Difficulties of One-Dimensional Fiscal Policy in the EMU

Abstract

Membership in the European Economic and Monetary Union (EMU) causes an individual country to lose the possibility to using monetary policy for the stabilization of country-specific shocks, thus leaving fiscal policy as its only remaining instrument. However, fiscal policy is restricted because the member countries receive instructions from the European Commission to coordinate their fiscal policies. In 1993, the Maastricht treaty sets four convergence criteria that must be met by each member country before it can take part in the third stage of the EMU: that is, before it can adopt the common currency, the “EURO.” The convergence criteria are meant to ensure that economic development within the EMU is balanced and does not give rise to any tensions among member countries. One of the convergence criteria was the restrictions on fiscal policy. In our study we focus on the individual national outcome of fiscal policy instructions given to all member countries of the EMU. We show that fiscal policy restrictions affect developing and developed countries differently. We employ a growth model with optimal fiscal policy and the Convergence Hypothesis, to define reasons for the balance between public and private capital in a developed country as well as the different effects of one-dimensional fiscal policy restrictions on developing and developed countries. Then we empirically analyze conditions of public and private capital and their effects on GDP in EMU member countries. Our findings suggest that one-dimensional fiscal policy coordination prevents smooth development of economic growth in the bottom four EMU countries, defined in terms of GDP per capita. We conclude that the bottom four countries have not reached the economic level of the top eight countries; therefore, identical fiscal policy instructions for the entire EMU will lead to disturbances of the capital conditions and economic growth in the bottom four countries.