Monetary and Fiscal Policy in Eurozone - Essay Example

Monetary and Fiscal Policy in Eurozone Table of Contents I. Introduction ………………………………………………………………. 3 II. Monetary Policy in the Eurosystem ……………………………………… 3 III. Effects of a Centralized Currency ………………………………………... 4 II. Fiscal Policy Applied in the Eurosystem ………………………………… 4 III. Effects of the Stability and Growth Pact in the Eurozone ……………….. 5 IV. Effects of Decentralized Fiscal Policies with the Eurozone ……………... 6 V. Solution to Fiscal Deficits that Resulted from a Centralized Monetary Policy and Decentralized Fiscal Policies ……………………… 7 VI. Conclusion ……………………………………………………………….. 8 References ………………………………………………………………………... 9 Introduction As of the first quarter of 2007, a total of 13 countries are referred to as the ‘Eurozone’ or the ‘Eurogroup.’ Among the 13 countries are: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Slovenia and Spain.1 In November 2005, Slovenia became the last member of Eurozone.2 The initiative of the European Commission way back in 1969 aims to coordinate the economic policies as well as to set a monetary integration in different countries. Having a European currency is part of the strategy used in a monetary union. It is the European Parliament that is expected to react on certain economic events that arises over time despite the fact that they do not have the authority to implement policies to counter act the effects. Also, the authorities empowered to act on the ECB for monetary policy and the European Commission for the fiscal policy does not have the right to implement some needed policy to make the overall economy better.3 It means that power and responsibility over the economic activities does not come from a political process. The European policy makers who are eager to come up with solutions to economic shocks do not have the power to react and those who have the authority to do so do not have a democratic right to intervene in any economic situation. Monetary Policy in the Eurosystem Each member of the Eurozone has a mutual assurance regarding the stability of the currency. The purpose of having a ‘single currency’ is to enhance a free trade between the members of the Eurozone by promoting the coordination of credit and exchange rate policies.4 In the case of Eurozone, only the European System of Central Banks (ESCB) has the sole authority to create and implement a monetary policy for all the members of Eurozone.5 ESCB is composed of the European Central Bank (ECB), and the Eurozone Central Banks that operates in Euro countries. Effects of a Centralized Currency Since a single currency imposed on the Eurozone countries, they can use only one monetary policy for all. Hence, only one interest rate among all Eurozone countries is allowed. In case of an economic problem, the national government is therefore deprived of using the monetary policy (monetarism) to solve any economic issues. This leaves them the option to control over the fiscal policy instead. Aside from the political issue attached with having a single currency, this strategy can be beneficial for the participating countries in terms of inter-trading opportunities, currency stability and having a transparency in the costs of goods and services.6 Fiscal Policy Applied in the Eurosystem To facilitate and maintain the Economic and Monetary Union among the European Union, each member of the Eurozone signed an agreement called ‘Stability and Growth Pact (SGP).’7 It is basically an agreement regarding the fiscal policy to be used within the eurosystem. The pact was adopted in 1997 stating that all members of the Eurozone must meet the Maastricht convergence criteria. The said criteria include “a yearly budget deficit not higher than 3% of the Gross Domestic Product (GDP); also, the national debt should be limited to lower than 60% of the GDP.”7 The pact is good in the sense that it prevents excessive government deficits and national debts in each euro countries are set to a limit. The purpose of the pact is to control the possible increase in the inflation and interest rates by setting a budget equilibrium and financial stability in each eurozone members. Effects of the Stability and Growth Pact in the Eurozone Despite the good side of the SGP, there are also some aspects that slow down the economic growth in some members of the eurozone. The fact that the pact sets limit in the abilities of the governments to spend in times when the economy of one of the Eurozone members is on the downside hampers the economic growth in some country.8 For example in a situation wherein one of the Eurozone member is experiencing an economic slowdown, its government cannot fully use the option of increasing the government spending in order to create more jobs in order to reduce the huge unemployment rate. (See Figure 1 – Supply and Demand Curve when Government Decreases Government Spending on the GDP below) Automatically, when the government decreases or limit its government spending, the demand for the GDP also decreases. The decrease in demand for GDP decreases the job opportunity for the local citizens. (See Figure 2 – Supply and Demand Curve of a decreased GDP on the employment level on page 6) Because of the limited power the government have in following the SGP, the Keynesian theory of economics is violated wherein each government maximizes the use of fiscal policy in order to maintain a sound and stable economy.9 Another major negative effect of the pact is that it is not applicable in big countries like France and Germany. Back in 2004, the budget deficit in France rose up to more than 3.5 percent of their GDP while Germany had a little more than 3 percent of the GDP. However, it was impossible to punish these two countries because of their influence over a large number of votes on the Council of Ministers 1. The lenient treatment of the council of ministers toward