Universidade de Aveiro Departamento de Economia, Gestão e Engenharia Industrial. Documentos de Trabalho em Economia Working Papers in Economics

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1 Unvesdade de Aveo Depaameno de Economa, Gesão e Engenhaa Indusal Documenos de Tabalho em Economa Wokng Papes n Economcs Áea Cenífca de Economa E/nº 30/2005 On Pospey and Posey: The Need fo Fscal Dscplne n a Moneay Unon* Casen Deken, Vío Gaspa and Benhad Wnkle *Ths pape was pesened by Vo Gaspa a he Unvesy of Aveo n he semna Inegação Moneáa e Políca Oçamenal na UE on 20 May Submsson of Papes fo Publcaon (Paa submssão de agos paa publcação): Pof. Fancsco Toes (foes@eg.ua.p). Unvesdade de Aveo, DEGEI, Economa, Campus Unvesáo de Sanago Aveo. Pougal.

2 On Pospey and Posey: The Need fo Fscal Dscplne n a Moneay Unon Casen Deken, Vío Gaspa, Benhad Wnkle* *Euopean Cenal Bank, The opnons expessed hee ae hose of he auhos and do no necessaly epesen hose of he Euopean Cenal Bank. We hank Roel Beesma, Buno Gead, Manmohan Kuma, Gudo Tabelln, Haald Uhlg, Fedeck Van de Ploeg and Jügen von Hagen fo commens on vey ealy vesons of hs pape and ou colleagues Loenzo Capello, Foella De Foe, Phlpp Hamann, Ludge Schuknech, Oese Tsan and especally Leopold von Thadden fo vey useful dscussons. We also hank semna pacpans a Dallas, he Euopean Commsson, Havad, he IMF and he ECB as well as an anonymous efeee fo vey helpful suggesons. Fnally we ae gaeful o Pee Galos fo hs asssance and Paca Keans-Endes and Lusa Rey who helped wh edng. The esponsbly fo he emanng eos s ou own.

3 Absac We show how n a Blanchad-Yaa, ovelappng geneaons famewok, pefec subsuably of govenmen bonds n Moneay Unon emps govenmens o explo he enlaged common pool of savngs. In Nash equlbum all govenmens ncease he bond fnanced ansfes o cuen geneaons (pospey effec) a he expense of fuue geneaons (posey effec). The esulng defc bas occus even f one assumes ha befoe Moneay Unon counes had elmnaed he defc bas by desgnng appopae domesc nsuons. The pape povdes a aonale fo an nceased focus on fscal dscplne n Moneay Unon, whou he need o assume mpefec cedbly of exsng Teay povsons o o efe o exeme suaons nvolvng soveegn defaul. We daw on exsng empcal evdence o ague ha he degee of govenmen bond subsuably whn he Euopean Moneay Unon s an ode of magnude lage han n he global economy. JEL classfcaon: D62, E6, E63 Keywods: fscal spllove effecs, common pool, ovelappng geneaons, bond make negaon, fscal dscplne, fscal ules, Euopean Moneay Unon 2

4 Non-echncal summay Budge defcs edsbue wealh and welfae fom fuue o cuen geneaons. In hs pape we dscuss how fnancal negaon assocaed wh Moneay Unon ales govenmens ncenves fo he neempoal dsbuon of govenmen fnancng and hus negeneaonal equy. We sa fom a sandad ovelappng geneaons model and add he assumpon ha democacally eleced govenmens face he empaon of benefng geneaons cuenly alve (pospey) a he expense of fuue geneaons (posey). In a closed economy ( auaky ) a poflgae fscal polcy wll push up nees aes, hus mposng long-em coss on fuue geneaons. In an neempoal se-up a ade-off ases beween he ably of govenmens o affec aggegae expendue n he sho un and advese cowdng-ou effecs wh negave gowh consequences va hghe nees aes n he longe un. We fomally capue hs ade-off by specfyng a govenmen pefeence funcon ncludng cuen ansfes (pospey) and he (negave) equlbum nees ae (posey). The elmnaon of exchange ae sk mpled by Moneay Unon endes govenmen bond makes close o pefec subsues. The hgh degee of euo aea bond yeld convegence and he almos pefec coelaon of euo aea govenmen bond yelds snce he sa of Euopean Moneay Unon n 999 ndcae a lack of any szeable make dscmnaon wh egad o soveegn sk chaacescs of govenmen bonds. We also ague ha empcally he degee of bond make negaon whn he euo aea s an ode of magnude lage han ha of global fnancal makes. The empcal evdence pesened suggess ha he noducon of he euo has had a sgnfcan mpac on fnancng condons fo euo aea govenmens. Govenmen bond make negaon has he effec ha he common nees ae n he moneay Unon ses less n esponse o a sngle govenmen s expansonay fscal polcy han hs couny s domesc nees ae would have esponded n he case of auaky. The eason s ha a govenmen can now daw on he common pool of oal Moneay Unon savngs. Wh educed magnal long-un coss of poflgae fscal polcy, each govenmen has an addonal ncenve o expand s domesc fscal polcy n Moneay Unon. Of couse, each sngle govenmen ealzes ha hs ncenve pevals fo all govenmens and ha he common nees ae wll be deemned by he combned fscal polces of all counes pacpang n he Moneay Unon. The Nash soluon s he equlbum n whch each govenmen s expecaons abou he ohe govenmens fscal polces ae valdaed and n whch, gven hese expecaons, hee s no ncenve o devae fom he chosen fscal sance. 3

5 The Nash equlbum of hs game beween fscal auhoes shows ha Moneay Unon exacebaes he challenge of mananng fscal polces, whch peseve negeneaonal equy. Whou addonal mechansms o fose fscal dscplne, nees aes wll be hghe, deb and defcs lage and fuue geneaons wll lose elave o geneaons bon eale. Ou appoach has wo advanages compaed o exsng models explanng he need fo fscal dscplne n he Euopean Moneay Unon. Fs, he case fo fscal dscplne n ou model does no ely on mpefec cedbly of Teay povsons n he felds of moneay polcy and he fscal polcy famewok. Second, ou case fo fscal dscplne does no have o assume unsusanable developmens n publc fnances, whch ae had o econcle wh models assumng fowad-lookng agens and aonal expecaons. Insead n ou model, he elevan spllove effecs n pefecly negaed bond makes opeae a all mes and povde an addonal song undepnnng fo he need fo fscal dscplne n Moneay Unon based on negeneaonal equy consdeaons. 4

