Lecture on Sovereign Risk and the Recent Crisis in the Eurozone (part I)

Question 1

In a monetary union, what does fiscal policy mean?

Answer 1

• The only remaining macroeconomic instrument on national level
• Government borrows in slowdown and pays back on behalf of citizens
• Government acts as substitute to inter-country transfers in case of asymmetric shock

Question 2

What are the problems of fiscal policy?

Answer 2

• Effectiveness of fiscal policy depends on private expectations
• Slow implementations
• Undisciplined fiscal policy results in high public debt which in turn may destabilize economies

Question 3

What is meant with “automatic stabilizers”?

Answer 3

Fiscal policy is spontaneously countercyclical

Question 4

What is meant with discretionary fiscal policy?

Answer 4

A voluntary decision to change tax rates or spending

Question 5

What is the footprint of automatic stabilizers?

Answer 5

Difference between actual and cyclically adjusted budget

Question 6

When should fiscal policy be subjected to some form of coordination?

Answer 6

When fiscal policies are a significant source of externalities

Question 7

What are potential spillover (externalities) channels?

Answer 7

• Trade
• Inflation
• Borrowing costs
• Financial Distress

Question 8

What four spillovers were identified by the founding fathers of the euro?

Answer 8

• Debt monetization would undermine ECB independence
• Heavy public borrowing by one member country is a sign of indiscipline that could trouble the international financial markets.
• A government that accumulates a debt that it can nog longer service must default which causes massive capital outflow, a collapse that would be union-wide in the EMU
• The threat of one member country’s default would so concern all other member goverments that they would feel obliged to bail out the nearly bankrupt government

Question 9

What is the deficit bias?

Answer 9

Deficits allow governments to deliver goods and services today, but
without facing the costs, in effect passing the burden to future
governments or even to future generations

Question 10

The theory of fiscal federalism deals with which question?

Answer 10

At which level of government should policies be conducted?

Question 11

What are two arguments for sharing responsibilites

Answer 11

• Externalities / spillovers
• Increasing returns to scale

Question 12

What are two arguments for retaining sovereignity?

Answer 12

• Heterogeneity of preferences
• Information asymmetries

Question 13

Theory of fiscal federalism does not provide a general answer, what is needed?

Answer 13

Case-by-case approach

Question 14

What is the principle of subsidiarity/

Answer 14

The burden of proof lies with those who argue in favour of sharing sovereign tasks. Unless there is a strong case of increasing returns to scale or externality, the presumption is that decisions remain at the national level.

Question 15

What is the Stability and Growth Pact?

Answer 15

The SGP was meant to avoid excessive deficits, with fines for countries not respecting it. SGP was reformulated in 2005 to avoid its rigidity.

Question 16

The SGP consists of which five elements?

Answer 16

1. Definition of what constitues an ‘excessive deficit’
2. Preventive arm designed to encourage governments to avoid excessive deficits
3. Corrrective arm which prescribes how governments should react to a brech of the deficit limit
4. Procedures designed to embed members country’s budget process within a European Framework
5. Sanctions

Question 17

When are deficits excessive according to the SGP?

Answer 17

When they are above 3 percent of GDP

Question 18

What is the weakness of the deficit treshold?

Answer 18

The existence of automatic stabilizers. when an adverse asymmetric shock occurs, the limit can be breached. At the same time, an adverse shock is just when a fiscal policy expansion is desirable.

Question 19

What does the SGP require regarding the strucutral budget?

Answer 19

It should always be in balance or suplus, meaning that the deficit does not exceed 0.5 per cent of GDP

Question 20

When is the public debt excessive according to SGP?

Answer 20

When it exceeds 60 per cent of GDP

Question 21

Why do many governments exhibit a deficit bias?

Answer 21

Domestic pressure and political expediency

Question 22

What is the Medium-Term Objectgive (MTO)?

Answer 22

The budget balance that countries commit to acheiving within a three-year period. The MTO must be compatible with ‘minimum benchmarks’ established by the European Commission

Question 23

When is the corrective arm aplpied?

Answer 23

When a country does not meet the requirements of the SGP the 3 per cent deficit and 60 per cent debt limits - it is declared in excessive deficit by the Council

Question 24

What happens when recommended course of action by the council is repeatedly not followed?

Answer 24

A sanction procedure is triggered

Question 25

What is EDP?

Answer 25

Excessive Debt Procedure

Question 26

What does the procedure of EDP involve?

Answer 26

Recommendations not orders