September 2009, policymakers
announced that they wished to achieve strong, sustainable, and balanced growth
through a cooperative international agreement on a set of policies for the world
economy. A monitoring system, known as the G20 Mutual Assessment Process, or
G20MAP, was established, in collaboration with the IMF to provide accountability
for that process of cooperation. Many hoped that the G20MAP would provide the
institutional basis for international cooperation in macroeconomic policymaking,
including in the establishment of a sufficiently expansionary fiscal policy.21
However, when policymakers met next at the Toronto G20 summit in June 2010,
it was agreed that policymakers in advanced economies would cooperate in the with-
drawal of fiscal support, despite the lack of demand in most countries. Since then,
austerity policies have been adopted in the USA, the UK, the Eurozone, and, in par-
ticular, in Germany. Attending to the growing level of public debt has become the
dominant feature in determining fiscal decisions. Faced with the very large increases
in public debt which had occurred, policymakers effectively declared enough is
enough. This was, for all intents and purposes, a decision to carry out no further dis-
cretionary stabilization, and to override the operation of the automatic stabilizers.
This short account of international events brings out a point which is important
for an understanding of subsequent policymaking within the Eurozone. Worldwide,
fiscal and monetary policy reactions initially worked well; disaster was avoided. But
as recovery developed, fiscal practices inherited from the NCAa concentration on
fiscal sustainability and the pursuit of good housekeepingwere put back in place.
This was done, even though there was no longer any monetary policy in place of a
kind which would help economies to recover. G20 communiques presented the re-
sulting fiscal consolidation as a sustainable and balanced policy, even though there
was no policy in place to ensure that the recovery would be strong.

21 Christopher Adam, Paola Subacchi and David Vines, International Macroeconomic Policy Coordination:
An Overview (2012) 28 Oxford Review of Economic Policy 395; Creon Butler, The G20 Framework
for Strong, Sustainable, and Balanced Growth: Glass Half Empty or Half Full? (2012) 28 Oxford Review
of Economic Policy 469.
124  Journal of Financial Regulation

I would argue that the global recovery would have been much faster if fiscal policy
had been allowed to take responsibility for the restoration of full employment, in an
environment that tolerated the necessary rises in public debt. The policies of auster-
ity which have been adopted, designed to reduce public debt, have slowed the global
recovery. Global growth will not be resumed until the private sector begins to invest
strongly again, creating the financial assets which the private sector wishes to hold,
thereby enabling public debt to be retired. This has not yet happened because the
private sector, correctly, does not believe that macroeconomic policy is capable of
sustaining a strong recovery.

The onset of the intra-European crisis

In early 2010, just as preparations for the Toronto summit were underway, it became

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clear that the economic position in the GIIPS countries had become particularly vul-
nerable. They had borrowed extensively, as described above. The collapse of demand
brought about by the GFC made the returns on this borrowing particularly vulner-
able, all the more because these countries were so uncompetitive. These countries
were unable to devalue their currencies, and so were unable to increase exports, or to
divert domestic demand from imports to home production, in order to recover.
As a result, the GIIPS countries became fiscally vulnerable. The collapse in output
hit fiscal revenues everywhere, leading to a very large accumulation of public debt.
But in the uncompetitive GIIPS countries, with no means of promoting recovery
through exchange-rated devaluation, it became clear that fiscal debts might never be
repaid. As a result, Europe faced a number of sovereign debt crises. Previously, such
crises were only found in emerging market economies: Latin America (1981), East
Asia (1997), Russia (1998), and Argentina (2001). Suddenly, such sovereign debt
crises came to Europe.

Implications for fiscal policy

Since the onset of the crisis, the European macroeconomic policy framework has
faced a dual challenge.
First, in line with the position in other advanced countries, monetary policy
within the Eurozone became unable to manage aggregate demand within the
Eurozone, because the zero bound had been reached. That is to say, the first compo-
nent of the four-part EMPS ceased to be operable. I argued earlier, when discussing
global policy responses to the GFC, that when the zero bound is reached, this creates
a need for fiscal policy to step away from its task of targeting the level of public debt,
and towards the task of stabilizing aggregate demandbecause monetary policy is
no longer able to do this. But I noted that countries moved in the opposite direction,
towards the stabilization of public debt. This certainly describes what happened in
Germany. There was a need for sustained fiscal stimulus in Europe, butjust like
everywhere elsethis need was not recognized. Germany was the country which
could have most easily fulfilled this role. But it did not. Instead, the German ambition
was to bring fiscal policy back within the framework stipulated by the SGP, according
to the principles underlying the NCA.
Fiscal Governance  125

Secondly, the sovereign debt crisis in the GIIPS countries led to an additional
reason for tightening fiscal policy. These uncompetitive countries, which had over-
borrowed, were unable to find a way to stimulate growth by currency depreciation
or in any other way. Andbecause the collapse in output in these countries had led
to a collapse in fiscal revenues, fiscal consolidation was seen to be essential, even-
though this worsened the collapse in output.