6 As a vey mpoan souce of sengh and secuy, chesh publc ced. One mehod of pesevng s o use as spangly as possble by culvang peace ( and) avodng lkewse he accumulaon of deb, no only by shunnng occasons of expense, bu by vgoous exeons n me of peace o dschage he deb ha was have occasoned, no ungeneously howng upon posey he buhen ha we ouselves ough o bea. Geoge Washngon, Faewell Addess, 796. Inoducon Snce he 970s, mos ndusalzed counes have ecoded pessen budge defcs, leadng o he accumulaon of publc deb o levels unusual fo peaceme. In he comng yeas he challenges fo publc fnances ae exacebaed by he mpac of demogaphcs and n hs conex he queson of negeneaonal equy has come o he foe. In mos Membe Saes of he Euopean Unon susanably of pensons and healh sysems s among he mos pessng challenges callng fo sucual efoms. The benefs assocaed wh sound publc fnances ae geneally ecognzed. Ove he medum o long em budge defcs have a negave mpac on gowh o he level of poenal oupu. Fom a neo-classcal vewpon, pessen budge defcs and he accumulaon of publc deb lead o an ncease n equlbum eal nees aes, cowdng ou of pvae nvesmen and, heefoe, o a lowe capal sock ove me. Avalable empcal evdence seems o confm hese effecs. Fo example, Easely e al. (994), usng a cosssecon sample of moe han 50 counes coveng he peod fom , found a posve, and sascally sgnfcan elaon beween gowh n GDP pe capa, and budge supluses (n pe cen of GDP). Adagna e al. (2004) povde evdence on sgnfcan nees ae effecs of naonal publc deb and defcs fo 6 OECD counes even afe conollng fo he woldwde fscal sance. Budge defcs also edsbue wealh and welfae fom fuue o cuen geneaons. In hs pape we ae concened wh neempoal effecs fom govenmen fnancng and how fnancal negaon assocaed wh Moneay Unon ales govenmens ncenves fo defc spendng. We use an ovelappng geneaon model o consde ssues of negeneaonal buden shang. The basc dea s o ague ha budgeay auhoes face he empaon of benefng geneaons cuenly alve (cuen pospey) a he expense of fuue geneaons (posey). In a closed economy ( auaky ) when he govenmen follows a poflgae polcy hs pushes up nees aes. The long un coss of he polcy pusued ae See Blanchad (985), Bue (988), Wel (987). 5

7 appaen n he nceased level of eal nees aes. In an neempoal se up a ade-off ases beween he ably of govenmens o affec aggegae expendue n he sho un (say, fo sablzaon puposes) and he cowdng ou hough hghe nees aes wh advese effecs on gowh n he longe un. A he naonal level, ules amng a fscal dscplne may be jusfed on he bass of a polcally movaed defc bas (see Pesson and Tabelln, 2000, fo a evew of he elevan agumens). In hs pape, we need no ely on he assumpon of a domesc defc bas n ode o esablsh a case fo fscal dscplne n a Moneay Unon. In an open economy splloves acoss counes ase. In pacula, moneay unfcaon exacebaes he challenge of mananng budgeay dscplne o he exen ha s assocaed wh a close negaon of bond makes. Then he cos of cuen defc fnancng fo ndvdual govenmens, n ems of hghe nees aes, s spead ou ove he whole unon. An eale, closely elaed pape s Beesma and Vemeylen (2003), who emphasze he supply sde of publc deb n a Moneay Unon. An nceased degee of deb subsuably n Moneay Unon leads o a lowe demand fo govenmen bonds. Ths mples a hghe equlbum nees ae. The effec on oveall publc deb ssuance s ambguous and woks va he cenal bank eacon funcon. The auhos show ha he elave shae of Moneay Unon counes deb ssued by govenmens wh pevously moe dependen cenal banks and moe myopc govenmens nceases n Moneay Unon. Ou conbuon follows Beesma and Vemeylen n focusng on mplcaons fom nceased bond make negaon. Howeve, we do no ake accoun of pofolo dvesfcaon effecs n ode o sngle ou he effecs of nceased subsuably of soveegn bonds on govenmens ncenves o ssue. The concepual famewok n ou pape and he elevan economc mechansm follows closely he conbuon by Chang (990) bu uses n he conex of Moneay Unon. The esuls follow fom hee feaues of he model. Fs, he model allows fo depaues fom Rcadan equvalence. Theefoe govenmen fnance has eal effecs. In Chang s model, he depaue fom Rcadan equvalence s mpled by a dscee-me ovelappng geneaons se-up, ognally due o Samuelson (958). Second, hee s full capal mobly acoss counes. In ohe wods govenmen deb makes ae assumed o be pefecly negaed. Thd, naonal govenmens cae abou he welfae of he own naonal consuences and dsegad he welfae of foegnes. Chang agues ha he fs wo condons mply ha hee ae negave splloves assocaed wh domesc expanson hough hghe nees aes. The hd condon means ha, n he absence of appopae supa-naonal nsuons, fscal defcs wll be excessve fom he vewpon of all counes aken ogehe. 6

8 Ou conbuon dffes fom Chang s n wo mpoan aspecs. Fs, nsead of a dscee me se-up we use he connuous-me ovelappng geneaon model of Blanchad and Yaa. Ths allows fo a smple pesenaon of he game among fscal auhoes. In ou seup he game s a smple sac one-sho game. Second, Chang focuses on he wold economy. He saes: In a wold wh nenaonal capal mobly, he fscal defc of any sngle govenmen affecs he wold nees aes and heefoe affecs neempoal esouce allocaon n all counes. We ague nsead ha he agumen s much moe elevan fo moneay unons among soveegn naons (lke he euo aea). The agumen s empcal. Specfcally, we show ha moneay unfcaon s empcally assocaed wh soveegn deb make negaon nsde he unon, whch s an ode of magnude deepe han n he global economy. Ths suggess ha he case fo fscal dscplne nsde Moneay Unon s much songe han he case fo a global concen ove fscal dscplne. In geneal, he need fo supa-naonal fscal dscplne n Moneay Unon s jusfed by he exsence of elevan splloves acoss counes. Boadly speakng hee ae hee man ypes of spllove mechansms menoned n he leaue. One souce of splloves esuls fom he neacon of mulple fscal auhoes wh he sngle moneay polcy. An nceased popensy o buld publc deb s seen o make he ask of moneay polcy o manan pce sably moe dffcul. The second mechansm eles on unsusanable publc fnances wh he pospec of nsolvency pompng a bal-ou by ohe govenmens (ehe on polcal gounds o on feas of he sysemc fall-ou fom a soveegn boowe defaul). Fnally, he hd ype of agumen, whch s also he appoach aken n ou model, nvolves fscal-fscal splloves n Moneay Unon, whch lead o hghe eal nees aes and a wosenng of any pe-exsng domesc defc bas. 2 The emande of he pape s oganzed as follows: Secon 2 dscusses some ecen evdence on he negaon of bond makes n he euo aea. Dawng on evdence fom Baele e al. (2004) and Cappello e al (2003) we ague ha he elmnaon of exchange ae sk n Moneay Unon, ogehe wh pogess owads he sngle Euopean make, nceasngly allows govenmens o consde euo aea savngs as a common pool when ssung publc deb. Usng non-euo aea counes as conols we ae able o show ha he degee of negaon eached nsde he euo aea s much deepe han a he global level. 2 See, fo example, Beesma (200) o Ongena and Wnkle (200) fo a evew. Uhlg (2003) pesens a model based on he hd mechansm. In he dscusson Gaspa (2003) oulnes he appoach followed n ou pape. 7

