The Precarious Fiscal Foundations of EMU

“The European Monetary Union has the appearance of an attempt to create a central bank and a monetary unit that have no corresponding fiscal authority behind them. In the light of this new fiscal approach to the price level, such an attempt appears to carry with it great dangers” (Introduction, p. 1). Sims’s stated purpose is to “outline the fiscal theory of the price level (FTPL) and examine a number of hazards for EMU that the theory brings out” (Introduction, p. 1), concluding that unspecified new fiscal institutions will need to emerge for the union to succeed (Conclusion, p. 13).

Starting from the instantaneous government budget constraint relating real debt growth to the real interest rate and the primary surplus, Sims shows that in the simple case of constant real interest rate ρ and primary surplus τ, the only non-explosive value for real debt b is b = τ/ρ, which rearranges to P = ρB/τ – “the price level is determined by the ratio of nominal government liabilities to the primary surplus” (Section II, pp. 2-3, eqs. 1-6). He stresses this coexists with, but does not replace, the standard money-demand relation P = M/L(r,Y): “neither of these equations stands alone, generally, in determining the price level. Each must be understood as a component of a general equilibrium system” (Section II, p. 3).

“Naive discussions of fiscal policy sometimes, misreading the implications of ‘Ricardian equivalence’, take it to be true that whenever the government issues additional debt, it is implicitly committing itself to raising additional future revenue, in real terms… But in fact the new debt commits the government only to raising additional future revenue in nominal terms.” If markets believe no real backing exists, “the effect is not to make the new debt valueless, but simply to dilute the value of all outstanding nominal debt” – Sims compares this directly to a private company issuing new shares that the market understands will fund non-productive expenditure, which dilutes existing shareholders rather than leaving the stock price unaffected (Section II, p. 3).

Following Leeper (1991), a unique stable path exists when “passive” (Ricardian) fiscal policy – the primary surplus responding more than one-for-one to the level of debt (φ1 > ρ) – is combined with “active” monetary policy (a positive interest-rate response to prices, θ > 0), and, symmetrically, when “active” fiscal policy (φ1 ≤ ρ) is combined with “passive” monetary policy (θ ≤ 0) (Section II, pp. 4-5). The intuition: the government budget constraint is an unstable differential equation in real debt unless the surplus responds sufficiently to debt, while the consumer’s Euler equation is unstable in prices if the interest rate responds positively to prices; “if both these equations…are unstable, the model has no stable solution. If neither is unstable, the model has a continuum of stable solutions and…an indeterminate price level. If just one is unstable, the model has a unique stable solution” (Section II, p. 5).

The more recent literature recognizes that paths on which real balances explode upward or shrink toward a barter equilibrium may not violate transversality or solvency constraints and so can be legitimate additional equilibria; if money is not essential to the economy, “equilibria in which the price level explodes upward while real balances shrink toward zero are usually possible,” potentially rendering the price level indeterminate under active-monetary/passive-fiscal policy (Section II, pp. 5-6). Ruling this out requires “widespread belief in a fiscal commitment to a floor value for the currency” – a backstop policy that redeems government liabilities at a fixed real value if inflation gets high enough: “no amount of ‘commitment’ or ‘credibility’ on the part of the monetary authority can rule out such equilibria,” and crucially, “the credibility of such a ‘backstop’ policy depends on the existence of a fiscal authority that can be seen to be committed to it. A commitment of the central bank to keep monetary policy active cannot by itself remove the indeterminacy” (Section II, p. 6).

Following Benhabib, Schmitt-Grohe, and Uribe (1998), Sims shows that even a policy combination of a fixed interest rate rule with passive fiscal policy can admit a liquidity-trap equilibrium in which prices spiral downward toward zero with the nominal rate stuck at zero, because real balances and government “lending” can grow without bound while private net worth stays bounded, avoiding any transversality violation (Section II, pp. 6-7). But this indeterminacy hinges on the government feeling obliged to tax to back its non-interest-bearing liabilities even as they balloon in real value; and separately, “if fiscal authorities display some money illusion and are therefore slow to cut the nominal primary surplus, fiscal policy could behave more like” an unresponsive (active) rule even while nominally following a passive rule, which can itself trigger a deflationary spiral (Section II, pp. 5-6). The general principle: “active monetary policy generates expansionary pressure by forcing a rise in the real value of high-powered money…But this expansionary pressure can be completely offset by misguided fiscal policy motivated by a desire to absorb ’excess liquidity’ or by sluggish adjustment of fiscal instruments to price declines” (Section II, p. 6).

Discussing why the Federal Reserve did not act more aggressively against deflation in the 1930s, Sims argues that ordinary open-market operations were “pointless” once interest rates hit zero and banks already held large excess reserves; what might have worked – aggressively discounting bank loans to restore confidence in bank solvency – “would clearly have been risky, and would thereby have acquired a fiscal dimension,” since losses on such lending would require “Congressional approval of appropriations to restore Federal Reserve solvency” (Section III, pp. 6-7). He draws the same lesson from two contemporary (1990s) cases: Mexico’s central bank effectively discounted roughly $60 billion in bad loans in 1994 without legislative approval, later triggering “an extended political battle,” while in deflationary Japan, “the central bank has not undertaken any quasi-fiscal actions on its own, as the need for a fiscal component in the resolution has been apparent” (Section III, p. 7).

