Fiscal policy is coming back into fashion

Christopher Johnson on how governments will cope when the european central bank holds the monetary reins

NOW THAT Europe's First Eleven are going ahead into Emu, Britain should not waste time complaining that the French are refusing to give us tickets for the Euro X (call it Euro-11) Council. The game now shifts from pre-entry criteria to post-entry policies. As the British will have to adopt these policies when they join within the next few years, they have a vital interest in shaping them.

Emu members will be swapping monetary policy for fiscal policy. The European Central Bank (ECB) will take over monetary policy, and governments will have to accept the interest rates it grinds out. National finance ministries will then have to use active fiscal policy to run their economies so as to complement European monetary policy.

This will be the opposite of what we have now. The Bank of England will have to merge into the ECB, which will target British inflation only as part of its wider European inflation objective. The European Council of Finance Ministers (Ecofin) will co-ordinate fiscal policies, but the Treasury will be responsible for seeing that the Budget is used to manage the economy.

Active fiscal policy has gone out of fashion. It was eclipsed by active monetary policy in the 1980s, and in the 1990s governments had to give priority to reducing deficits, rather than moving them up and down. Fiscal policy became a one-way street, leading to the paradise of balanced budgets - a fool's paradise for the UK in the late 1980s.

Emu provides the ideal conditions to say to fiscal policy: "Come back, all is forgiven." With interest rates given from Frankfurt, and exchange rates largely swept away, fiscal changes will no longer be swamped by interest and exchange rate changes.

An increase in the budget deficit will not make interest rates rise, and exchange rates go up or down (it could be either), provided that governments stay within the Emu framework.

The Maastricht Treaty says that governments should stay within budget deficits of 3 per cent of GDP, or else. The Stability Pact says that in order to ensure this they should aim at budget balance or small surplus. Even though all 11 have passed the 3 per cent test, many of them are still some way from balance.

Seven out of the 11, including the four biggest, are still forecast to have deficits of between 2 and 3 per cent in 1999, when the excessive deficit procedure punishing those over 3 per cent starts to operate. Finland and Ireland will be in surplus, as well as, ironically, three of the four non-joiners, Denmark and Sweden, soon to be joined by the UK.

It would be some help if governments had to aim at balance in a normal year, one where the budget deficit was not swollen by the cycle, as happens when output is below its potential trend. The recession on the Continent boosted budget deficits. The recovery has reduced them, but there is some way to go. The normal, or structural budget deficit of the EU as a whole is forecast at 1.7 per cent of GDP in 1999, compared with an actual deficit forecast of 2.0 per cent.

Most of the 11 still need to improve their structural deficits without aborting the recovery, and will be relying on the ECB to continue the low-interest monetary policy of the Bundesbank to help them do so. The reason for improving on 3 per cent deficits is to allow for fluctuations in GDP - "shocks" in the jargon of economics - which also affect the budget balance.

For the EU as a whole, a 1 per cent change in GDP produces a 0.5 per cent change in the budget balance. Taxes rise or fall with GDP, and benefits to the unemployed fall or rise. For the average country, if its GDP growth varies by 2 per cent each side of the potential output trend, its budget varies by 1 per cent. So a balanced budget, or even a deficit of 1 per cent, leaves some headroom within the 3 per cent limit.

The national response to growth shock varies with the share of tax in national income and the response ("elasticity") of tax revenue to income changes. It is thus above average in high-tax countries such as Denmark, Sweden and the Netherlands, and in countries with a high tax elasticity such as the UK.

The response of the budget balance to growth shocks is an automatic stabiliser. If growth falls below trend, people pay less tax, and get benefit if they become unemployed. The former effect is about four times the size of the latter in the EU. Both the OECD and the European Commission have shown that these stabilisers offset a quarter of the growth shook in the first year, and a half in two years.

Countries with a high budget response to GDP changes can rely more than others on the stabilisers to bring them back on course. It used to be argued that Europe needed a federal budget on American lines to stabilise shocks. Many experts now argue that Europe's national stabilisers are more effective than America's federal ones.

The first rule for new national fiscal policies is not to interfere with the automatic stabilisers. Countries have in the past been all too prone to increase taxes in deficit, and cut them in surplus (the UK budgets in 1981 and 1989 are good examples). Masterly fiscal inactivity is better than pro-cyclical fiscal activism, which aggravates shocks. Benign neglect will be the correct reaction to deficits, particularly if there is some slack in the economy, and to surpluses, particularly if there is overheating.

The stabilisers will often need to be supplemented by active fiscal policy. Because national tax and expenditure patterns vary so widely, the subsidiarity principle indicates that each government should use its local knowledge to design tax and expenditure measures to suit the needs of its economy. Economic stabilisation cannot be the sole purpose of national budgets, but it will become the overarching principle within which other aims must fit.

Governments will have to study the effects of different kinds of tax and expenditure change on the economy more closely. To take a recent UK example, it is clear that a pounds 5bn tax increase on pension funds has the same effect on the public finances as a pounds 5bn increase in income tax, but the latter has a more powerful effect on demand and on GDP. Expenditure changes are generally more immediate in their effects on the economy than tax changes, and are in any case easier in a low tax-low spending economy such as the UK.