9 In Secon 3 we noduce a sandad wok-hose n macoeconomcs he Blanchad-Yaa connuous me ovelappng geneaons model wh govenmen bonds as he sngle sae vaable. Ths allows o capue he ade-off a fscal polcy make faces beween cuen and fuue geneaons welfae. The ade-off occus because he govenmen has he powe o gan ansfes o cuen geneaons o he demen of fuue geneaons, who wll have o shae he buden of hghe axes. We skech how he govenmen balances he pospey of cuen wh he welfae of poseo geneaons. Thus he model can be used o llusae he possbly of a polcal-economy domesc defc bas n an negeneaonal famewok, whch would hen be exacebaed by splloves asng n a Moneay Unon. In Secon 4 we ague ha due o he negaon of bond makes n a Moneay Unon, govenmens ae lkely o face a common pool poblem. Specfcally, n Moneay Unon hee s an mpoan fscal-fscal spllove assocaed wh he negaon of bond makes. When a govenmen engages n expansonay ansfes, benefng cuen geneaons, affecs he nees ae less han would have n a closed economy. Ths weake effec lowes he (domesc) coss of fscal poflgacy. The (sac) Nash soluon shows ha he noducon of a Moneay Unon ceaes a defc bas even f dd no exs n he closed economy (and wosens an exsng defc bas). Secon 5 concludes. 2. The negaon of euo aea bond makes In hs secon we pesen some evdence on he degee of negaon of bond makes n he euo aea. The evdence pesened suppos ou clam ha afe he even of Euopean Moneay Unon (EMU) euo aea savngs can be consdeed as a common pool by euo aea govenmens, when ssung he deb secues. The degee of negaon of euo aea bond makes, alhough no pefec, s of a scale no compaable o nenaonal negaon of bond makes elsewhee. Thus we ague ha ove and above he moe genealsed end owads globalsed fnancal makes, he noducon of he euo has had a sgnfcan mpac on fnancng condons fo euo aea govenmens. Euo aea bond make negaon n ou vew has eached a level, a whch he common pool spllove exposed n Secon 4 s of sgnfcan concen. I s possble o magne mulple easons jusfyng a lnk beween moneay unfcaon and fnancal negaon. Such lnks ae no decly addessed n he eal (non-moneay) model 8

10 pesened n secons 3 and 4. Fo he agumen pu fowad n hs pape, he pecse deemnans of bond make negaon, leadng o hgh subsuably among soveegn bonds, ae no mpoan. Wha s mpoan s ha govenmen bonds ae egaded as pefec (suffcenly close) subsues n pofolos. An obvous lnk beween moneay unfcaon and bond make negaon s povded by he mpac of exchange ae sk, and ohe depaues fom uncoveed nees ae pay. Godon and Gaspa (200) pesen an example whee bonds povde a hedge agans domesc nflaon sk befoe moneay unfcaon, nducng a home bas n bond pofolos. In he seng he bas s elmnaed afe moneay unfcaon and bonds nsde he sngle cuency aea become pefec subsues 3. Fgue : Yeld spead fo 0-yea govenmen bonds elave o Gemany Yeld n % Jan-93 - May-93 Sep-93 Jan-94 May-94 Sep-94 Jan-95 May-95 Sep-95 Jan-96 May-96 Sep-96 Jan-97 May-97 Sep-97 Jan-98 May-98 Sep-98 Jan-99 May-99 Sep-99 Jan-00 May-00 Sep-00 Jan-0 May-0 Sep-0 Jan-02 May-02 Sep-02 Jan-03 May-03 Souce: Baele e al. (2004, p. 50, Cha 5.) Ausa B e lg u m Fnland Fance Geece Ieland Ialy Nehelands Pougal Span Fgue aken fom Baele e al. (2004) depcs he declne n nomnal yeld speads of euo aea counes wh espec o Geman govenmen bonds. The skng declne of speads owads he vcny of zeo by May fo all counes excep Geece (whch adoped he euo n Januay 200) suggess ha nees ae dffeenals elaed o expeced exchange ae depecaon wh espec o he DM (possbly ogehe wh an exchange ae sk pemum) seem o have domnaed speads of euo aea counes. The exchange ae sk seems no o have been ansfomed no dosyncac defaul sk n EMU. Ths suggess ha make 3 Moneay Unon has also been assocaed wh a numbe of mpoan egulaoy changes. Fo example he elmnaon of exchange ae sk made bonds ssues by soveegn boowes, n he euo aea, equvalen fom he vewpon of nvesmen aos of penson funds and ohe fnancal nsuons. 4 Noe ha on 3 May 998, he pocedue fo deemnng he evocable conveson aes fo he euo was announced. I was decded ha he conveson aes would be based on he ERM blaeal cenal aes. 9

11 dscplne could no be much eled upon o guaanee fscal dscplne n a Moneay Unon as ecognsed n he debaes abou how bes o ensue budgeay dscplne n EMU 5. Anohe neesng pece of evdence fom Baele e al. (2004) whch suppos ou common pool assumpon egads he asse shae of bond make funds nvesng Euope-wde, whch has nceased damacally snce 999. Fgue 2: Aveage shae of bond funds wh Euopean o global nvesmen saeges 70% 60% 50% Asse Shae of Euopean-Wde Invesng Bond Make Funds 40% 30% 20% 0% 0% Asse Shae of Globally Invesng Bond Make Funds Souce: Baele e al. (2004, p. 72, Cha 6.9) As depced n Fgue 2, he asse shae of Euopean-wde nvesng funds nceased fom abou 20% n 998 o above 60% n 2002 manly a he expense of naonally oened bond make funds. A he same me he shae of globally nvesng bond make funds also declned fom abou 30% o jus below 20%. The lae developmen suppos ou clam ha 5 Fo example he Delos Repo (Commee fo he Sudy of Economc and Moneay Unon, 989) saed (page 24): ( ) expeence suggess ha make pecepons do no necessaly povde song and compellng sgnals and ha access o a lage capal make may, fo some me, faclae he fnancng of economc mbalances. Rahe han leadng o a gadual adapaon of boowng coss, make vews abou he cedwohness of offcal boowes end o change abuply and esul n he closue of access o make fnancng. The consans mposed by make foces mgh ehe be oo slow and weak o oo sudden and dsupve. Hence counes would have o accep ha shang a common make and a sngle cuency aea mposed polcy consans. In a companon pece Lamfalussy (989) eeaes ha hee s eason o be scepcal abou he adequacy of sancons mposed by he make mechansm. Fo empcal evdence and fuhe dscusson see Resoy (996) and Benoh e al. (2004), who examne he evoluon of soveegn sk pema beween 99 and See also he small effecs of soveegn defaul sk found n Codogno e al. (2003) and Poes (2003). 0

12 he bond make negaon n he euo aea s lkely o be a dsnc developmen fom he geneal globalsaon of fnancal makes. Neveheless, he queson whehe he negaon pocess n Euopean bond makes has a paallel n he globalsaon of bond makes a he wold level deseves fuhe nvesgaon. Fuhe evdence pesened n Fgues 3, 4 and 5 suppos ou vew ha negaon nsde he euo aea s much songe and deepe han ha pevalng a he global level and s closely assocaed wh he pocess of moneay unfcaon. Fgue 3: 0-yea govenmen bond yelds 8 Yeld Sep-92 Sep-93 Sep-94 Sep-95 Sep-96 Sep-97 Sep-98 Tme Sep-99 Sep-00 Sep-0 Sep-02 Sep-03 Ausa Belgum Fnland Fance Gemany Geece Ieland Ialy Nehelands Pougal Span Ausala Canada Czech Republc Denmak Japan New Zealand Noway Sweden Swzeland Uned Kngdom Uned Saes Souce: Daaseam, daly obsevaons. Fgue 3 plos he 0-yea bond yelds fo weny-wo OECD counes (eleven fom he euo aea Luxemboug s no ncluded and eleven non-euo aea counes). The daa dffes fom Fgue because n ha fgue dffeenals o Geman bonds ae shown, whle Fgue 3 s pesened n levels. I s obvous fom Fgue 3 ha euo aea counes cluse closely ogehe. The pon s made moe pecse n Fgue 4 whch plos he sandad devaon of 0 yea bond yelds n he euo aea.

