The document discusses the interplay between economic cohesion, fiscal austerity, and growth within the EU, highlighting the mechanisms of the excessive deficit procedure (EDP) and its implications for member states. It outlines the history and rules governing EU fiscal policy, particularly around maintaining budget deficits below 3% of GDP, and examines the effects of fiscal policy on economic output and growth. The author argues that economic policy mistakes can lead to long-lasting consequences, emphasizing the need for clarity regarding economic cohesion and policy objectives.

1. Cohesion, austerity and growth:
A helicopter’s view
Paolo Zagaglia
Universit`a di Bologna
September 4, 2019

2. “Words matter very much, Miss Barnes. You should care more
about them, given your profession.”
Frank Underwood, House of Cards

7. Economic cohesion

8. Economic cohesion Economic integration

9. Political approach Functional approach
⇓ ⇓

11. The general idea of economic cohesion:
a) A helps B and asks for nothing in return, either directly or
indirectly
b) A helps B and asks for something in return, either directly or
indirectly
c) all other options in between a) and b)

12. A practical example:
• Road security project in country A, which enjoys no financing,
no hardware or software capabilities
• Country B lends the resources to Country A for the realization
of the project
• Country B produces both the hardware and software, and sells
it country A
=⇒ Economic cohesion between A and B?

13. Economic cohesion?
• self-interest as the main motive for preferences
=⇒ ‘rational’ decision making at the individual level
=⇒ ‘market drive’. . .
• other motives for individual preferences, e.g.:
=⇒ role of social/group preferences
=⇒ role of psychological factors

15. Fiscal austerity:
• multi-year public deficit reduction
• fiscal consolidation over the business cycle
• reduction of ‘structural’ or ‘cyclically-adjusted’ deficit
=⇒ rule-based fiscal austerity in the EU

16. The EU fiscal policy framework:
• Articles 121 and 126 of the Treaty on the Functioning of the
European Union (Maastricth Treaty) provided for fiscal
monitoring in 1992.
• Procedures were further clarified in the Stability and Growth
Pact (SGP) of 1997.
• Subsequent modifications took place in 2005, 2011 and 2013.

17. The key overall point of the EU fiscal framework:
• In April, national governments present 3-year ‘stability’ /
‘convergence’ programmes.
• If the planned or actual budget deficit exceeds 3% of GDP,
the European Commission prepares a report in which it
examines whether the transgression deviation from target
declines, and whether it is small, exceptional and temporary.
• If the EC considers that an excessive deficit exists or may
occur, it addresses an opinion to the ECOFIN Council
• All relevant factors are considered, including the medium-term
economic and budgetary position of the member state.
• The ECOFIN Council votes on whether a deficit is indeed
‘excessive’.

19. The Excessive Deficit Procedure:
• Corrective actions to excessive deficits are spelled out in EDP
recommendations.
• These are usually quantified as changes in the structural
budget balance within clear deadlines.
• In case countries do not follow the recommendations, they can
be sanctioned.
• EMU member states can be required to make a non-interest
bearing deposit consisting of a fixed component of 0.2% of
GDP and a variable component equal to a tenth of the
difference between the deficit and the 3% threshold (with a
combined maximum of 0.5% of GDP).
• In case of persistent non-compliance, the deposit will be
converted into a fine.
• For non-EMU member states, a temporary suspension of
assistance from the Cohesion Fund can be contemplated.

20. Revisions to the EU fiscal policy framework:
• In 2005 the Pact was changed to enhance the economic
rationale underlying the fiscal rules:
• Introduction of a ‘Debt Sustainability Monitor’ report (twice a
year) with a detailed government debt sustainability exercise.
• In 2011, the debt criterion was operationalized and voting
rules on sanctions were changed:
• Countries with debts exceeding 60% of GDP should reduce
their debts by 1/20th of the excess over 60% of GDP each
year.
• In 2013 the ‘Two-Pack’ and the Treaty on Stability,
Coordination and Governance entered into force:
• Countries should establish independent fiscal councils at the
national level.
• Countries should use macroeconomic forecasts produced or
endorsed by an independent body.

21. Summing up:
• The importance of the EDP procedure
• The centrality of the 3%- threshold for government deficits
• Role of the cyclically-adjusted balance at the center of the
analysis.
• Role of macroeconomic forecasts in assessing a country’s
fiscal position.
=⇒ In the technical exercises, long-term forecasts are
independent from short-term forecasts.

