Sustainability of Fiscal Policies in the EU and the CEEC

Abstract

The persistently large government deficits, and the resulting accumulation of debt in most developed countries since the mid seventies, raised significant concerns over the existence of long-run constraints on public borrowing, and the economic consequences of fiscal indiscipline. This has been one of the most controversial and discussed economic issues among academics and policymakers during the process towards EMU, and has now been revived with the plans for EU enlargement and, especially, with the recent controversy over the excessive deficit procedure in Germany and France. The discussion over these questions is particularly important in a monetary union for several reasons. On the one hand, a deeper degree of economic and financial integration increases the probability that the effects of unsustainable fiscal policies in one country may spill over to other member states, eventually threatening the stability of the whole union. On the other hand, the complete liberalisation of financial markets, and the elimination of exchange rate risk, increases the internal mobility of goods, services and production factors, raising spending and tax competition and hence restricting national fiscal flexibility. This may be particularly problematic for a highly indebted country, where a significant fraction of public revenues is permanently reserved to debt service, restricting considerably its capacity to implement stabilisation policies and provide sufficient public goods. This could further deteriorate the fiscal situation, by jeopardising growth prospects and diverting the tax base. Despite recent efforts towards fiscal consolidation in most EU and Central and Eastern European countries (CEEC), complying with the Maastricht’s convergence criteria and the Amsterdam’s Stability and Growth Pact, expensive welfare programs and unfunded social security systems, together with an ageing population, can exert considerable strain on public finances over the next generations. The main objective of this section is to investigate whether current fiscal policies are sustainable, that is, able to guarantee the government’s solvency. This question is tested, for those countries where data is available, by examining the long-run univariate and multivariate stochastic properties of the fiscal variables, as implied by the intertemporal budget constraint. For the other countries, most CEEC, data restrictions do not allow the application of such methodology, but a careful observation of recent trends may give some insights on the state and prospects for public finances.