13 Fgue 4: Coss seconal dspeson (SD) fo 0-yea mauy govenmens bonds SD 2.5 SD Euo aea SD Euo aea whou Geece SD OECD-Euo aea Sep-92 Ma-93 Sep-93 Ma-94 Sep-94 Ma-95 Sep-95 Ma-96 Sep-96 Ma-97 Sep-97 Ma-98 Souce: Daaseam, daly obsevaons. Sep-98 Tme Ma-99 Sep-99 Ma-00 Sep-00 Ma-0 Sep-0 Ma-02 Sep-02 Ma-03 Sep-03 I s clea ha yeld dspeson dmnshed apdly n he un-up o moneay unon and now sands a vey low levels. The declne became ponounced fom 995 and snce 999 seems o have sablsed a vey low levels. The same dd no happen n non-euo aea OECD counes, whee he dspeson of bond yelds emaned ahe fla n he las decade. Some ecen papes ae elevan fo a deepe look a he ssue of euo aea vesus global bond make negaon 6. Fo he es of he secon we follow Capello, Engle and Shephad (2003). In hs pape he auhos look a changes ove me n coelaon paens acoss nenaonal asse makes. They fnd sgnfcan changes assocaed wh he noducon of he euo. Specfcally hey fnd song evdence of sucual beaks n condonal coelaons. Fo bond makes nsde he euo aea hey fnd ha bond euns became vually pefecly coelaed aleady 5 weeks befoe he sa of EMU. Eve snce he coelaon has always emaned above 0.96 (see Fgue 5). The same dd no happen fo he Euopean counes no pacpang n he Moneay Unon. Coelaon sayed bascally unchanged. The same holds ue fo Noh Ameca,.e. he coelaon beween Canada and he US (see Fgue 5). 6 Includng Keaney and Po (2004), Sknz and Refenes (2004), Beben and Jansen (2004) Chsansen (2004), Keme, Pesan and Sauch (2004) and Capello, Engle and Shephad (2003). 2

14 Fgue 5: Aveage bond coelaon fo he hee goups of counes Souce: Capello e al (2003, p. 56) 3

15 The auhos also epo on he bond eun coelaon beween he euo aea, he emande of Euope and Noh Ameca 7. They fnd ha coelaons beween he euo aea and he es of he wold also have nceased snce he sa of Moneay Unon (see Fgue 6.) Howeve he magnude of he coelaon s que dffeen. Even nsde Euope beween he euo aea and ohe Euopean counes he coelaon s abou 0.7. Beween each of he wo goups of Euopean counes, on he one hand, and Noh Ameca on he ohe, he coelaon s much lowe, n he ange of 0.3 o 0.4. We conclude ha he evdence shows ha a) bond make negaon has nceased makedly n he euo aea. In pacula, hee s a song lnk beween soveegn deb make negaon and moneay unfcaon n 999. By conas, b) compaable ends a global level (f hey exs) ae much less ponounced. In any case he degee of negaon acheved nsde he euo aea s much geae han obseved n he global economy (even when consdeng only OECD counes). 8 We beleve ha he empcal evdence above s suffcenly song o movae applyng he heoecal model pesened n he followng secons o he case of Euopean Moneay Unon. In hs ven, Beesma (200) n he fs nsance lnks he spllove effec fom fscal polcy, hough he accumulaon of publc deb, o an ncease n wold eal nees aes. Theefoe he agues ha, fom a concepual vewpon, he nees ae effec s no lnked o moneay unon pe se. Neveheless, he ecognses ha n a wold whee soveegn bonds ae no pefec subsues s lkely ha moneay unfcaon would ncease he subsuably of bonds ssued by pacpang counes. The empcal evdence we pesen povdes a suffcenly song lnk beween moneay unon and bond make negaon o jusfy eang he savngs n Moneay Unon as a common pool as we assume n secon 4 of hs pape. 7 The counes nclude n he sample used ae Ausa, Belgum, Fance, Gemany, Ieland and he Nehelands, fo he euo aea; Denmak, Sweden, Swzeland and he Uned Kngdom, fo he es of Euope; Canada and he US fo Noh Ameca. 8 An enely dffeen hypohess would be ha nsead of moneay unfcaon s ahe he exsence of he Sably and Gowh Pac, whch by makng soveegn defaul vey unlkely, mgh be esponsble fo he vey hgh coelaon of euo aea govenmen bond euns. We do no egad hs agumen as convncng. Fs, he SGP bnds also EU Membe Saes ousde he euo aea, whee we do no see hs ncease n eun coelaon. Second, pas dffcul epsodes wh egad o he mplemenaon of he SGP have no wdened speads sgnfcanly and dd no educe coelaons. 4

16 Fgue 6: Bond eun coelaon beween he EMU, he es of Euope, and Noh Ameca Souce: Capello e al (2003, p.55) 5

17 3. The Blanchad-Yaa model: he ade-off We use he sandad Blanchad-Yaa connuous ovelappng geneaons model wh nfnely lved agens (Wel, 987) wh govenmen deb and whou capal and money. Each momen n me he gowh ae of he populaon s n. Newbons ae dsconneced fom cuen membes of he populaon by he fac ha hey ae bon wh no fnancal wealh and nally sa consumng only due o he posve endowmen. Each ndvdual of geneaon [x] wll face he followng maxmsaon poblem. () max c s [x], s= - ln ( cs [x]) e θ (s-) ds (2) s.. b& [x] = s s b s [x] + y τ s c s [x] The ndex ndcaes me and he squae backes gve he bh dae of an ndvdual o denfy hs/he geneaon. Real consumpon s denoed c and eal govenmen bonds ae b. θ s he ae of me pefeence, whle sands fo he eal nees ae. Real non-nees ncome, a consan endowmen, s denoed y and eal lump sum axes by τ. New geneaons ae bon wh zeo non-human wealh, whch s efleced by he fac ha fnancal wealh s accumulang a ae and no -n n he dffeenal equaon fo he sae vaable b n equaon (2). The ndvdual consumpon funcon, deved fom he fs ode condons, s depced n equaon (3) 9. Agens consume wh popensy θ ou of he oal wealh, conssng of fnancal and human wealh, h. (3) c [x] = θ [b [x] + h ] whee human wealh s defned as he pesen value of endowmen eceps ne of axes. s u du u (4) h y s e = = ( τ ) ds s= 9 The neempoal elascy of subsuon of wll no esc he genealy of he esuls, as he focus wll be on he seady sae and no on he anson pahs (Fsche 979, Cohen 985). 6

