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