DP15309 On Public Spending and Economic Unions
|Author(s):||Fernando A Broner, Alberto Martín, Jaume Ventura|
|Publication Date:||September 2020|
|Keyword(s):||Crowding out, Economic union, Financial Frictions, Fiscal coordination, Public Spending, Spending externalities|
|JEL(s):||E62, F32, F34, F36, F41, F42, F45|
|Programme Areas:||Public Economics, Financial Economics, International Trade and Regional Economics, International Macroeconomics and Finance, Monetary Economics and Fluctuations, Macroeconomics and Growth|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=15309|
We analyze the conduct of fiscal policy in a financially integrated union in the presence of financial frictions. Frictions create a wedge between the return to investment and the union interest rate. This leads to an over-spending externality. While the social cost of spending is the return to investment, governments care mostly about the (depressed) interest rate they face. In other words, the crowding out effects of public spending are partly "exported" to the rest of the union. We argue that it may be hard for the union to deal with this externality through the design of fiscal rules, which are bound to be shaped by the preferences of the median country and not by efficiency considerations. We also analyze how this overspending externality - and the unionÃs ability to deal with it effectively - changes when the union is financially integrated with the rest of the world. Finally, we extend our model by introducing a zero lower bound on interest rates and show that, if financial frictions are severe enough, the union is pushed into a liquidity trap and the direction of the spending externality is reversed. At such times, fiscal rules that are appropriate during normal times might backfire.