18 Human capal n each pon n me s he same fo each geneaon alve, whch s why h does no need a [x] n equaon (3). Equaon (5) mmedaely follows fom he fs ode condons and descbes he behavo of ndvdual consumpon ove me. A posve dffeence beween he eal nees ae and he ae of me pefeence encouages people o buy govenmen bonds a ealy sages of he lves o affod a sng consumpon seam ove me. (5) c& [ x] =( -θ ) c[ x ] Equaon (6) shows he pocedue o deve aggegae pe capa values. Ths pocedue s necessay because dffeen geneaons wll have accumulaed dffeen amouns of fnancal wealh and hus wll have dffeen levels of consumpon. Populaon s gowng a ae n. 0 The oal populaon sze n peod s e n hus he populaons sze n peod 0 was. The sze of a geneaon bon n peod x s n e nx. Each vaable s fs summed up ove all geneaons as x s unnng fom peod 0 unl oday and he sum s hen dvded by he cuen populaon sze. Capal lees denoe hese ansfomed vaables,.e. eal aggegae pe capa vaables. (6) Q = q [x]ne x=0 e n nx dx Equaon (7) descbes he dynamcs of aggegae pe capa consumpon on he opmal pah. Noe ha he second em on he gh hand sde of equaon (7) s he dffeence o he dynamcs of ndvdual consumpon n equaon (5). I s explaned by he fac ha newbons (n) consume θ B less han he ohe geneaons alve, as hey do no ye own any govenmen bonds. (7) C& =( -θ )C - nθ B As Y s consan and govenmen (non-nees) expendues ae zeo, C mus be pemanenly consan also on he anson pah o a new seady sae. Thus equaon (7) wll deemne he nees ae fo a gven sze of he economy and sock of govenmen deb. We noduce a ax eacon funcon as specfed n equaon (8), whch means ha he govenmen can decde on a pemanen, lump sum ansfe paymen of he sze z (z 0). In 7

19 ode o peven eal pe capa deb fom volang he ansvesaly condon, axes wll be nceased a ae β wh he gowng sock of govenmen deb. Ths ules ou deb susanably ssues n ou model. (8) T = β B z Noe ha axes ae lump sum hus do no depend on ndvdual holdngs of govenmen bonds, bu only on he aggegae pe capa level of govenmen bonds. Afe nseng he ax funcon no he equaon descbng govenmen deb dynamcs, he model can hen be fully descbed by equaons (9)-(). θ n (9) = θ + B C & (0) B = ( n β ) B z + () Y = C Assumng n < β < n seady sae s a necessay and suffcen condon o have a posve seady sae deb level when z>0. Equaon (9) eveals ha assumng θ>n wll make sue ha we ae only dealng wh dynamcally effcen equlbum. Fgue 7 shows he phase dagam fo he model (9)-() n /B space. The upwad slopng sagh lne s equaon (9) whle he B demacaon lne deved fom (0) s gven n (2). z (2) B& = 0 : = β + n B Thee could exs wo equlba. The fs one (e.g. pon D) s sable, whle he second one (e.g. pon B) s unsable. We do esc ou aenon o he fs equlbum, whee equaon (9) also epesens he adjusmen pah. Thee exss a maxmum value fo he ansfe z, whch s assocaed wh equlbum pon C, n whch he nees ae would each s maxmum level of ( β + n + θ ) / 2. A fscal polcy wh no ansfes,.e. z=0, would lead o 0 Noe ha he esuls would also go hough fo a consan o even shnkng populaon, f a non-zeo deah ae was noduced n he model. All ha s scly needed s a posve bh ae. See Blanchad 985, p. 240 who uses hs ax funcon wh a consan nees ae veson of hs model. 8

20 equlbum n pon A, wh no deb and he nees ae equal o he ae of me pefeence. Pon D depcs some equlbum fo 0<z<z max. Fgue 7: The phase dagam =θ+θ nb /C β+n db=0; 0<z<z max B C db=0; z=z max (β+n+θ)/2 A D θ A 0 B Fo he sake of smplcy we assume ha he paamee of he ax eacon funcon, β, s gven 2, so ha z s eally he only conol vaable fo he govenmen. The govenmen hen faces a ade-off beween pospey and posey n he followng sense. A posve and pemanen ansfe, z, whch s fnanced by accumulang deb, edsbues wealh fom fuue o cuen geneaons. In seady sae he ne (of ax) wealh of he aggegae pe capa sock of govenmen deb s B-T/. The lae s posve as long as new geneaons ene he economy. Moe pecsely he conbuon o seady sae ne wealh semmng fom govenmen deb o geneaons cuenly alve s nb/ o wh ou fscal 2 The pupose s o keep he govenmen decson poblem one-dmensonal. As we aleady excluded on pupose he ssue of publc solvency, no allowng he govenmen o manpulae he mng of deb epaymen should no affec he esuls n any qualave sense. 9

21 polcy egme zn/[(β+n-)]. Govenmen bonds ae ne wealh o hose who hold hem, as fuue geneaons wll have o shae he ax buden o fnance he deb 3. To see exacly how he edsbuon of wealh fom fuue o cuen geneaons woks when z s nceased, consde an nal suaon a pon A n Fgue 7 whee no ansfes ake place and s equal o he ae of me pefeence θ. Defne me =v he momen n me whee he govenmen noduces a fscal egme accodng o he ax ule (8) and decdes on a posve ansfe 0<z<z max. All geneaons cuenly alve - ncludng he geneaon bon n =v - ae exacly equal n ems of he consumpon and savng pofle. As equaon (3) also holds n aggegae pe capa vaables and he smulaneous ssuance of govenmen bonds does no ye gve se o a posve wealh effec, aggegae pe capa consumpon s puely deemned by human wealh,.e. C v = θ H v. As aggegae pe capa consumpon C mus always equal Y follows ha H v emans also consan. Thus fo all geneaons alve a he me of he change n polcy =v he posve ansfe polcy has no effec on he human wealh. The eason s ha he nfne seam of cuen and fuue ansfe paymens s exacly compensaed by hghe fuue ax paymens and hghe fuue nees aes. Geneaons alve a me v use all he ansfe eceps n peod v o buy he govenmen bonds ssued o fnance he ansfe. The ncenve o save he ansfe s due o he fac ha nsananeously exceeds θ. Fom me v onwads consumpon of all geneaons alve ses a he ae -θ, accodng o equaon (5). Gven ha C s a consan and newbons n >v do nally no own any govenmen bonds as opposed o pevous geneaons, mples ha newbon geneaons a me >v have an nal consumpon level a bh, whch s less han Y. Fuhemoe, he nal consumpon level a bh of geneaons bon afe me v s declnng, as depced n Fgue 8. Fgue 8 shows he consumpon level pahs of geneaons bon a abay pons n me,.e. v (and befoe), v+, v+2 and v+j. As shown above, human capal emaned consan n me v. Theeafe human capal wll shnk as axes and nees aes ae connuously nceasng wh he level of aggegae pe capa bonds on he pah o he new seady sae (see adjusmen pah n Fgue 7). To compae he exemes, noe ha human capal fo a geneaon bon a me v (o befoe) as of me v (o befoe) s Y/θ. Human capal fo a geneaon bon n he new seady sae wh a n y z β + n posve z, say a me v+j n Fgue 8 s, whee s hen he hghe new 3 See Blanchad (985), Bue (988) and Wel (989). See Deken (999) fo negeneaonal dsbuon effecs n hs model n he pesence of a cenal bank monesng pa of he govenmen deb. 20

