FIRSTRUN deliverable 2.6 Enhancing credibility and commitment to fiscal rules has been published today.

Abstract: The objective of this paper is to derive the characteristics of an effective fiscal governance framework, focusing on the incentives that ensure a commitment to the fiscal rules. We study this problem with the use of econometric tools, complementing this analysis with formal modelling through the lens of a dynamic principal-agent framework. Our study shows that both economic and institutional factors play an important role in incentivising countries’ fiscal efforts. Fiscal balances are affected not only by the economic cycle, but, among others, by the level of public debt and the world economic situation. We find that the existence of numerical fiscal rules, their strong legal entrenchment, surveillance mechanisms, and credible sanctions binding the hands of governments have a significant impact on curbing deficits. The relationship between the Commission and European Union (EU) Member States (MS), where the EU authorities act as a collective principal that designs contracts for MS, has elements in common with the assumptions of the principal-agent framework. These are: asymmetry of information, moral hazard, different objectives, and the ability to reward or punish the principal. We use a dynamic principal-agent model and show that to ensure good fiscal performance, indirect benefits should be envisaged for higher levels of fiscal effort. In order to account for the structural differences of exerting effort by different MS, it is efficient to adjust fiscal effort to the level of indebtedness. To ensure a commitment to the rules, MS with difficulties conducting prudent fiscal policies should be required to exert less effort than the MS with more modest levels of debt.

JEL classification: D82, E61, H60

Keywords: Principal-Agent, Moral Hazard, Fiscal Effort, Fiscal Rules, Cyclically-Adjusted Balance

Author:
Grzegorz Poniatowski, CASE

FIRSTRUN deliverable 3.5 “Medium-run impacts of cross-country transfers through a European Union central budget: a general equilibrium evaluation” has been published today.

Abstract
The European Union budget mostly redistributes resources across its member countries. Using a multi-country overlapping-generations model covering 14 European countries, I investigate the macroeconomic and labor market impacts of central budget options, each leading to different transfers between governments. Simulations show that one can shift prosperity from country to country, measured as gross domestic product variations, at no efficiency cost nor efficiency gains, as long as the central budget can be operated for free and net recipient countries use the transfers to stimulate economic activity rather than support household income. Failing these conditions, the net deadweight loss caused by the distortionary nature of taxation can reach 5% to 8% of the size of the central budget. Simulations also show that the economic burden of large, one-time asymmetric shocks can be shared by all members of the union with a limited public finance cost. Chief among policy implications is a recommendation for earmarking cross-country transfers.

Author
Thomas Davoine, IHS

FIRSTRUN deliverable 4.8 “Implementing macroprudential policy in NiGEM” has been published.

Abstract
This is the second of two papers in which we incorporate a macroprudential policy block within the National Institute’s Global Econometric Model, NiGEM. The first paper provided the theoretical background and description of how NiGEM model is expanded to include two macroprudential tools: loan-to-value ratios on mortgage lending and variable bank capital adequacy targets along with a systemic risk index that tracks the likelihood of the occurrence of a banking crisis. This paper starts from the extensions to NiGEM for the UK, Germany and Italy . We then show counterfactual scenarios, including a historic dynamic simulation of the subprime crisis and the endogenous response of policy thereto, based on the macroprudential block as well as performing a cost-benefit analysis of macroprudential policies. Conclusions are drawn relating to use of this tool for prediction and policy analysis, as well as some of the limitations and potential further research.

Authors
Oriol Carreras, NIESR
E. Philip Davis, NIESR and Brunel University
Iana Liadze, NIESR
Rebecca Piggott, NIESR
Ian Hurst, NIESR

FIRSTRUN deliverable 5.2: Formulating and evaluating long-term fiscal rules based on the Medium-Term Budgetary Objective has been published.

Abstract
The paper considers fiscal rules for Finland that are explicitly based on the Medium-Term Budgetary Objective (MTO) and aim at keeping public finances sustainable in the long run. We use a general equilibrium overlapping-generations model to study fiscal rules where consumption taxes are conditioned on observed and forecasted variables related to the MTO. The uncertainties considered include future demographics, productivity, and asset yields. We find that a rule based directly on the ‘implicit liabilities and debt’ part of the MTO keeps public debt at roughly acceptable levels. The rule, however, would work better, especially in timing the measures, if structural deficits would exclude social security funds. We also find that the MTO contains forecast elements that could be left out without essentially weakening the rule. Finally, additional forecast-based information is likely to improve the rule.

Author
Jukka Lassila, ETLA

FIRSTRUN deliverable 5.3 published: Population aging, pensions and cross-country spillovers in currency unions

Abstract:
Population aging challenges the financing of social security systems in developed economies, as the fraction of the population in working age declines. The resulting pressure on capital-labor ratios translates into a pressure on factor prices and production. While European countries all face this challenge, the speed at which their population ages differs, and thus the pressure on capitallabor ratios. If capital markets are integrated, differences in population aging may lead to crosscountry spillovers, as investors freely seek the best returns on capital. Using a multi-country overlapping-generations model covering 14 European Union countries, I quantify spillovers and find that capital market integration leads to redistribution across countries over the long run. For instance, GDP per capita would on average be 2.9 %-points lower in Germany in each of the next 50 years if capital markets were perfectly integrated and increases in labor income taxes maintained public debt constant, compared to a closed economy case; by contrast, GDP per capita would on average be 2.1 %-points higher in France, whose population ages slower than in Germany. I also show that pension reforms can change the cross-country redistribution patterns, some countries losing from capital market integration without the reform but winning with it. The research has policy and methodological implications.

Author:
Thomas Davoine (IHS)