22. Estimation of cyclically-adjusted balances:
cyclical comp = semielasticity × output gap (1)
c.a.b. = total budget − cyclical comp (2)

24. Fiscal stance in the euro area

25. Drivers of changes to government balances in the Euro area

26. Contribution to fiscal stance in the Euro area

27. “If, even with the threat of non-participation, a member state is
neither willing nor able to observe the limits for budget deficits
and indebtedness, it is hardly likely that it will make increased
efforts when such a strict sanction is no longer available.”

28. What economic case for the ‘Excessive Deficit Procedure’?
• counterbalancing macroeconomic incentives towards
over-borrowing
* Masson and Melitz (1991), Artis and Winkler (1997),
Pisani-Ferry (1996)
• limiting the ‘political bias’ towards public deficit
* Roubini and Sachs (1989), Corsetti and Roubini (1993)
• achieving coordination between fiscal and monetary policy
* Von Hagen et al. (1993), Artis and Winkler (1997), Mongelli
(1996)
• preventing banking system crises with union-wide effects
* Giovannini and Spaventa (1991), Lemmen (1998)

29. Financial-market discipline hypothesis (Lane, 1993):
• capital markets must be free and open
• information about the borrower’s position must be readily
available
• no bailout is allowed
• the borrower must respond to market signals
• the financial system must be strong enough to sustain the
costs of a default

31. “It’s just money; it’s made up. Pieces of paper with pictures on
it so we don’t have to kill each other just to get something to
eat. It’s not wrong. And it’s certainly no different today than
its ever been. 1637, 1797, 1819, 37, 57, 84, 1901, 07, 29, 1937,
1974, 1987 - Jesus, didn’t that f***** f*** me up good - 92,
97, 2000 and whatever we want to call this. It’s all just the
same thing over and over; we can’t help ourselves.”
John Tuld, Margin Call

33. Three phases in the policy debate:
• pre-2007: business as usual
• 2007-2010: worldwide call for fiscal stimulus to avoid another
Great Depression;
• 2010-2012: shift to fiscal consolidation as high public debt
appeared swelling even more;
• 2012-: with anemic growth, calls for austerity appear to have
fallen out of fashion again.

36. • Non-Keynesian effects of deficit reductions / ‘Expansionary’
fiscal contraction hypothesis
=⇒ Expectations about fiscal policy
=⇒ German view of fiscal consolidation
=⇒ Role of the composition and timing
• Fiscal multipliers:
• are larger during recessions than during expansions
• are contingent on various factors
• exchange rate regime
• monetary policy
• trade linkages

39. IMF forecasts of current and potential GDP for the Euro area

40. bt
yt
=
bt−1
yt−1 + ∆yt
stock
+
pdt + rtbt−1
yt−1 + ∆yt
flow
(3)
∆yt = yt − yt−1 (4)
yt = ¯yt
permanent
+ ˜yt
cyclical
(5)

41. • When designing fiscal policy from an intertemporal
perspective, governments take into consideration forecasts of
both potential output and the output gap.
• If either cyclical or one-off events lead to reductions of
long-term projections of GDP, more contractionary fiscal
policy may be warranted to achieve a public deficit target
today.
=⇒ If multipliers are large, additional fiscal tightening is needed to
reduce a government deficit during a downturn
=⇒ The initial cyclical drop of GDP becomes sustained
=⇒ Drop in cyclical GDP can become drop in permanent GDP
=⇒ Pro-cyclical fiscal policy becomes persistent
=⇒ Policy-induced hysteresis

42. Propagation channel: pessimism in macroeconomic projections in
setting fiscal policy:
• Fiscal policy can have a negative impact on output over a
long horizon.
• Both the cyclical and permanent part of output can be
affected by fiscal policy today over a long horizon.
‘Fiscal policy doom’ hypothesis (Fatas, 2018):
• What if potential output changes after a cyclical downswing?
• Should macroeconomic hysteresis be taken into account?
• Should second-round effects induced by fiscal policy
expectations be taken into account?

43. Forecast Errors for Real GDP

44. Key take-away points:
a) economic policy mistakes can be very costly
a.1) self-inflicted economic pain can last in time
b) think about what ‘economic cohesion’ truly means. . .
c) ‘cycles’ of economic ideas can be fairly disconnected from
‘cycles’ of policy decisions
d) economic policy requires clarity on the final objectives

45. THANK YOU!
Any questions?
Email me at: paolo.zagaglia@unibo.it

46. Appendix I

47. Appendix II

48. Appendix III
Growth dispersion in the Euro area (%)

49. Appendix IV

50. Appendix V
Gross fixed capital formation (Percent of GDP)

51. Appendix VI
Net Gini coefficient (after taxes and transfers), 1960-2015

52. Appendix VII

53. Appendix VIII
GDP per capita growth (% yearly growth, 2018)

54. Appendix IX
GDP per capita growth in EU regions, 2003-2015