22 seady sae nees ae. Ths compose em s less han Y/θ as we ae n a dynamcally effcen economy whee >n. Fgue 8: The negeneaonal consumpon pofles 4 c C v =Y=θ h v θ h v+ θ h v+2 θ h v+j v v+ v+2 v+j Noe ha he pesen dscouned value of consumpon of a geneaon bon n peod s smply s= s s ( θ ) c [ ] c [ ] e u du u du u = u e = ds =, hus equal o s consumpon a bh θ dvded by θ. I follows ha he pesen value of consumpon of geneaons bon up o (and ncludng) he peod of he noducon of he ansfe sysem = v, emans unchanged a Y/θ, despe he noducon of posve ansfes. Bu lfeme uly of hese geneaons afe noducng he ansfe sysem s clealy hghe han befoe, due o he effec ha consumpon s now on an eve nceasng pah. The hghe consumpon pah and nceased uly of cuen geneaons s acheved a he cos of lowe consumpon and lowe uly of fuue geneaons. The annex poves ha he lowe nal consumpon level a bh of geneaons bon n he new seady sae - n Fgue 8 possbly depced by he consumpon pah sang n peod v+j - anslaes no lowe uly fo hese geneaons han he uly of geneaons lvng foeve n a fscal egme 2

23 whou ansfes (despe he fac ha he consumpon pah sang n v+j s sng foeve). Havng hus shown ha he uly of geneaons cuenly alve nceases, whle he uly of geneaons bon n he new seady sae deceases wh espec o he suaon of no fscal ansfes, suggess ha hee s some geneaon bon a >v whch s ndffeen o he noducon of he ansfe polcy egme. All geneaons befoe hs beak-even geneaon would pof whle followng geneaons would suffe a loss n uly. The ax adjusmen paamee β deemnes how soon he beak-even geneaon wll see he lgh of day he fase he ax adjusmen (he hghe β), he fewe ye unbon geneaons wll pof fom he noducon of a fscal ansfe egme. As he ae of ncease of consumpon depends on -θ, follows ha geneaons cuenly alve would pefe ha he govenmen comms self o a pemanen ansfe polcy wh z as lage as possble. The vas majoy of fuue geneaons nsead would nsead pefe no pevously nsalled ansfe sysem n ode o mnmse he nheed ax buden assocaed wh he publc deb. Noe ha n a complee model wh capal, he lowe nees ae assocaed wh lowe deb would be anslaed no hghe seady sae pe capa consumpon, a hghe pe capa capal sock and hghe wages, whch enfoces hs lne of easonng. Keepng ack of connuous geneaons welfae n he Blanchad/Yaa model s a cumbesome execse. To smplfy maes we assume a govenmen pefeence funcon, whch capues hs ade-off beween cuen and fuue geneaons n an ad hoc way. The ade-off beween cuen and fuue geneaons s peennal boh n economcs and n polcs. In ou se up s naual o hnk of he auhoes aemp o ansfe esouces o he geneaons cuenly alve as epesened by z whle he longe un coss ae epesened by he seady sae level of nees aes,. The sze of z (pospey effec) and he sze of (posey effec) appoxmae he ade-off a polcy make faces beween cuen and fuue geneaons welfae. We smply assume govenmen pefeences can be descbed by equaon (3), whee α s he wegh gven o hose geneaons pofng fom a ansfe polcy z, and (-α) he wegh o hose fuue geneaons fo whom lowe seady sae nees aes ae moe mpoan. (3) U = α z ( α) 2 4 Noe ha he populaon shae weghed sum of all geneaons consumpon a any pon n me n Fgue 8 equals C. 22

24 The pacula shape of (3) s abay. Bu any funcon whch s well-behaved n he agumens z and would do fo ou puposes. 5 One mgh ague ha n he eal wold he wegh α wll be vey lage, as govenmens ae nclned o gve much moe wegh o cuen geneaons, whch ae he cuen voes. Ths would gve se o wha has been labelled he defc bas of democaces n he polcal economy leaue. Whou loss of genealy we wll assume ha n he closed economy (auaky) case, naonal nsuons have been devsed n such a way as o pefecly deal wh he defc bas poblem so ha each geneaon s eaed alke. Ths assumpon makes he esuls pesened below concenng he negave ncenve fo fscal laxy n a Moneay Unon songe. We wll show ha he even of Moneay Unon would no only wosen any exsng defc bas, bu ha would deeoae he oveall fscal oucome even f naonal nsuons had been devsed opmally o deal wh he naonal defc bases befoe Moneay Unon. Maxmsng (3) wh espec o afe subsung z by usng (9) and (2) one deves he opmal seady sae nees ae n a closed economy ( auaky ). Equaon (4) depcs he nees ae maxmsng he govenmen pefeence funcon. (4) op, auaky α C( θ + β + n) = 2 [( α) θ n+ α C] Fo he sake of smplcy we assume ha he socally opmal ansfe polcy s z=0, so ha each geneaon s eaed alke. The coespondng opmal wegh α* auaky esulng n =θ can hen be deved as follows. * (5) α auaky = 2 2θ n θ + β + θ 2 2 n C( n ) If equals θ n equlbum, hee s no ncenve o save, z and B wll be zeo and all geneaons smply consume he endowmens. We wll assume n he followng ha naonal nsuons manage o povde ncenves so ha fo he govenmen α=α* auaky. 6 5 E.g. one can show ha f he z (pospey) em on he gh hand sde of (3) s eplaced by he ne wealh of govenmen bonds of cuen geneaons n seady sae zn/[(β+n-)], he pefeence funcon s sll suffcenly well-behaved fo he esuls o go hough. These esuls ae avalable on eques. 6 α* auaky s always smalle han as β > θ - n due o β > - n and θ. 23

25 In ems of Fgue 7, we wll consde equlbum n pon A as ou sang value fo compason wh he case of negaed bond makes n Moneay Unon. 4. The Blanchad-Yaa model: he common pool poblem n Moneay Unon Swchng fom a closed economy o a Moneay Unon wh negaed bond makes eques o dscuss hee aspecs of ou model fom a dffeen pespecve. Fs, s mpoan o noe ha he same negeneaonal ade-off would be pesen n a small open economy, whch akes he wold nees ae as gven. The govenmen would face he same ade-off beween ansfes o cuen geneaons and he welfae of fuue geneaons. The dffeence s ha n a small open economy ansfes educe he wealh of fuue geneaons by he accumulaon of ne foegn lables. 7 Second, naonal consumpon s no anymoe esced o he naonal endowmen, as unnng cuen accoun defcs allows o boos naonal consumpon. We do no chaacese cuen accoun defcs explcly fo wo easons. We consde pefecly symmec counes so ha n equlbum all counes n a Moneay Unon behave he same. Thus no cuen accoun defcs among pacpang counes ase n equlbum. 8 Fuhemoe, as menoned above, does no eally mae whehe he ade-off s cas n ems of sng nees aes o ne foegn lables, one can poxy fo he ohe. Neveheless, he possbly of unnng cuen accoun defcs, dawng on ohe unon membe counes cuen endowmens povdes an addonal ncenve fo expansonay naonal fscal polcy n a Moneay Unon. The eason s ha each govenmen ealses ha f does no ncease ansfes bu ohe govenmens do, domesc agens foego cuen consumpon o fnance he pane counes fscal ansfes. Thd, o capue he common pool poblem 9 n he Moneay Unon we need o explcly assume ha govenmens ae naonalsc, n he sense ha hey only cae abou he welfae of he own domesc consumes. As n a Psone s Dlemma ype suaon hs mples ha nees ae splloves fom naonal fscal polces ae no nenalsed acoss he Moneay Unon. 7 See Blanchad (985). 8 In he model we absac fom any elaonshp wh counes ousde he Moneay Unon. 24