Nevertheless, the Eurozone survived the crisis of 2010. In 2012, Mari Draghi
announced that the ECB would do whatever it takes, and by the end of 2013 there
was widespread optimism that recovery was on its way. Buttwo years laterthat
optimism has faded. It has been replaced by a belief that the revival of economic

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growth will be very slow, and that the recovery will be fragile.
I now discuss three additional aspects of whatever it takes. These go beyond actions
of the ECB. They involve changes to the conduct of fiscal policy changes of two kinds:
short-term changes in policy and longer-term changes in the policy framework.

The need for revision of the SGP and the imbalances procedure
As described earlier, the SGP forced Germany to follow excessively tight policies dur-
ing the Great Moderation but allowed excessive laxity in the GIIPS countries. Now,
however, the SGP is imposing excessive fiscal deflation across Europe. As described
earlier, there is a policy of fiscal constraint in northern Europe, following the prin-
ciples of the NCA. However, this is coupled with severe austerity in the South, as a
result of the sovereign debt crisis there. As a consequence, the SGP needs to be
reformed, for reasons which build on those set out above. But in fact it has been
tightened since the onset of the GFC in 2008. (This statement is correct even allow-
ing for the fact that there have been repeated extensions of deadlines.)
The SGP has also been accompanied by a new policy process, the Macroeconomic
Imbalances Procedure, designed to deal with the intra-European adjustment problem
described earlier. But I would argue that these adjustments to the EMPS have become
part of the problem, not part of the solution.22 This procedure imposes surveillance
on all countries with an external deficit of more than 4 per cent of GDP, forcing them
to curtail fiscal deficits, but allows countries with surpluses of up to 6 per cent to es-
cape surveillance, rather than forcing them to expand fiscally. It is very strange that
Germany, with a surplus of nearly 8 percent, is escaping pressure to expand, and that
the Netherlands is doing the same, with an even greater surplus.
This set of policies has had the effect of holding back the European recovery.
Numbers presented by the OECD suggest that the level output in Europe is 34 per
cent lower than it would have been without such fiscal austerity.23
With such a combination of discipline and asymmetry, the only way that demand
can begin to grow again in Europe is through growth in net exports. And, the only

22 These changes to the EMPS have been introduced in a set of reforms known as the Two Pack and the
Six Pack.
23 OECD, Economic Outlook Volume 2014/2 (2014).
126  Journal of Financial Regulation

way to achieve this is through currency depreciation, brought about by Quantitative

Easing. Such an approach to macroeconomic management for Europe has been
described as currency warfare, and can be seen as contributing to global
I would argue that the current fiscal position in Europe must change, even now so
long after the onset of the crisis. There must be a significant fiscal expansion in
Germany combined with an easing of fiscal austerity in the GIIPS countries. And, in
future, the fiscal framework within the Eurozone must allow fiscal policy to play a
symmetrical part in the resolution of intercountry imbalances. There have been
many descriptions of what is required.25 The implication for European governance is
that Germany must come to understand that membership in a Monetary Union re-
quires that a country do two things: to expand fiscally now, and to agree to an overall
change in the European fiscal-policy framework.

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Whatever it takes includes such fiscal changes. A sustainable European Monetary
Union requires the rewriting of both the SGP and the Macroeconomic Imbalances

Fiscal policy and the adjustment of relative unit labour costs

I described earlier how, in 2008, costs and prices in Southern Europe were of the
order of 30 per cent out of line with those in northern Europe. How can such large
differences in unit labour costs be adjusted? After the East Asian financial crisis,
Thailand, Korea, Indonesia, and Malaysia were able to devalue their real exchange
rates by the same order of magnitude3040 per centand to begin to recover
again by export-led growth. Of course, this option is not available in Europe.
What is required is for the GIIPS countries to have less inflation than Germany
and other countries in northern Europe. There has been considerable movement in
this direction over the eight years since 2008,26 but we still require the GIIPS coun-
tries to have 2 or 3 per cent inflation less than Germany for a period of four or five
There are two ways of achieving this objective. The first method would be for de-
flation to continue in the GIIPS countries for a further period of time. But we have
known, ever since Britain re-joined the gold standard at an overvalued rate in 1925,
that deflation like this is hard to bring about. It takes time, and, as in Britain showed
in the late 1920s, the outcome may not be successful.27 Even productive firms will
find it difficult to borrow in such circumstances, debt burdens will rise, and bankrupt-
cies will occur. Consumers will suffer from debt deflation as described by Irving
Fischer. Increasing international competiveness by carrying out internal devaluation
like this is so much harder than simply devaluing the currencyas happened in East

