Economic Policy Coordination in the Euro Area

Armin Steinbach

• Publisher: Routledge
• Year: 2014
• ISBN:
  9781317689614
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

The European debt crisis has given new impetus to the debate on economic policy coordination. In economic literature, the need for coordination has long been denied based on the view that fiscal, wage and monetary policy actors should work independently. However, the high and persistent degree of macroeconomic disparity within the EU and the absence of an optimum currency area has led to new calls for examining policy coordination.

This book adopts an institutional perspective, exploring the incentives for policymakers that result from coordination mechanisms in the fields of fiscal, monetary and wage policy. Based on the concept of externalities, the work examines cross-border spillovers (e.g. induced by fiscal policy) and cross-policy spillovers (e.g. between fiscal and monetary policies), illuminating how they have empirically changed over time and how they have been addressed by policymakers. Steinbach introduces a useful classification scheme that distinguishes between vertical and horizontal coordination as well as between cross-border and cross-policy coordination. The author discusses farther-reaching forms of fiscal coordination (e.g. debt limits, insolvency proceedings, Eurobonds) with special attention to how principals of state organization affect their viability. Federal states and Bundesstaaten differ in the incentives they offer for debt accumulation – and thus in their suitability for fiscal coordination.

Steinbach finds that the originally strict separation between policy areas has undergone significant change during the debt crisis. Indeed, recent efforts to coordinate policy are no longer limited to one policy area, but now extend to several areas. Steinbach argues that further fiscal policy coordination can be effectively deployed to address policy externalities, but that the coordination mechanisms used must match the form of state organization in the first place. Regarding wage policies, there are significant barriers to coordination. Notwithstanding some empirical successes in the implementation of a productivity-oriented wage policy, the high heterogeneity of national wage-setting institutions is likely to prevent any wage coordination.

1 Introduction

Discussion about the necessity of economic policy coordination and the appropriate governance structure has accompanied the EU integration process for some time. The current coordination system is asymmetric: monetary policy is set centrally by the ECB, while economic policy, especially fiscal policy and wage policy, is determined on the national level.

Today’s coordination system has long been controversial. The Werner Report and the MacDougall Report stressed that a monetary union requires centralized decisions for national budgets as well as an enlarged Community budget.¹ The Werner Report concluded by calling for the creation of a central bank and a European economic government. But the goal of aligning budgetary policy to Community targets was abandoned when the monetarist view gained prominence in the EU. From its perspective, the privileged position of the central bank, together with rule-based fiscal policy, made additional coordination and transfer of sovereignty to the European level unnecessary. Instead, policymakers decided to base monetary union on a “thin” model that required little transfer of institutional sovereignty. In the run-up to Maastricht, the main task of budgetary policy switched from stabilizing aggregate demand to supporting the inflation targets of monetary policy. To this end, the Delors Report provided for the establishment of an effective cap for budgetary deficits.² It called for binding and contractual fiscal rules but nevertheless advocated the “soft” coordination of national policies at the EU level. European-wide mechanisms of economic governance were not a feature of its recommendations. For many years, policymakers forwent comprehensive economic policy coordination because they assumed that economic growth in the EU could be achieved through a centralized stability-oriented monetary policy and some more or less binding fiscal rules.

The coordination debate has grown more heated over the course of the European sovereign-debt crisis. The macroeconomic divergences between eurozone states cast doubt on the views expressed by many economists predicting that a monetary union would synchronize economies across the EU. There has been much political disagreement about what do to in response. Some politicians have demanded that states that lose competitiveness and pile up debt be forced from the Union. Others have called for greater integration at the EU level to mend its “birth defect” – the absence of political and monetary union – and standardize fiscal policies. As the sovereign-debt crisis continues, a number of European legislative decisions have been introduced. Most measures have sought to compel a sharper form of fiscal discipline at the national level, including legislation to strengthen fiscal rules (e.g. Sixpack, Twopack, Euro Plus Pact, European Redemption Pact). These proposals have also encompassed an additional means of coordination beyond fiscal policy: the monitoring of macroeconomic imbalances through a range of parameters. All in all, this new legislation represents a qualitative advancement in the area of EU economic policy coordination.