26 In he followng we wll deve he Nash equlbum n he sac game, when all counes ae pefecly symmec. Upon eneng Moneay Unon, he govenmen has o se s ansfe polcy by choosng z, once and fo all. Any change of z fom s auaky level wll lead o adjusmen pocesses of axes, deb and nees aes accompaned by edsbuon of wealh acoss geneaons. Hee we wll no focus on he anson pah, bu compae he seady sae suaon befoe and afe Moneay Unon. We show n a vey smple way how, sang wh opmal naonal nsuons befoe Moneay Unon (MU), fully negaed bond makes wll hen lead o a defc bas. Ths esul caes ove o he case of pe-exsng naonal defc bases, whch would wosen when a common pool of savngs becomes avalable o govenmens. We pesen he govenmen pefeence funcon U(z, ) and he common pool poblem gaphcally n /z space, whch s why we fs deve he slope d/dz of U(z, ) by means of he mplc funcon heoem. (6) d dz = α 2( α U ) The slope depced n (6) s defnely posve fo a posve. In /z space, he se of ndffeence cuves can be depced as n equaon (7) fo dffeen levels of U. (7) = α U z α α The se of pefeence funcons can hen be depced n /z space as n Fgue 9. A hghe uly s obaned, he close s he depced ndffeence cuve o he lowe gh cone, hus U()<U(2)<U(3)<U(4). The concave shape of he ndffeence cuves s due o he fac ha a hghe levels of z and hus of, fuhe nceases of he nees ae ae seen as nceasngly cosly n ems of dsadvanagng fuue geneaons (posey effec). 9 On common pool poblems wh espec o fscal polcy see e.g. Pesson and Tabelln (2000, Ch. 7+3) and Von Hagen and Haden (996). 25

27 Fgue 9: The common pool poblem (β+n+θ)/2 (z)= (z ; z j =z ) C U () op, MU op, auaky =θ A D B (z)= (z ; z j =z auaky ) U (3) U (2) U (4), auaky z z,mu z z,max The soluon of he model (9)-() fo he nees ae as a funcon of z can easly be deved. As fom now on we ae neesed n compang hs oucome wh he oucome n a Moneay Unon, we wll noduce couny supescps whee appopae. Equaon (8) eveals he (closed economy) equlbum nees ae fo couny as a funcon of z. (8) 2 β + n + θ ( β + n + θ ) θ n = θ ( β + n) z 2 4 C wh (9) d dz = 2C ( β + n + θ ) 4 θ n 2 θ n θ ( β + n) z C 26

28 Obvously d/dz>0 and s saghfowad o show ha d 2 /dz 2 >0 as well. Thus equaon (8) has he convex shape depced n Fgue 9 (hyphenaed lne). The equlbum, maxmsng govenmen pefeences, n a sngle closed economy wh α a α* auaky s depced by pon A. In equlbum he govenmen of couny has chosen z auaky =0. We assume now couny enes a Moneay Unon of all-ogehe m pefecly symmec counes (z..z..z m ). Bond makes wll become negaed as bonds of each couny can now be sold o ohe counes czens, whch was no possble o desable befoe Moneay Unon. The aonale s ha elmnang he exchange ae sk and dsegadng defaul sk makes govenmen bonds of he m pacpang counes pefec subsues. Thee s only one common nees ae level n he unon. In he Moneay Unon equaons (9)-() now have o be ewen as follows. m θ n (20) = θ + m B j j C m = j= j j (2) B& = ( n β ) B + z j= m j= j m j= j m j (22) Y = C j= m j= j Fuhemoe he seady sae value fo all Moneay Unon counes deb s gven n (23). (23) m m j j= B = j= β + z j n As all m counes ae pefecly symmec and all govenmens wll evenually chose he same z n equlbum, we know ha (24) holds. m j j (24) C = mc ; B = m B ; z j= m j= m j= j = m z Inseng (24) n he model (20)-(22) and solvng fo he common nees ae,, esuls n he vey same equlbum locus as gve n equaon (8) and depced n Fgue 9. Also he ndffeence cuves n Fgue 9 apply fo each couny wh o whou Moneay Unon n he vey same way. Ths s so because we keep nsuonal ncenves as 27

29 summased by α consan acoss egmes. Dong so allows us o hghlgh he effec of an negaed bond make whou any povsons o smulaneously enhance fscal dscplne. Howeve, he funcon (z) depced n Fgue 9 changes n Moneay Unon, once one assumes ha govenmens ake he fscal polces of he ohe counes as gven. Solvng he model (20)-(22) gves he followng esul fo : (25) 2 m β + n + θ ( β + n + θ ) θ n = + θ ( β n) z + m z 2 4 j C j j = j= j whee he slope n /z space s gven by (26). (26) d dz = 2 m j= C j ( β + n + θ ) 4 2 θ n θ ( β + n) θ n m j= C j m j= z j Agan we see ha he slope s posve, bu compang (26) wh (9) one ealses ha he slope of (z) n Moneay Unon s smalle n equlbum fo all z, as m j C > C j= and θ n m m j j C = j= z j θ n = z. C The flae schedule s epesened by he doed cuves n Fgue 9, fo dffeen assumpons wh egad o he ohe counes ansfe polces ( z j fo all j ). The lowes one, passng hough pon A, s dawn fo he case he govenmen of couny expecs all ohe counes o leave he ansfes unchanged a he auaky levels. Unde hs assumpon couny s govenmen could hope o each pon B by nceasng he ansfes sgnfcanly, whch would esul n hghe uly as U(4) > U(3).The eason why he govenmen could benef fom beng moe expansonay s ha he couny could possbly daw on savngs of he whole unon o fnance s ansfes. Ths would dampen he ncease n nees aes and allow fo hghe domesc consumpon. In ou smple model, he govenmen would expec foegn consumes o gve up pa of he pesen consumpon o buy pa of couny s deb. In B couny would be expecng o un a cuen accoun defc vs á vs he ohe unon membes. 28