the Germany and France is causing an unequal treatment towards other eurozone members. Effects of a Centralized Monetary Policy and Decentralized Fiscal Policies on Eurozone The effect of a centralized monetary policy and decentralized fiscal policy among the Eurozone countries is a huge fiscal deficit and an enormously increasing ratio of debt to GDP. This is true because of the limited power each government have over the government spending. Failure to create more employment opportunities for their local citizens is creating a high level of unemployment rate and low level on the country’s gross domestic product. This also means that the tax collected with in the country is also limited. In order for them to survive, these government officials would end up borrowing money from the central bank, etc. Aside from the fact that the huge budget deficit will increase the inflation rate in the long run, the accumulated deficits may also cause harm over the purchasing power parity of Euro at the expense of those countries that are economically doing well. In the long run, the value of Euro and its long-term interest rates will have to respond according to the size of its fiscal deficit and the national debt of the Eurozone as a whole. A decentralized fiscal policy applied to the Eurozone countries resulted to a contraction of the tax revenue in case there is a decrease in the GDP due to poor economic performance in any of the 13 members. As of 2005, there are nine out of the 13 Eurozone countries have deficits more than 3.5 percent of the GDP. Among the five euro members are: Hungary (6.5%); Portugal (6.0%); Greece (5.2%); Italy (4.1%); and Czech Republic (3.6%).10 Solution to Fiscal Deficits that Resulted from a Centralized Monetary Policy and Decentralized Fiscal Policies Since the eurozone governments has a limited power to increase the government spending, other fiscal policy control such as setting a much higher tax rate on imported goods can be implemented. Despite the globalization, a higher tariff rate outside the eurozone will trigger the demand for goods within the eurozone members to increase. This will create more job opportunity and a higher tax collection to cover up the ballooning budget deficits. The solution in preventing the fiscal deficit is to have an effective political agreement among the Eurozone countries.11 A structuring in the fiscal policy such as implementing a tighter control over the Stability and Growth Pact should be imposed. On the other hand, the implementation of the Excessive Deficit Regulation has to be more flexible based on the economic development of each country. The huge deficits made the authorities of the European Economic and Monetary Union (EMU) decide on implementing a single currency and independent fiscal policy among the members of Eurozone.12Independent fiscal policy can be used in decreasing the budget deficit by using investment tax credit to offset the temporary increase in the corporate income tax rate. It also means that enforcing a strictly close monitoring on the fiscal and economic performance on each eurozone members could maintain the future economic growth of the euro nations. Based on a report made last October 2006, Eurozone was able to cut down on the public deficit that was really alarming back in 2005. The combined deficit of the first 12-nations fell to 2.3 percent of GDP in 2005 from its 2.7 percent of GDP in 2004.10 However, the combined debt increased from 62.4 to 63.4 percent of GDP. Conclusion There are a lot of economic problems that could arise from having a group of countries that is using only one currency. These economic problems such as high inflation, huge public deficit, the long-term purchasing power parity of euro (€), including the high rate of unemployment can be solved with the proper use of fiscal policy. There is still no officially accepted macroeconomic policy instrument for the Eurozone. Since all the 13 euro nations is being governed by their own government officials, a fiscal discipline and coordination with the use of the fiscal policy is necessary in maintaining a well and sound eurozone economic system. *** End *** References: 1 Wikipedia (2007) ‘Euro’ Retrieved: March 29, 2007 < http://en.wikipedia.org/ > 2 Wikipedia (2007) ‘Eurozone’ Retrieved: March 29, 2007 < http://en.wikipedia.org/ > 3 Fitoussi, JP. (2004) ‘European Parliament – Committee for Economic and Monetary Affairs’ November 2004 Retrieved: March 29, 2007 < http://www.europarl.europa.eu/ > 4 Volcker P. (2003) ‘Monetary Unions: Current and Future’ Single Global Currency Association – A Global Economy Requires a Global Currency Retrieved: March 29, 2007 < http://www.singleglobalcurrency.org/ > 5 Bigpedia (2007) ‘Euro’ Last Updated: January 4, 2007 Retrieved: March 29, 2007 < http://www.bigpedia.com/ > 6 Artis M. (2006) ‘The UK and the Eurozone’ CESifo Economic Studies Retrieved: March 29, 2007 < http://cesifo.oxfordjournals.org/ > 7 Wikipedia (2007) ‘Stability and Growth Pact’ Retrieved: March 29, 2007 < http://en.wikipedia.org/ > 8 Fitoussi, JP. (2004) ‘European Parliament - Reform of the Stability and Growth Pact’ Committee for Economic and Monetary Affairs. April 2004 Retrieved: March 29, 2007 < http://www.europarl.europa.eu/ > 9 Investopedia (2007) ‘Keynesian Economics’ Retrieved: March 29, 2007 < http://www.investopedia.com/ > path: terms 10 AFP (2006 a) ‘EU, Eurozone Deficit Ease in 2005 but Debt Rises’ AFP Business News. October 23, 2006 Retrieved: March 29, 2007 < http://www.turkishpress.com/ > 11 Pisani-Ferry,J. (2002) ‘Fiscal Discipline and Policy Coordination in the Eurozone: Assessment and Proposals’ April 15, 2002 Retrieved: March 29, 2007 < http://ec.europa.eu/ > path: archive 12 Feldstein M. (2005) ‘The Euro and the Stability Pact’ National Bureau of Economic Research. March 30, 2005 Retrieved: March 29, 2007 < http://www.nber.org/ > Read More