Although inflation differentials among member countries of the European Community have fallen significantly since the start of the EMS, convergence of fiscal policies has not been achieved. The wide remaining divergences among ratios of government debt and deficits to GNP are a major cause of concern. The Delors Report advocated binding upper limits on individual member countries' budget deficits and a procedure for coordinating their fiscal policies. In Discussion Paper No. 516 Research Fellows Alberto Giovannini and Luigi Spaventa consider the possible contradiction implied by a central monetary authority's coexistence with decentralized fiscal authorities.

Giovannini and Spaventa note a possible rationale for the proposed rules: that national authorities' pursuit of their own objectives through uncoordinated fiscal policies may lead to excessive crowding out via real exchange rate appreciations or increases in real interest rates. They argue, however, that this does not apply to the European Community: its member countries abandoned fiscal policy as a means of fine-tuning in the late 1970s and 1980s; and many member countries are large relative to the region, so their incentives to `export' crowding out are small.

Giovannini and Spaventa then turn to the sustainability of fiscal imbalances and find that some EC member countries' current and projected tax revenues and expenditures are inconsistent with the stabilization of their debt/GNP ratios. Economic and monetary union will multiply the opportunities for tax avoidance by mobile factors and therefore exacerbate any problems of structural imbalance. Unsustainable fiscal imbalances that affect the market values of government securities and hence the stability of financial markets could force a common European Central Bank to inject liquidity in order to avoid widespread financial crises and their undesirable effects on the real economy. They find that the present fiscal imbalances in European countries are unlikely to trigger major financial crises, however, although the increased integration of financial markets and a single currency imply that any problems originating in one country will be transmitted quickly to the rest of the union.

Giovannini and Spaventa propose instead that governments running unsustainable deficits be denied entry to the monetary union. Such a sanction would increase the political cost of debt finance since a government denied entry would suffer a dramatic loss of prestige vis-à-vis its electorate. Such a no-entry clause would still leave governments free to choose, so it would not infringe national sovereignty.

Fiscal Rules in the European Monetary Union: A No-Entry Clause
Alberto Giovannini and Luigi Spaventa

Discussion Paper No. 516, January 1991 (IM)