1. Introduction
Ten years after the adoption of the single currency, the status of national fiscal policies
remains an unresolved and controversial issue. On the one hand, fiscal policy is not a shared
competence. On the other hand, the Excessive Deficit Procedure (EDP) rests on the principle
that national budget outcomes are an area of common interest. As implemented by the
Stability and Growth Pact (SGP), it envisages situations where a national government is
requested to make explicit quantitative commitments, which can be specified by the Council,
following recommendations from the Commission. More broadly, within the Stability
programs, each Eurozone country must present each year its intended budget balance to be
reached over the following three years, with the explicit aim of achieving budgets close to
balance or in surplus. These programs must gain Council approval when they are presented
and cannot be subsequently changed unless specific conditions are deemed acceptable. A
country found in violation of its commitments is bound to face increasingly tight requests,
with the possibility of being imposed a fine.
Thus, national fiscal policies belong to a grey zone of potentially constrained sovereignty.
Governments remain fully sovereign in setting the level and detailed composition of their
spending and revenues1 and they can run smaller deficits or larger surpluses than they
committed themselves to. The SGP only deals with the balance and is geared towards limiting
deficits, both absolutely by setting a maximum deficit of 3% of GDP and by aiming at
budgets close to balance or in surplus, and relatively by banning larger deficits or smaller
surpluses than those initially approved.
This grey zone aspect raises important constitutional issues, as was amply illustrated by the
November 2003 Council decision to put the SGP “in abeyance” and by the subsequent
deliberation of the European Court of Justice. The new SGP, adopted in June 2005, has not
addressed this particular issue, which, consequently, remains open. The revision instead
introduced some implementation flexibility, with the aim of preventing economically
inefficient consequences.
This paper starts with the macroeconomics of fiscal policy to evaluate various institutional
arrangements. It argues that limits to budget balance sovereignty need to be carefully
justified. The usual argument in favor of the EDP and the SGP is that fiscal indiscipline by
one or more Eurozone members constitutes a negative externality that threatens price
stability. The basis of this argument can be found in the theory of fiscal dominance, which is
reviewed in Section 2. Whether this argument is strong enough to justify the EDP remains an
unresolved issue. At any rate, even if it is justified, there remains the need to examine how it
can be implemented without excessive economic costs.
To that effect, we evaluate the idea that, to be sustainable, restraints to the countercyclical use
of national fiscal policy must be compensated for by an adequate collective insurance system.
This idea has a long legacy. The desirability of a collective insurance system in a European
Monetary Union was mentioned early on in MacDougall Report (European Commission
1977a, b) and the Delors Report (Delors, 1989) and presented as an extension of the Optimum
Currency Area theory (see, e.g. Wyplosz, 1991). It has given rise to a significant literature,
both theoretical (van Wincoop, 1995; Sorensen and Yosha, 1997; Persson and Tabellini,
1996b; Fatas, 1998; Kletzer and von Hagen, 2001) and empirical (Sala-i-Martin and Sachs,
1991; von Hagen, 1992; Pisani-Ferry, Italianer and Lescure, 1993; Bayoumi and Masson,
1995; von Hagen and Hammond, 1998; Melitz and Zumer, 1999).
1 There exist some limits on the size of taxes like VAT.