When U.S. gold reserves shrank rapidly from 1890 to 1894, President Cleveland issued bonds without consulting Congress to buy gold and replenish reserves – “from one point of view, it was simply an open market operation,” but Cleveland’s opponents argued, correctly in Sims’s view, “that while the issuance of the bonds was not directly a purchase of goods and services, it nonetheless imposed fiscal obligations, and Congress was constitutionally charged with deciding such issues” (Section IV, p. 8). Sims’s broader point is that open-market operations always have a fiscal dimension – selling interest-bearing debt to absorb non-interest-bearing liabilities raises current and future interest expense and so requires eventual expenditure cuts or tax increases – and that modern central banks’ routine authority to buy and sell government bonds without case-by-case legislative approval is itself a settled fiscal delegation, not something outside fiscal policy altogether (Section IV, pp. 7-8).

“In simple multicountry extensions of the model…domestic price levels are determined by the ratio of nominal government liabilities to discounted future primary surpluses, and exchange rates are then determined by the ratios of price levels,” with the important twist that if a country borrows in both domestic and foreign currency, fluctuations in its fiscal status are magnified, because it is “the ratio of domestic debt to the primary surplus after dollar interest is subtracted that determines the price level” – so “foreign currency borrowing…acts as leverage in the FTPL relationship” (Section V, pp. 8-9). This opens a fiscal channel for speculative-attack multiple equilibria, distinct from the standard monetary-policy-response channel studied in the international finance literature: Sims suggests that “one aspect of the recent Asian financial crises may be precisely such a mechanism: devaluation can lead to financial distress in large companies or banks and thereby to government bailouts that produce sudden increases in the liabilities of the government” (Section V, p. 9).

The Maastricht fiscal criteria “amount to a commitment that each country individually will follow a passive fiscal policy,” which, combined with an active ECB, gives a locally unique stable price path – but “this policy combination also allows unstable equilibria, in which a self-reinforcing, accelerating inflation wipes out the real value of the money stock while leaving the real value of the stock of interest-bearing debt unchanged. No amount of ‘commitment’ or ‘credibility’ on the part of the monetary authority can rule out such equilibria” (Section VI.1, p. 10). Ruling them out for EMU as a whole requires “widespread belief in a fiscal commitment to a floor value for the currency” – but any single EMU member “might well worry that if it moves first with such a backup tax, it could end up carrying the burden for the rest of Europe,” and it is unclear whether any single, especially smaller, member state “has the fiscal resources to credibly promise such a backup” alone, so the needed commitment “would have to involve coordination, with at least several countries jointly taking on the task,” a political achievement Sims regards as untested and uncertain to materialize quickly if a crisis actually began (Section VI.1, p. 10).

As deflation pushes interest rates toward zero, escaping the trap requires fiscal action that reduces primary surpluses and credibly signals this will persist – but “standard passive fiscal policy,” which Maastricht enshrines, calls for exactly the opposite as the real value of government liabilities rises, so “if the Maastricht rules are taken seriously, they will point in precisely the wrong direction in such a situation” (Section VI.2, p. 10). Sims notes the irony that the “fiscal free rider problem,” normally a weakness of EMU, could here work toward a solution: “even one country that is sufficiently fiscally expansive despite the Maastricht rules, could undo the liquidity trap, with the resultant reversal of deflation benefiting all members of the EMU” – though if the logic behind this exception is not understood, “the need to break the Maastricht rules in this situation could undermine adherence to them more generally” (Section VI.2, p. 11).

An alternative view holds that interest-rate differentials across EMU members, reflecting market-perceived default risk, will substitute for formal fiscal discipline, much as US states (which lack independent monetary policy and have occasionally defaulted) are disciplined by their own borrowing costs. Sims calls this “naive, at least as it applies to the first decade or two after the EMU begins,” because unlike US states, EMU members are sovereign states with recent histories of independent monetary policy and their own central-banking apparatus still intact: “if a country were in such distress that its interest rates rise substantially above those of other EMU members…it seems very likely that it would leave the EMU and restart its independent monetary system,” reviving “the option of gentle, uniform, and partial default via inflationary finance and devaluation” (Section VI.3, p. 12). If markets anticipate this exit option, “rising interest rates on debt will fuel speculation that drives the rates up even faster, increasing fiscal distress further, in a rapid spiral leading to crisis” – a dynamic Sims warns “would likely breed contagion effects in other countries” even from a single such episode (Section VI.3, p. 12).

“Human institutions are never perfect, and it is difficult to predict how they will actually work from their paper constitutions… I think it is unlikely that EMU can long survive with the degree of vagueness and weakness in the associated fiscal structure that currently characterize it. This does not mean, though, that the EMU cannot long survive” – Sims’s point is not that EMU is doomed, but that “fiscal institutions can emerge and adapt as necessary in order that EMU survive,” and that “the EMU is more likely to succeed if those running it have thought carefully about all the ways it might fail,” with the FTPL offered as “a useful tool to deploy in that enterprise” (Conclusion, p. 13).