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Fiscal Rules and Strategies under Externalities and Uncertainties

Periodic Reporting for period 2 - FIRSTRUN (Fiscal Rules and Strategies under Externalities and Uncertainties)

Reporting period: 2016-03-01 to 2018-02-28

The FIRSTRUN project investigated the need for fiscal policy coordination in the EU, assessed the coherence of the recent reforms in the economic governance framework, and sought to identify reforms to fill possible gaps in the current EU governance framework.

The project has identified several reasons why the enhanced EU economic governance framework sometimes fails to generate good outcomes. One of them is the difficulty of distinguishing between structural and cyclical shocks in real time. Another reason relates to the output responses of fiscal adjustments. The failure to take fiscal multiplier effects fully into account has increased policy volatility.

The need for fiscal coordination is related to the existence of fiscal spillovers. The results are in line with the view that during “normal times”, fiscal spillovers from changes in the level of government spending or taxation are relatively small. However, spillovers may be much larger during “crisis times”, when the borrowing of many households is constrained, or when monetary policy has effectively reached its limits. These results underline the importance of fiscal coordination at least under special circumstances. Fiscal coordination may also be needed to make sure that national fiscal policies have room for stimulus when needed.

The project has considered both private and public risk-sharing mechanisms in the Economic and Monetary Union (EMU). The results show that there is still relatively little cross-country risk-sharing via private capital markets in the EMU. One reason for this is that the cross-border ownership of productive assets remains very limited.

The results also raise concerns about the erosion of democratic legitimation in EU fiscal governance. Given that fiscal policy has more direct distributive consequences than other areas of policy which have become more technocratic, this may undermine the implicit contract between voters and national governments.
To investigate the need for fiscal coordination and the current coordination mechanisms, the FIRSTRUN project has used structural economic models, econometric methods, and qualitative case studies.

One important theme of the project has been the effects of cross-country spillovers from national economic policies. Both the empirical and model-based results are in line with the view that during “normal times”, fiscal spillovers from changes in the level of government spending or taxation are relatively small. However, spillovers may be much larger during “crisis times”, when e.g. the borrowing of many households is constrained. These results underline the importance of fiscal coordination under special circumstances. Also certain structural reforms, such as pension reforms, have non-trivial spillover effects via international capital markets.

A related issue is how exactly fiscal policies should be coordinated in a currency union to stabilise output growth and maximise average welfare. An analysis based on an appropriate two-country model characterised by country-specific price rigidities and distortions suggests that fiscal policies should be used to reduce net export gaps.

The FIRSTRUN project has considered private and public risk-sharing mechanisms and compared cross-country risk-sharing in the Economic and Monetary Union (EMU) to risk-sharing across states in the United States. The results show that there is still relatively little cross-country risk-sharing via private capital markets in the EMU. One reason for this is that the cross-border ownership of productive assets remains very limited.

A large part of the FIRSTRUN research was dedicated to evaluating the new, enhanced framework of EU fiscal governance. One approach has been to consider how the new fiscal rules would have constrained fiscal policies during past economic booms and busts. One result in this regard is the use of the structural deficit for steering fiscal policy often fails to generate counter-cyclical or even neutral fiscal policy. However, alternative measures for estimating the structural deficit, such as the so-called expenditure rule would have been conducive to less procyclical fiscal policy than the most commonly used method. The project has also provided new tools to account for output responses when designing fiscal consolidation programs.

In a similar vein, the project has analysed whether the Macroeconomic Imbalance Procedure (MIP) would have been able to detect increasing macroeconomic risks prior to the 2008 financial crisis and the subsequent recession. The results show that the MIP would have provided only moderately useful alerts in terms of crisis prediction before 2009.

The project has also raised concerns regarding the erosion of democratic legitimation in EU fiscal governance. One problem is the proliferation and complexity of fiscal rules. From the point of view democratic legitimation, they should be rationalised with the emphasis placed on national rules.

Finally, the project has produced new tools in the form of quantitative economic models for designing national fiscal policies and developing fiscal coordination mechanisms in the EU. For instance, it has developed an entirely new dynamic simulation model that allows quantifying the constraint that the current fiscal rules impose on fiscal policy.

To engage stakeholders and to disseminate the research results, the project organized seven FIRSTRUN seminars, most of them in Brussels. These seminars have been attended by other researchers as well as policymakers from different EU institutions and national governments. FIRSTRUN researchers have also presented their research in numerous other seminars and conferences and published refereed articles in scholarly journals. In addition, they have published many blog posts and policy briefs intended for a wider audience.
The FIRSTRUN project has gone beyond the state of the art by i) quantifying fiscal spillovers in the EU countries with new methods; ii) developing quantitative simulation models to analyse how the current fiscal rules steer fiscal policy in different situations; iii) illustrating how the uncertainty about the current state of the economy influences optimal fiscal policy and the workings of the current fiscal coordination mechanisms, iv) providing an ex-post evaluation of many fiscal coordination mechanisms; v) evaluating different channels of cross-country risk-sharing in the EU; vi) investigating the legitimacy of institutional mechanisms needed for effective fiscal coordination.

The results are relevant to the ongoing process of reforming the fiscal governance in the EU. They should also be useful when designing national fiscal policy strategies that take the EU fiscal rules into account in a forward-looking manner.
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