Identikit of the European Monetary Fund

Does Europe need a Monetary Fund? And, if so, what sort of Fund?

In order to answer these questions one needs to clarify two issues: a) what’s wrong with the current system for ensuring budgetary discipline in the Euro-zone; b) how should European institutions be amended, accordingly.

There are at least three problems with the current European set up: 1) the decentralization of statistical agencies; 2) the “excessive deficit procedure”, i.e. corrective arm of the Stability and Growth Pact; 3) the absence of mechanisms for resolving sovereign debt crises.

One Single Statistical Agency

I think it’s pretty obvious that the presence of national statistical agencies, whose chief executives are politically appointed by national governments, is at the root of data manipulations that we have recently witnessed, Greece (but not only) docet. There must be a single European agency, Eurostat, with branches in member countries.

The second issue is more complicated, because it requires an answer to three questions: a) what kind of national budgetary policy would be desirable from a European standpoint? b) How (instead) are fiscal policies conducted in practice? c) What type of European institutions could bring the second in line with the first? I’ll try to answer, and then go back to the issue of the European Fund.

Desirable Fiscal Policies[1]

There is wide consensus that fiscal policies should be counter-cyclical, i.e. moderately expansive during recessions and moderately restrictive during phases of recovery, so that the budget is balanced over the business cycle (and therefore public debt is sustainable). This rule applies when the so-called “automatic stabilizers” (progressive taxation, unemployment benefits) are at work.

Fiscal Policies in Reality

For many reasons, mostly political, (lobbies, the electoral cycle, concessions to partners in coalition governments, strong ideological polarization, etc.) governments tend to run excessive deficits most of the time[2]. These deficits fuel the growth of public debt, and lead to sovereign default (and instability of the common currency). How do we fix this?

The Excessive Deficit Procedure

The European procedure boils down to a fine for the country whose budget deficit exceeds 3% of GDP, when this excessive deficit is deemed neither exceptional nor temporary. In this case, a lengthy procedure is started, and in the absence of an adjustment within the next year, the European Council may force the country to make a transfer, proportional to the slippage, into a non-interest bearing deposit[3]. Within two years, a new resolution may turn the deposit into a fine, if the country does not comply. Why does the procedure not work? Surely, because the penalty is too weak, the procedure lacks credibility and is too slow. Unfortunately, that’s not all. The procedure is intrinsically flawed[4] for a number of reasons: a) it is irrelevant when the economic situation is favourable: the constraint of  3% does not “bite” and the country has no incentive to generate budget savings in good times; b) it generates costly pro-cyclical policies if the situation is intermediate: in order to avoid the fine, governments keep the deficit at the maximum level allowed,  3% of GDP, thus taking advantage of GDP increases for raising the deficit, and cutting the deficit  if the economy worsens; c) because it is rational to break the ceiling in times of crises: during recessions it is too costly to keep the deficit at  3% , and the government optimally breaks the ceiling and faces the possible sanction. Finally, the procedure does not mention what should be done in the case of a member’s sovereign debt crisis.

The European Fund

What should replace the excessive deficit procedure? There is an extensive international experience[5] with fiscal rules, self-imposed constraint that seek to ensure fiscal discipline. These rules set targets and limits to different budgetary items (expenditures, revenues, deficit, debt), for different levels government (central, local), different time horizons (one year, a business cycle), and different legal enforcements (ordinary, constitutional laws, political agreements), see Table 1 for an overview. Broadly speaking, Europe needs an incentive mechanism that ensures a balanced budget over the business cycle but does not throw away the baby of fiscal stabilization.  The following is a way to achieve this aim[6] :

1) each country should have a share of a European Fund, determined by an initial commitment of resources, such as 3% of GDP (possibly adjusted upward if the country’s debt exceeds 60% of GDP). This would guarantee a budget of around 280 billion euro, almost twice the value of the outstanding stock of Greek short term external debt;

2) A system of automatic “points” (credits) would apply, so that a country accumulates credits each year it runs a surplus, and loses them whenever it runs a budget deficit (for example, if the country presents a surplus of 1.5 points of GDP for 3 years in a row, it  cumulates 4.5 credits,  and this allows it run  a 4.5% of GDP deficit, without incurring into penalties).

