On the Desirability of Fiscal Constraints in a Monetary Union

The desirability of fiscal constraints in monetary unions depends critically on whether the monetary authority can commit to follow its policies. If it can commit, then debt constraints can only impose costs. If it cannot commit, then fiscal policy has a free-rider problem, and debt constraints may be desirable. This type of free-rider problem is new and arises only because of a time inconsistency problem. ∗The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. In the last decade, the subject of how best to design monetary unions has been attracting more academic interest. A central issue in designing such unions is whether constraints should be imposed on the fiscal policies of the member states. Here we address this question using standard economic models with benevolent policymakers. Our answer is that the desirability of fiscal constraints depends critically on whether the union’s monetary authority can commit to its future policies. If this authority can commit, then fiscal constraints on member states will not increase welfare, but if it cannot commit, then such constraints will increase welfare. The driving force behind our results is that a time inconsistency problem in monetary policy leads to a free-rider problem in fiscal policy. The time inconsistency problem arises because the monetary authority has an incentive to inflate away nominal debt. Without commitment to future policy, a benevolent monetary authority’s optimal policy is to set high inflation rates when the inherited debt levels of the member states are high and low inflation rates when they’re low. The cost of inflation is borne by the residents of all the member states. When a fiscal authority in a member state is deciding how much debt to issue, it recognizes that as it increases its own debt, the monetary authority will increase the inflation rate. The fiscal authority takes account of the costs of the induced inflation on its own residents, but ignores the costs this induced inflation imposes on other member states. This free-rider problem leads to inefficient outcomes, each fiscal authority will issue too much debt, and the inflation rate will be too high. Imposing constraints on the amount of debt that each fiscal authority is allowed to issue can thus make all the member states better off. If some way can be found to solve the monetary union’s time inconsistency problem, then the free-rider problem disappears, and imposing fiscal constraints will typically reduce welfare. In our simple model, the only way to solve the time inconsistency problem is to assume that the monetary authority can commit. In richer models, even without commitment, reputational benefits can solve the time inconsistency problem, eliminate the free-rider problem, and make debt constraints unnecessary and possibly harmful. The idea that groups of various forms, such as members of a monetary union, may have a variety of free-rider problems in either static models or models with commitment is not new. What we find here, though, is new: we identify a new type of free-rider problem, one which arises only because there is a time inconsistency problem. We show that this free-rider problem can be solved by the appropriate choice of fiscal constraints on debt. Moreover, the type of problem we identify is clearly relevant for policy. The logic of how these constraints prevent the problem seems to capture well the arguments made for fiscal constraints by the framers of the agreements which established the European Monetary Union (EMU). We illustrate our results in the simplest possible framework, a reduced-form twoperiod benchmark model. In the first period of this model, fiscal authorities of states in a monetary union issue nominal debt to risk-neutral lenders who live outside the union; in the second period, the union’s monetary authority decides the common inflation rate. We assume that second-period output is a decreasing function of the inflation rate, so that the monetary authority balances the benefits of devaluing nominal debt against the costs of reducing output. The larger the debt the monetary authority inherits, the higher it wants to set the inflation rate and, without some mechanism to prevent that, the higher it sets the inflation rate. Thus, without monetary policy commitment, when one of the fiscal authorities issues more debt, the others are made worse off. This free-rider problem implies that the level of debt in a noncooperative equilibrium is different from that in a cooperative equilibrium. If the monetary authority instead commits to its policies, then the union has no free-rider problem. In the Appendix, we show that the results from our benchmark model do not depend on government default to lenders who live outside the monetary union. We describe a slightly modified model in which governments borrow from their own consumers, and we show that in it results similar to the benchmark’s hold. In this modified model, the monetary authority trades off reduced output from higher inflation against the need for each fiscal authority to raise revenue through distorting taxes. Notice that in both models, the monetary authority trades off the costs of higher inflation against its benefits. In our benchmark model, the benefit of inflation is defaulting on foreign debt. In the modified model, it is reducing the need to levy distorting taxes. Our theory provides a new lens through which to analyze existing monetary unions. The most high-profile union lately, of course, is the EMU, and the most controversial aspect of that union is the fiscal policy constraints embedded in the agreements which set it up, the Maastricht Treaty and the Stability and Growth Pact.