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Central bankers often fear that establishing a European Monetary Union (EMU) leads to excessive accumulation of public debt. In response to this fear, the Maastricht Treaty incorporates fiscal entrance criteria for the EMU, including ceilings on public debt and fiscal deficits. In discussion paper No 1299, Research Affiliate Roel Beetsma and Research Fellow Lans Bovenberg investigate public debt accumulation in a monetary union. First, they show that monetary unification leads to higher public debt. Second, they explore whether this increase in public debt can be termed excessive, in the sense that it reduces welfare. The authors formulate a dynamic two-period model with non-indexed wages (cf. Barro and Gordon, 1983) and discretionary monetary and fiscal policy-making in a monetary union. Within this framework, decentralized, national fiscal policies impact on the other fiscal players by affecting the inflation rate set by the common central bank (CCB), which is unable to commit. If discretionary monetary policy implies an inflation bias, monetary unification boosts the accumulation of public debt. The additional debt accumulation is welfare reducing only if governments are sufficiently myopic. In the presence of myopic governments, debt ceilings play a useful role in avoiding excessive debt accumulation in a monetary union and allow a conservative, independent central bank to focus on price stability. Does Monetary Unification
Lead to Excessive Debt Accumulation? |