The Delors Committee maintained that a successful European economic and monetary union will require rules on the conduct of national budgetary policies. In Discussion Paper No. 492, Research Fellow Frederick van der Ploeg presents a model in which national treasuries appropriate the seigniorage revenues collected by the common central bank. Without policy coordination, each will act independently to gain a greater share. They can therefore externalize the adverse effects on the common inflation rate of grabbing more seigniorage, which risks eroding the monetary base and even putting the region on the wrong side of the `seigniorage Laffer curve'.

If problems of monetary discipline and the credibility of the common central bank are assumed away, then an independent central bank appears less desirable than a central bank under political control, since central bank independence leads to a sub-optimal government revenue mix: too little inflation and tax rates that are too high. Most observers agree, however, that maintaining monetary discipline is a problem and that only an independent central bank will prevent finance ministers from succumbing to the temptation to levy a `surprise' inflation tax to wipe out the real value of nominal wage or debt contracts.

Van der Ploeg extends his model to consider four reasons why in the absence of European policy coordination of budgetary policies the public sector may be too small relative to the first-best outcome. First, if the Eurofed is independent and concerned exclusively with price stability, then seigniorage can only accrue through real growth, so national treasuries must raise taxes and cut public spending. Second, in an economic union spending by one treasury benefits the others. Third, tax competition affecting mobile factors of production will drive down tax rates. Finally, an appreciation of the European exchange rate vis-à-vis the rest of the world has the characteristics of a public good, so the level of exhaustive public spending tends to be too low.

Van der Ploeg concludes that, contrary to conventional belief, the danger of uncoordinated budgetary policies is not that the European public sector will be too large, but rather that it will be too small. Those who think that the public sector in Europe is too large should therefore welcome EMU, while those who are concerned to protect the public sector should favour the coordination of budgetary policies at the Community level.

Budgetary Aspects of Economic and Monetary Integration in Europe
Frederick van der Ploeg

Discussion Paper No. 492, January 1991 (IM)