24 David Vines, On Concerted Unilateralism: When Macroeconomic Policy Coordination is Helpful and
When It is Not in Tamim Bayoumi, Stephen Pickford and Paola Subacchi (eds), Managing Complexity:
Economic Policy Cooperation after the Crisis (Brookings Institution 2015) ch 2.
25 For a discussion of how this needs to be done, see Allsopp and Vines (n 17), Kirsanova and others
(n 17), Kirsanova, Stehn and Vines (n 9), Pisani-Ferry (n 11), and Wyplosz (n 11).
26 European Commission, Quarterly Report on the Euro Area, (2015) vol 14, no 4.
27 Britains overvaluation in 1925 was less than half of what was required in Europe in 2008, and yet adjust-
ment proved to be impossible.
Fiscal Governance  127

Asia in 1997. Furthermore, during the adjustment process it will be difficult for
growth to resume. It is hard to imagine that political support for such a strategy will
be sustained throughout this period of time.
Adjustment would be easier if Germany shared the burden, allowing a much higher
rate of German inflation for a period of some years, and so bringing about a difference
in inflation rates without requiring deflation in the GIIPS countries. The behaviour of
German representatives at the ECB since 2012 has revealed their unwillingness to
allow a European monetary policy which would bring this about. This explains why, in
late 2014, the ECB was so unwilling to take decisive action to prevent inflation from
falling well below the two per cent target. German resistance to Quantitative Easing
(QE), early in 2015, can be seen in this light. The action of the ECB in carrying out
significant QE from 2015 has begun to push the process in the right direction, by gen-
erating greater Eurozone-wide inflation, through the depreciation of the Euro.

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Nevertheless, the rate of inflation in Europe is still low, even after stripping out
allowance for lower energy costs. Moreover, success in this strategy involves beggar
thy neighbour devaluation vis-a-vis the rest of the world.28
What is required is a much looser fiscal position in Germany. But the German
focus on the need for fiscal discipline, guided by the principles laid down in the
NCA, is making this impossible. The Macroeconomic Imbalances Procedure should
be required to act against this conduct of policy in Germany.
There is also a much longer-term question, going beyond the immediate competi-
tiveness problem inherited from the period before 2008. The German model, in which
a semi-coordinated process of wage determination bids down nominal wage costs,
firm by firm, lowers prices, and raises German competitiveness, economy-wide. Such a
process dates back to the pre-EMU European Monetary System, and even before that,
when it was the Bundesbank which ensured anti-inflation discipline. But, such behav-
iour within a monetary union undercuts other countries in union. A continuing monet-
ary union between Germany and those other countries will be difficult to sustain in
the longer term, since wage-fixing processes in other countries are not like those in
Germany. It may require what Martin Wolf has described as a continuing reserve army
of unemployed in the GIIPS countries. Such a Eurozone may not be politically sustain-
able in the long-run even if it is sustainable in the short run.

Writing down sovereign debt of GIIPS countries

I have left until last the item which was most discussed in the summer of 2015 in re-
lation to Greece: the prospect that the sovereign debt of at least some of the GIIPS
countries will need to be written down.
In considering this issue, it is helpful to recall the Latin American debt crisis of
1981. In that case, the move to debt relief took eight yearsLatin Americas lost
decadebecause the necessary debt reduction was resisted for many years both by
US banks and by the US government.29 A similar write-down is inevitable in many

28 Vines (n 24).
29 Brett House, David Vines and W. Max Corden International Monetary Fund in Steven Durlauf and
Lawrence E Blume (eds), The New Palgrave Dictionary of Economics (2nd edn, Palgrave 2008); James M
Boughton, Tearing Down Walls: The International Monetary Fund 1990-1999 (IMF 2012).
128  Journal of Financial Regulation

of the peripheral countries of Europe if growth is to resume. This is the case because
the existence of a debt overhang of the current size is likely to go on depressing both
consumption and investment, and so to prevent a recovery.30 What is more, the fiscal
surpluses necessary to bring the debt-to-GDP level back to acceptable levels do not
appear to be politically sustainable. This has already become evident in the case of
Greece, but the point is a more general one and applies across all of Portugal,
Spain, and Italy. The necessary write-downs are being resisted by Germany. German
policymakers are acting in a way similar to what happened in the 1980s in the USA,
when the US government, acting on the behalf of US banks, prevented write-downs
of Latin American debt.
In Ireland, in late 2010, the ECB and the European Commission prevented the
Irish Government and the Irish Central Bank from imposing losses on bond holders
who had invested in Irish banks which had become bankrupt. Such debt-reliefworth

