The Economic Rationale of an EMU Fiscal Capacity

This paper explores the economic rationale of an EMU fiscal capacity. It explains that the EMU's architecture suffers from two structural weaknesses: a tendency to develop imbalances and an inherent deflationary bias. The analysis shows that the external imbalances developed during the first decade of the EMU were driven by the large demand shock brought forward by financial integration, rather than by differences in relative competitiveness. Results suggest that when capital flows stopped, the adjustment was significantly driven by an important fall in aggregate demand in deficit countries, with large output and employment gaps. The main leverage of the efforts to regain relative competitiveness was massive labour shedding. In the absence of a common instrument for demand management, the natural tendency towards an asymmetric path of adjustment, between deficit and surplus countries, determines an inevitable deflationary bias in the whole area. A common fiscal capacity should have been designed and linked with the relative (intra-EMU) external positions of the participating countries. This would have reduced external imbalances, periodically correcting them without a drag on aggregate demand; it would have also reduced the need for the system to exclusively rely on financial markets, thus reducing systemic risks; and it would have also provided an instrument for stabilization against common shocks. Its absence has undermined the stability of the monetary union