Given the developments of recent years, this book tries to answer the question of whether more economic policy coordination is necessary and which additional forms of coordination in the field of fiscal, monetary and wage policies are possible and useful, with a view to avoiding future crises.

1.1 Basic criticisms of economic policy coordination

Any study of economic policy coordination and governance issues must begin by addressing misgivings expressed by economists concerning the need for coordination. Critics of coordination follow two lines of attack.

The first basic criticism relates to the preconditions that are supposed to indicate the need for coordination: it is commonly argued that a prerequisite for coordination is the existence of identifiable variables that disrupt the long-term equilibrium of target economic variables. This premise – a key component of the underlying theoretical model – limits the applicability of economic policy coordination from the start. Why? In a model that expects rational outcomes, monetary disturbances in wage and price flexibility exert a real influence in the short term only when they are permanent and unexpected; disturbances that are expected or publicized do not. Hence, as long as nominal variables (e.g. price levels) do not factor in the objective function, the predictions of game theory remain irrelevant in the short term.³ In the long term, a rational model offers no incentives whatsoever for discretionary monetary policy. The same is true of fiscal policy, given sufficient flexibility for prices and wages. The critics argue instead for greater flexibility in the labour and goods markets, which promises to decrease economic interdependence, thus eliminating the need for coordination.⁴ I consider this point in detail below. Though I will not take issue with the philosophical assumptions of the Keynesian and monetarist views, I cannot avoid addressing the basic conflict between these views when it comes to discussing economic policy coordination. I will also consider current empirical evidence of the persistence of macroeconomic heterogeneity and, on that basis, investigate existing forms of coordination and proposed forms of coordination with regard to the incentives they provide for policymakers.

The second precondition that is supposed to indicate the need for coordination is the absence of an automatic correction mechanism once a disruption occurs (such as an asymmetric shock). An ideal monetary union ought to provide such a correction mechanism by adjusting prices, wages, migration or fiscal transfers based on optimal currency area theory. The critics of economic policy coordination argue that efforts should be directed not at strengthening coordination, but at reducing obstacles in the way of adjustment (through, say, higher wage flexibility or easier migration).

If the first line of attack against economic policy coordination sees no need for coordination based on the theoretical model, the second line of attack emphasizes the practical problems of coordination. It contends that we can be certain neither about the state of the economy on which coordinated activity is based nor about how or whether other states will act. Critics point out that the existing literature on international macroeconomic policy coordination unrealistically assumes that policymakers all operate on the same model, preferring the Nash bargaining solution to the Nash non-cooperative solution in most cases. The problem with this assumption is that policymakers differ in the models they use. In sum, there are three obstacles to successful international coordination: (1) uncertainty as to the position of the economy, (2) uncertainty as to the correct objective and (3) uncertainty as to the correct model linking policy actions to their effects in the economy.⁵

These concerns about the uncertainty involved in coordination cannot be dismissed, nor should they be. Research has indicated that coordination among policymakers who differ about models is likely to reduce national prosperity, not raise it.⁶ I will argue, however, that uncertainty about the homogeneity of coordinating states with regard to models can be reduced, if not eliminated, with “hard” coordination that excludes discretionary measures. The same applies to uncertainty about the position of the economy. Indeed, I will claim that persistent macroeconomic heterogeneities make coordination necessary in the first place.

