Making sense of fiscal rules in EMU

In this paper we extend Nordhaus’ (1994) results to an environment which is characterized by a single monetary authority and several fiscal bodies, as is currently the case in Europe in Economic and Monetary Union (EMU). We show two results. First, cooperation among national fiscal authorities is welfare improving only if they also cooperate with the central bank. If this condition is not satisfied, fiscal rules, such as those of the Maastricht Treaty and the Stability and Growth Pact, may work as coordination devices that improve welfare. Second, the fiscal authorities of the small countries participating in EMU will have no incentives to discipline themselves, since each of them faces a vertical monetary authority reaction function. Though it is well known that fiscal authorities free-ride (see, e.g. Uhlig 2002), we prove this conventional wisdom in an original way, namely by using a modified version of the Nordhaus model. We also show that such a conclusion emerges precisely when the other well-established result of the Pareto superiority of fiscal leadership with respect to a non-coordinated (Nash) solution no longer applies (since with a vertical monetary authority reaction function the two equilibria coincide). The resulting policy-mix will therefore be inefficient, unless small countries coordinate their fiscal behaviour. Since that is unlikely, as they are expected to free-ride, we advocate fiscal rules to apply to small countries as well.