Fiscal Discipline vs. Structural Reforms in Europe: A Unified Framework Analysis

1. Is Lisbon far from Maastricht?Trade-offs and Complementarities between Fiscal Discipline and Structural Reforms Marco Buti, Werner Roeger, and Alessandro Turrini Fiscal Policy Challenges in Europe Berlin, 22-23 March 2007

2. The issue • Fiscal discipline to ensure macroeconomic stability in EMU → Stability and Growth Pact Structural reforms to raise growth potential and enhance adjustment to stocks → Lisbon agenda • Two opposite views: • “Brussels-Frankfurt (-Washington) consensus”: do both at the same time • “Either or view”: if you do one, you cannot do the other • Can the above views be reconciled in a unified framework for analysis? Can we find the conditions under which Maastricht and Lisbon are complements and those under which they are substitutes? • Aim of the paper: • Develop a simple model • Provide empirical evidence

3. The LiteratureTheoretical arguments • “Brussels – Frankfurt consensus” (Sapir et al. 2004) • Direct budgetary gains of reforms • Back against the wall/ “TINA” (e.g., Bean (1998), Calmfors (2001)) • Fiscal restrictions as signalling device (e.g., Deroose and Turrini (2005)) • “Either/or view”: • Budgetary losses of reforms: direct or indirect, to compensate reform losers (e.g., Razin-Sadka (2002), Beetsma and Debrun (2004)) • Expansionary policy in response to the increase in the output gap generated by reforms in the short-run (e.g., Hughes-Hallett et al. (2004), Fitoussi and Saraceno (2004) • Limited amount of political capital (e.g., Eichengreen and Wyplosz (1998))

4. The LiteratureEvidence • Fiscal discipline on reforms • Helbling, Hakura, and Debrun (2004): ΔCAPB neg. related to labour market reforms, but no impact on product and labour market reforms. CAPB positively related to reforms. Data: 20 OECD countries, 1975-2000. Source: WEO(2004) • Heinemann (2006): ΔCAPB neg. related to labour market reforms, but no impact on product and labour market reforms. CAPB negatively related to labour market reforms. Data: 20 OECD countries, 1975-2000. Source: WEO(2004) • Duval and Elmeskov (2005): change in the CAB not significantly related to an indicator of labour and product market reforms, level of budget balancepositively related. Data: 21 OECD countries, 1985-2003. Source: OECD • Duval (2006): change in the CAB negatively related to an indicator of labour and product market reforms, level positively related. Data: 21 OECD countries, 1985-2003. Source: OECD • Reforms on budget balances • Deroose and Turrini (2005): small deterioration of budgets following labour market reforms, no impact of product market and pension reforms. Data: 14 EU countries, 1971-2002. Source: WEO(2004) and RDBF • Hoeller, Giorno and Van den Noord (2006): an indicator of labour and product market reforms significantly negatively related to primary cyclically-adjusted expenditure. Data: 21 OECD countries, 1985-2003. Source: OECD

5. ModelSet up • Country in a currency union; two periods (today, the future). • Output is determined by supply (Phillips curve) and demand in 1st period • Central bank sets nominal interest rates targeting (euro area) inflation. Credible commitment, conditional on 1st period information. • Long run (2nd period): output is supply determined and equal to potential. • Potential output is positively affected by structural reforms and negatively affected by deficits. • Governments decide about deficits and reforms after inflation expectations are formed

6. ModelBasic equations Aggregate demand Phillips curve Inflation targeting Potential output

7. ModelBasic equations Output (+) (+/-) Government problem Two types of government: Forward looking (high β) Myopic (low β)

8. ModelBasic results Stricter fiscal constraints (a higher γ1) may either increase or reduce structural reforms. Myopia matters: myopic governments give less weight to medium-long term substitution relationship between reforms and fiscal discipline (both good for Y2* , both costly in the short-run) Myopic government Forward-looking government

9. Does Maastricht clash with the Lisbon objectives?Some simulation results

10. Empirical analysisData • Labour market reforms: structural indexes from WEO (2004) • Construction: Average of employment restriction, unemployment benefit replacement rate and benefit duration indexes. Original source: Nickell and Nunziata (2001) • Coverage: 1970-1998, EU-14 excl. EL • Reform indicator: y-o-y change in index> median positive change • Myopia indicator: election in current or forthcoming year

11. Empirical analysisImplementation • Specification : reduced form Reforms = f (fiscal variables, cycle, structural factors, election variables, EMU dummy) Structural factors = country-specific time trends Coefficient of EMU dummy allowed to vary with degree of government myopia • Estimation method: Probit regression

12. Empirical analysisPrima-facie evidence

13. Empirical analysisResults (I)

14. Empirical analysisResults (II)

15. Empirical analysisResults (III) • High debt ratio and lagged output gap positively associated with the probability of reforms • EMU dummy significantly negative (positive) for forward-looking (myopic) governments • EMU dummy significantly different for myopic and forward-looking governments only provided debt is high • Robustness checks: • Structural factors: country specific time ternds vs. fixed effects vs. lagged labour market structural indicator • Specifications eliminating variables likely to be correlated with EMU variable (debt, change in CAPB) • OLS vs. Probit

16. Conclusions and policy implications • The time horizon of governments and the general state of public finances are key in the complementairity/substitution relation between fiscal discipline and reforms • Empirical evidence shows the run up to EMU had a different impact on the reform stance of governments close to or far from elections • The reformed SGP allows for (limited) flexibility in the event of reforms. Implications from the analysis • Early years of EMU: deterioration in budgetary positions and lower reforms. All caused by weak cycle or evidence of increasing myopia? • Would a more lenient application of the SGP to high-debt countries facing elections yield more structural reforms?