1.2 State of the research

The stabilization potential of fiscal policy within the EMU has been the subject of many studies, including Bofinger and Mayer, Enderlein, van Aarle and Garretsen, van Aarle et al. and Hagen and Mundschenk.⁷ Often, such studies use “stabilization games” to examine the interaction between centralized monetary policy and national fiscal policy.⁸

A frequent approach for investigating coordination options uses an economic model to determine dependencies and externalities between policies. In many cases, however, the interdependencies identified depend on the choice of economic model. Dullien developed a model in which monetary policy can influence aggregate demand in a world without real balances by influencing interest rates via changes in short-term interest rates.⁹ On the basis of this model, Dullien finds that the central bank and wage bargainers must work in concert to guarantee stable prices and expanding output. In other words, a policy mix for optimal employment and inflation levels combines stability-oriented wage demands with an expansionary monetary policy.¹⁰ The core assumption of studies in support of coordination is that monetary policy can have (permanent or temporary) effects on output and employment even in a world in which all economic actors behave completely rationally.

One rationale for international policy coordination can be found in game theory.¹¹ The techniques of game theory provide useful tools for analysing the strategic aspects of policy coordination.¹² Researchers identify the benefits of coordination usually by comparing non-cooperative and cooperative strategies. The so-called Cournot–Nash equilibrium serves as the non-cooperative reference point, also known as the disagreement point. The Cournot equilibrium is a special case of the Nash equilibrium. The same applies to the Bertrand equilibrium.¹³ Players seek to provide best responses to maximize their outcome for a given objective by varying their strategies based on the decisions of other players. The Cournot–Nash equilibrium lies at the intersection of the reaction curves but is typically located outside the contract curve, signalling Pareto inefficiency. When players maximize a collective utility function – in other words, when they cooperate – each increases his or her payoff. The position of the equilibrium point on the contract curve depends on the bargaining power of the players. The Stackelberg equilibrium, in which “followers” know what the “leaders” are doing, lies between the non-cooperative Cournot–Nash equilibrium and the cooperation solution. The Stackelberg equilibrium seems particularly suited for the analysis of ECB activity and national fiscal policies, as the EU consists of a leader (the wage bargaining partners) and followers (ECB, fiscal policymakers).¹⁴ The reason why cooperative solutions are Pareto efficient is intuitive: externalities and trade-offs between policies (e.g. monetary and fiscal policies) are internalized through cooperation.

Game theory can be extended to many dynamic situations in real life, especially given the fact that the same game is played every year. In sequential bargaining and repetitive games, the best strategy is shaped over time with a number of refinements, including subgame perfection, open loops and closed loops. This suggests that cooperative solutions are more likely because the lack of cooperation in repetitive situations may be punished with “infinite periods”.

Investigations that rely on game theory usually start with the underlying economic model. For instance, Pusch uses a market constellation model to investigate the interaction of agents and game theory.¹⁵ Like most other investigators, Pusch assumes a working coordination mechanism. He believes that unions will always act strategically and that wage policy coordination will always be possible (though, empirically, this does not hold true for every case). Furthermore, all three agents in his study (central bank, unions, governments) employ an individual utility calculus whose interactions open up many possibilities for game theory. Dullien uses game theory to identify why an optimal policy mix between monetary policy and wage policy fails to materialize.¹⁶ Based on his analysis, he proposes three reasons: (1) coordination problems, (2) a lack of cooperation between European wage bargainers and the central bank and (3) risk-averse central bankers.¹⁷

But game theory has an Achilles’ heel when used as a tool for assessing coordination: its predictions very much depend on the underlying economic model. A game theory model can in principle accommodate uncertainties associated with agent behaviour, but it will have problems taking into consideration uncertainty or ignorance about which economic model to use, as this part of the equation deals with agent payouts. In this respect, the critics of coordination are right to stress the problems caused by uncertainty, especially where game theory is concerned.

1.3 This study’s approach

The purpose of this study is to examine the need for economic policy coordination within the eurozone and describe the form it might take. In contrast to recent research, this study steers clear of a key criticism of economic policy coordination – namely, uncertainty about the underlying economic model. Previous studies all make basic assumptions about the functional relatio...