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perhaps six or seven percent of GDPwould have greatly eased the debt burden
which has fallen on Irish taxpayers. The case of Greece is much more serious. Greek
debt should have been written down in 2010. Instead, an extremely harsh austerity
programme was imposed on Greece. The debt was partly written down in 2011, but
by an inadequate amount. By mid-2015, a further write-down had become inevitable.
This was the view of the IMF, which held some of the outstanding Greek debt.31 But,
the IMF did not prevent Germany from ensuring that debt reduction did not happen;
the necessary write-down of Greek debt is still to come. The same may well be true in
all of the other Southern European countries, namely Portugal, Spain, and Italy.
It is true that the European Stability Mechanism (ESM) has reduced the interest
rate which Greece and other Southern European countries must pay on their debt.
Estimates suggest that this figure for Greece may be as much as 4 per cent (or 400
basis points). The ESM has also enabled Greece and other countries to extend the
period of their low-interest loans, thereby greatly reducing their effective debt bur-
den. But these two things will almost certainly not reduce the debt enough to enable
the fiscal position of Greeceand of the other GIIPS countriesto be sufficiently
relaxed. Furthermoreeven if interest rates remain low and the debt is of very long
maturitythe existence of a debt overhang is likely to go on depressing private sec-
tor consumption and investment. This is essentially because, as long as a debt over-
hang remains, there is always the risk that interest rates will be raised or that
repayment will be demanded. As has already become evident in the case of Greece, it
is highly unlikely that the electorate in these countries will be willing to allow the
situation to continue indefinitely, even if the effective repayment obligations have
been substantially written down. At some stage this debt will need to be forgiven,
just as happened in Latin America.
Of course, there is resistance to such write-downs by Germany and by other
northern European nations, as became evident in the case of Greece in the first part
of 2015.32 The reason for this resistance is obvious; taxpayers in Germany and

30 See Reinhart and Rogoff (n 18).

31 Vijay Joshi and David Vines, If the IMF Had Made Its Position Clear, All This Might Have Been
Avoided, Financial Times (London, 7 July 2015) 12.
32 Jurgen Stark, German Prudence is Not to Blame for the Eurozones Ills Financial Times (London, 12
February 2015) 11.
Fiscal Governance  129

elsewhere will, in the end, become responsible for failed debts in the GIIPS coun-
tries. But, the need for the write-down is also obvious. The result that emerges will
be the result of some kind of bargaining process. And, it will be relevant to this bar-
gaining process that much of the debt was created by banks in northern Europe, who
over-lent to these countries in the first place, encouraged by the light-touch regula-
tion which went along with the financial liberalization that was part of the EMPS.
Nevertheless, writing down this debt has become much more difficult than it was
in 2010. In the intervening years, banks have been able to pass on their debt, first to
the IMF and then to the ECB and ESM. Writing down the debt held by the ESM
will be politically difficult, precisely because the burdens will end up with taxpayers,
rather than part of the burden being born by the private shareholders of those
northern European banksand US bankswho made some of the loans.
But until the necessary write-downs happen, uncertainty will cast a shadow over

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the ability of the GIIPS countries to return to growth. Whatever it takes must in-
clude a write-down of debt, sooner rather than later.

Within the Eurozones Macroeconomic Policy Framework, the task of monetary pol-
icy was to stabilize the macroeconomy, and fiscal policy was given the objective of
managing the level of fiscal deficits, and of ensuring that the level of public debt was
not too high. Within this framework, the wage-setting and price-setting processes
were to ensure that countries remained sufficiently competitive in relation to each
other, and policies of financial liberalization were undertaken to enable the closer in-
tegration of peripheral European economiesthe GIIPSwith their northern
neighbours, thereby generating an increase in well-being.
Even before the onset of the GFC, the process of wage and price fixing in the
GIIPs countries was ill disciplined, and the process of financial liberalization was
grossly mismanaged, creating a need for adjustment. There was a role for fiscal policy
to play a part in the adjustment process.
The onset of the GFC meant that interest rates soon reached the zero bound and
so that monetary policy was no longer able to effectively stabilize the Eurozone econ-
omy. QE, undertaken by the ECB, has helped to depreciate the Euro, and so has less-
ened the difficulties, both by stimulating demand and by raising Eurozone-wide
inflation. Nevertheless, in these circumstances fiscal policy needs to both help
stabilize the Eurozone economy in a way not allowed by the SGP, and also needs to
play a part in ensuring the resolution of imbalances within Europe. For it to be pos-
sible to carry out these two tasks, sovereign debt will need to be written down, more
than has happened to date.