The fiscal new deal has attractive political spin-off. The Treasury has to be generous where people are suffering from a growth setback, and mean when they are enjoying a boom, and can afford to pay up. The UK, with a balanced budget, will be better placed than most. Joining Emu with a flying start could be the secret agenda of Gordon Brown's policy of sound finance.

Christopher Johnson is UK adviser to the Association for the Monetary Union of Europe,39 Wood Lane, N6 5UD

Start your day with The Independent, sign up for daily news emails
News
people
Arts and Entertainment
Attenborough with the primates
tvWhy BBC producers didn't want to broadcast Sir David Attenborough's famed Rwandan encounter
News
Campbell: ‘Sometimes you have to be economical with the truth’
newsFormer spin doctor says MPs should study tactics of leading sports figures like José Mourinho
News
news
ebooks
ebooksA special investigation by Andy McSmith
Voices
Lance Corporal Joshua Leakey VC
voicesBeware of imitations, but the words of the soldier awarded the Victoria Cross were the real thing, says DJ Taylor
Life and Style
Alexander McQueen's AW 2009/10 collection during Paris Fashion Week
fashionMeet the collaborators who helped create the late designer’s notorious spectacles
Sport
football
News
i100
News
Perry says: 'Psychiatrists give help because they need help. You would not be working in mental health if you didn't have a curiosity about how the mind works.'
people
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

SThree: HR Benefits Manager

£40000 - £50000 per annum + pro rata: SThree: SThree Group have been well esta...

Recruitment Genius: Office Manager / Financial Services

£30000 - £37000 per annum: Recruitment Genius: Established in 1999, a highly r...

Jemma Gent: Year End Accountant

£250-£300 Day Rate: Jemma Gent: Are you a qualified accountant with strong exp...

Jemma Gent: Management Accountant

£230 - £260 Day Rate: Jemma Gent: Do you want to stamp your footprint in histo...

Day In a Page

War with Isis: Fears that the looming battle for Mosul will unleash 'a million refugees'

The battle for Mosul will unleash 'a million refugees'

Aid agencies prepare for vast exodus following planned Iraqi offensive against the Isis-held city, reports Patrick Cockburn
Yvette Cooper: We can't lose the election. There's too much on the line

Yvette Cooper: We can't lose the election. There's too much on the line

The shadow Home Secretary on fighting radical Islam, protecting children, and why anyone in Labour who's thinking beyond May must 'sort themselves out'
A bad week for the Greens: Leader Natalie Bennett's 'car crash' radio interview is followed by Brighton council's failure to set a budget due to infighting

It's not easy being Green

After a bad week in which its leader had a public meltdown and its only city council couldn't agree on a budget vote, what next for the alternative party? It's over to Caroline Lucas to find out
Gorillas nearly missed: BBC producers didn't want to broadcast Sir David Attenborough's famed Rwandan encounter

Gorillas nearly missed

BBC producers didn't want to broadcast Sir David Attenborough's famed Rwandan encounter
Downton Abbey effect sees impoverished Italian nobles inspired to open their doors to paying guests for up to €650 a night

The Downton Abbey effect

Impoverished Italian nobles are opening their doors to paying guests, inspired by the TV drama
China's wild panda numbers have increased by 17% since 2003, new census reveals

China's wild panda numbers on the up

New census reveals 17% since 2003
Barbara Woodward: Britain's first female ambassador to China intends to forge strong links with the growing economic superpower

Our woman in Beijing builds a new relationship

Britain's first female ambassador to China intends to forge strong links with growing economic power
Courage is rare. True humility is even rarer. But the only British soldier to be awarded the Victoria Cross in Afghanistan has both

Courage is rare. True humility is even rarer

Beware of imitations, but the words of the soldier awarded the Victoria Cross were the real thing, says DJ Taylor
Alexander McQueen: The catwalk was a stage for the designer's astonishing and troubling vision

Alexander McQueen's astonishing vision

Ahead of a major retrospective, Alexander Fury talks to the collaborators who helped create the late designer's notorious spectacle
New BBC series savours half a century of food in Britain, from Vesta curries to nouvelle cuisine

Dinner through the decades

A new BBC series challenged Brandon Robshaw and his family to eat their way from the 1950s to the 1990s
Philippa Perry interview: The psychotherapist on McDonald's, fancy specs and meeting Grayson Perry on an evening course

Philippa Perry interview

The psychotherapist on McDonald's, fancy specs and meeting Grayson Perry on an evening course
Bill Granger recipes: Our chef recreates the exoticism of the Indonesian stir-fry

Bill Granger's Indonesian stir-fry recipes

Our chef was inspired by the south-east Asian cuisine he encountered as a teenager
Chelsea vs Tottenham: Harry Kane was at Wembley to see Spurs beat the Blues and win the Capital One Cup - now he's their great hope

Harry Kane interview

The striker was at Wembley to see Spurs beat the Blues and win the Capital One Cup - now he's their great hope
The Last Word: For the good of the game: why on earth don’t we leave Fifa?

Michael Calvin's Last Word

For the good of the game: why on earth don’t we leave Fifa?
HIV pill: Scientists hail discovery of 'game-changer' that cuts the risk of infection among gay men by 86%

Scientists hail daily pill that protects against HIV infection

Breakthrough in battle against global scourge – but will the NHS pay for it?