The Maastricht Treaty places restrictions on national fiscal policies under the `Excessive Deficits Procedure'. To justify this, three streams of arguments have been developed. First, it is argued that there is a need for fiscal policy coordination across countries in a monetary union to ensure desirable inflation, growth, and balance of payments outcomes. Second, there are worries that large deficits in some countries will disturb the overall savings-investment balance of the EU, wreaking havoc with, inter alia, the level of real interest rates and the real exchange rate vis-à-vis the rest of the world. Third, there is a fear that unfettered national fiscal policies will be a source of inflationary pressures that the European Central Bank will find difficult to resist.

In Discussion Paper No. 1247, Research Fellows Barry Eichengreen and Jurgen von Hagen challenge these views. They show that the fiscal restraints under which state governments operate in the US were put in place for reasons unrelated to the existence of the US monetary union. They therefore convey no information about the connections between fiscal restrictions and monetary unification. Second, they show that the same is true for the other large, industrialized federal nation in which state governments were prominently fettered by fiscal restrictions until recently, namely Australia. Lastly, using a broader cross-section of countries, they show that there is no association between monetary union among federal states and fiscal restraints on sub-central (state, provincial, or local) governments. Some clear implications for Europe arise. Only if monetary union is accompanied by fiscal centralization, a scenario that is hardly plausible, will there be a need for fiscal restrictions as a concomitant of EMU.

Fiscal Policy and Monetary Union: Federalism, Fiscal Restrictions and the No-Bailout Rule
Barry Eichengreen and Jürgen von Hagen

Discussion Paper No. 1247, September 1995 (IM)