3) Every year, countries are required to settle the (negative) balance between their credit position and the initial allocation (for example, if the country has a deficit of 2% for two consecutive years, at the end of the second year it has to pay 1% of GDP  to the Fund). In case of arrears, the Fund will automatically tap into alternative sources of funding (the European cohesion or structural funds). Finally,

4) at the request of the country (provided there are no arrears with the Fund)), the Fund may provide a guarantee on external short term public debt up to the limit of 60% of GDP (6).

This Fund is more akin to a “sinking fund” than to the IMF.  Such a system of automatic adjustment would be useful to prevent unsustainable fiscal policies, encourage budget savings in good times and prevent contagion in the case of default.


Figure 1: Budget Rule With and Without Political Distortion



Figure 1 shows in blue the “socially desirable” relationship between d, the budget deficit relative to potential GDP, and the so-called output gap, e, the distance between actual and potential GDP. Following the automatic stabilizers, d rises when the economy worsens (when the output gap, e is negative), while the deficit becomes negative (a surplus) when the economy expands (the output gap is positive). For a detailed analysis see my paper on  IMF Staff Papers, 2005. The red line represents the rule followed “in practice”: because of a politically motivated bias, the government implements budget deficits that are too high, in all phases of the cycle.


Figure 2: Budget Rule with Excessive Deficit Procedure



In Figure 2 the red broken line represents the policy rule implemented by a government under a cap on the deficit-GDP ratio. The constraint states that if the deficit exceeds the x = 3% of GDP, so that d is above the line d  = x+ e, then the government  pays a fine proportional to the excess deficit. When the economic situation is favorable (and e > emax) the government’s desired deficit is below the ceiling, which is non-binding: here d moves along the downward sloping red line: when the economic situation is intermediate, emin < e < emax, the government would like to have a deficit higher than the ceiling; however in order to avoid the  penalty, it decides to remain close to the ceiling, moving along the positively sloped red segment: here  the deficit rises if the economy improves, and falls if it worsens. The government adopts a pro-cyclical policy. In a crisis situation, e < emin  the government rationally chooses to break through the roof and pay the fine, moving in the downward sloping red segment on the left.


Table 1: International experience with Fiscal Rules


Source: Debrun, Epstein and Symansky, “A New Fiscal Rule: Should Israel Go Swiss?” IMF Working Paper, 2008

[1] For a “technical” approach see graphs and the papers quoted in the footnotes. 

[2]  See Figure 1
[3] The deposit is composed of a fixed sum, 0.2% of GDP, more than 1 / 10 of the deviation from the 3% reference value ri. For example, a deficit / GDP ratio of 5% would be fined by a fine of = 0, 2 + 0.1 x (5-3) = 0.4 points of GDP
[4]  See Figure 2.
[5]5 Kopits, George, 2004, “Overview of Fiscal Policy Rules for Emerging Markets,” in G. Kopits (ed.), Rules-Based Fiscal Policy in Emerging Markets: Background, Analysis and Prospects, (New York: Palgrave Macmillan).
[6] This proposal has many similarities with the Swiss system of “Debt Brake” described in Danninger (2002), IMF Working Paper . There are some important differences with the original proposal of Gros and Meyer (GM) who started the debate on the EMF. In this proposal, the European Fund replaces the excessive deficit procedure, which GM do not mention, and has the purpose of generating a budget surplus “in good times”, and not just to avoid deficits in” bad times”.  Furthermore it is an automatic mechanism that does not require Commission meetings and votes of the European Council (ministers tend to absolve themselves), nor complicated procedures for compliance and conditionality.

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