European Monetary Union
Modelling fiscal autonomy

The Delors Report assumes that there is little to be gained from the fiscal policy autonomy of the member countries of a European Monetary Union (EMU) and favours ceilings on fiscal deficits. In Discussion Paper No. 414, Paul Masson and Research Fellow Jacques Melitz argue that the value of such fiscal independence arises from differences in the initial positions of the member countries at the time of entry into the union, and from asymmetries (e.g. national preferences). They conduct a number of simulations based on the IMF's MULTIMOD model, taking the current situation as a point of departure.

They focus on France and Germany, which for simplicity represent the EMU, and they assume that the two countries have a common nominal interest rate and a common exchange rate relative to the rest of the world, that the joint money supply is set by a single monetary authority which is entirely independent of the two fiscal authorities, and that the FFr/DM exchange rate is the same as it is today. In all their simulations, capital flows are perfectly elastic in the sense that since neither country can pay a higher interest rate than the other, no matter how much it borrows. Such flows <196> and the current account deficits they finance <196> can therefore be very large.

In their long-run simulations, Masson and Melitz assume that a shock causes an appreciation of EMU money sufficient to drive the current account into balance from an initial position of a surplus of 2% of GNP for the union, and that there are no fiscal policy responses based on national preferences. Their results indicate that that the resulting net capital flows within the union can run from zero to 4% of individual-country GNP, depending on the distribution of the surplus between the countries.

In their medium-run (five-year) simulations, they allow for such national fiscal policy preferences. They assume, first, that a 10% appreciation of the joint currency leads France to tighten its fiscal policy to offset the current account deficit; second, that the union's joint monetary policy is too loose for Germany, which tightens its fiscal policy to offset it; and third, that there is a doubling of the price of oil. In this case, France tightens its fiscal policy to fight the current account implications, and Germany does the same to combat inflation. In the first and second cases, the country chiefly affected can improve its lot by varying its fiscal policy without notably injuring the other, which provides some support for fiscal policy independence.

Masson and Melitz provide two reasons for this result: first, most of the change in the current account of the responding country is offset by an opposite change in the current account of the rest of the world and not of the partner country; and second, the exchange rate depreciation in the first country has favourable repercussions on the output of the second. The third case indicates possible instability in the absence of cooperation, resulting from the non-convergence of the two simulations.
Masson and Melitz consider separately the issue of whether current account targets within a monetary union still make any sense, for the case in which the monetary union as a whole has a balanced current account, but France has a deficit (or Germany a surplus). They suppose this imbalance is not warranted by structural differences in productivity, time preference, or demography, so that it is not sustainable and the policy question is the choice of the optimal path towards equilibrium.

They find that, even if the nominal exchange rate is fixed, continuing German surpluses lead to transfers of wealth from France to Germany, and the current account imbalances tend to move economic activity towards France. These results support the view that France will have less cause to make sacrifices to attain current account balance inside the EMU, and that France will have less reason to interfere with German efforts to sustain the current account imbalance by resisting increases in the prices of their goods.

If some of the indebtedness incurred by France during the adjustment process is not self-liquidating, then the adjustment will be more costly and will require French relative prices to be lower later on, so that market forces may still provoke current account deficits that are excessive from a French point of view. Hence, independent fiscal policy remains useful for France in dealing with current account imbalances.

Fiscal Policy Independence in a European Monetary Union
Paul Masson and Jacques Melitz

Discussion Paper No. 414, April 1990 (IM)