30 Evenually, B wll no be an equlbum as each govenmen wll face he same ncenves and counes ae pefecly symmec. The nees ae s deemned as a funcon of z unde symmec behavou on he (z) schedule as gven n equaon (8). In ems of Fgue 9, pon C would be he equlbum f all govenmens would expand as much as couny dd unde he unealsc assumpon ha he ohes would no change he ansfe polcy n he Moneay Unon. Bu C s no he equlbum ehe, as each sngle govenmen could mpove s suaon by unlaeally educng ansfes, akng he ohe s expansonay polces as gven (movng down he doed lne passng hough C) and because n C each govenmen s assumpon abou he ohe govenmens acons would un ou o be wong. The Nash equlbum s depced n pon D, a whch no govenmen can mpove s poson, gven he ohe counes fscal polces n equlbum. Only n D expecaons concenng ohe counes fscal polces ae valdaed. To show ha pon D s assocaed wh a lage z and hus hghe han n pon A s suffcen o have concave ndffeence cuves (see (7) and a flae (z) schedule n EMU han n he Pe-MU peod a he equlbum (o symmey-) locus (compae (9) and (26)). Thus we have fo (z) on he equlbum schedule (8): d d z = z j whee dz dz equal o z, coespondng o he especve locus on he equlbum schedule (8). j j (27) ( ) > ( z = z ) j z sands fo a consan z Moe fomally he new equlbum D can be chaacesed by he slope equaly of (26) and (6) evaluaed a he equlbum schedule (8). (28) α = 2( α) 2 ( β + n + θ ) 2 mc 4 θ n θ n θ ( β + n) z C Usng (8) o eplace he squae oo n (28) one obans he opmal seady sae nees ae n Moneay Unon gven by (29). (29), α m C ( θ + β + n) = 2 [( α) θ n+ α m C ] op MU 29

31 Noe ha f m equals (he no Moneay Unon case), he opmal nees ae s obvously he same as shown n (4). Equaon (30) eveals ha d/dm s posve. A hghe nees ae s, of couse, assocaed wh a polcy povdng hghe ansfes z accodng o equaons (8) o (25). (30) op, MU d C n n α ( α) θ ( β + + θ) = > 0 2 dm 2 ( αθ ) n+ α mc Thus he lage he Moneay Unon, he moe mpoan wll be he need fo nsuons o safeguad fscal dscplne. If m appoaches nfny, whch means ha govenmens wll no expec any nees ae effec whaeve he ansfe polcy, (29) shows ha op, MU ends o (β+θ+n)/2, whch n Fgue 7 s assocaed wh he lages possble ansfe polcy a z max as depced by pon C. One can oban he equed change n he nsuonal seng also by calbang agan he opmal wegh α* MU, whch would allow maxmsaon of he govenmen pefeence funcon o lead o =θ. (3) α * EMU 2 2θ n = 2 2θ n + mc( β + n θ ) Compang (5) wh (3) shows ha α* Pe-MU > α* MU fo m >. Thus o manan he same level of negeneaonal equy n a Moneay Unon, nsuons have o be adjused so ha govenmens have less ncenves o favou cuen geneaons. We have shown ha he common pool poblem ceaes o exacebaes an negeneaonal, polcal economy defc bas n a Moneay Unon. In ou smple model he bas becomes vsble hough he dffeence MU - θ > 0 ggeed by he nceased ansfe o cuen geneaons as z MU > 0 when no defc bas was pesen nally. Bu moe geneally, any pe-exsng naonal bas would ge wose as a esul of he common pool poblem as becomes clea fom equaons (29) and (30). We have hus exposed a aonale fo an enhanced need fo fscal dscplne n a Moneay Unon. Ou agumen could possbly be senghened fuhe n an exended model wh capal accumulaon. Then, as a esul of nally hghe aggegae pe capa consumpon followng he fscal expanson, seady sae capal would be sgnfcanly lowe when govenmens daw on a common pool of savngs, ceang an addonal channel fo negeneaonal edsbuon. As a esul, n he absence of a song mechansm povdng 30

32 ncenves fo fscal dscplne, poenal oupu and, n a model wh endogenous gowh, seady sae eal gowh would be lowe n Moneay Unon. 5. Conclusons Thee ae many dffeen vews n he leaue on he ole of fscal polces n a moneay unon. Those who emphasze he need fo dscplne ely manly on hee ses of dffeen agumens. The fs vew s based on he lnk beween he susanably of fscal posons and he cedbly of he commmen of moneay polcy o manan pce sably. The dea s ha unsusanable deb accumulaon n a Membe Sae could pu pessue on he cenal bank o eode he eal value of deb hough nflaon. The second vew sesses possble sysemc mplcaons fom he defaul of a soveegn boowe. Gven a hea of conagon and sysemc sk, ohe govenmens would be emped o bal ou a heavly ndebed couny. Somemes he fs mechansm s labeled ex ane bal ou and, analogously he second s labeled ex pos bal ou. The hd ype of agumen eles on a defc bas n naonal publc fnances, whch s exacebaed by splloves opeang n a Moneay Unon dvng up eal nees aes as a esul. The agumen n ou pape belongs o he lae caegoy whee he spllove deves fom he empaon, fo naonal govenmens, o explo he enlaged common pool of savngs n Moneay Unon a he expense of fuue geneaons. Mos exsng heoecal analyss has focused on he need fo fscal consans n ode o undepn he susanably of long-em publc fnances. In ou model susanably s no an ssue, bu nsead he queson of he negeneaonal dsbuon of esouces povdes a aonale fo fscal dscplne. The case fo dscplne s enhanced n Moneay Unon due o splloves fom naonal fscal polces on he common nees ae n an negaed bond make. In ohe wods, he magnal effec of any ndvdual couny s ncease n publc deb on deb fnancng coss falls, when a couny can daw on a lage common pool of savngs n Moneay Unon. In equlbum hs spllove encouages fee-dng behavo by all govenmens leadng o hghe nees aes and negeneaonal edsbuon a he expense of posey. We ecognze ha some feaues of ou model e.g. he assumpon of pefec bond make negaon and he use of a eal model wh no ole fo money o moneay polcy obvously leave ou some mpoan ssues. A he same me, n ou vew hs smple soy has wo man aacve feaues elave o alenave modelng appoaches offeed n he leaue. Fs, 3

33 he case fo fscal dscplne n ou model does no ely on he move o peven any of he wo ypes of bal ou, whch would mply a lack of cedbly of exsng Teay povsons (.e. he pmay objecve of pce sably, no moneay fnancng and he so-called no bal ou clause). Second, ou case fo fscal dscplne need no ely on unsusanable developmens n publc fnances and hus on exeme and elavely unlkely evens, whch ae had o econcle wh models assumng fowad-lookng agens and aonal expecaons. Insead n ou model, he elevan spllove effecs n pefecly negaed bond makes opeae a all mes. The neempoal budge polcy consdeed s susanable and heefoe compable wh equlbum unde pefec foesgh on he pa of he pvae seco. We have movaed he elevance of ou model fo Moneay Unon (bu no he global level) by ponng o he evdence ha moneay unfcaon has been empcally assocaed wh soveegn deb make negaon. The degee of negaon nsde he Unon s an ode of magnude deepe han n he global economy. Ths suggess ha he need fo fscal dscplne o safeguad negeneaonal equy nsde Moneay Unon s much songe han a he global level. Obvously, any effo o ncease fscal dscplne based on hs agumen would a he same me also pomoe pospecs fo he susanably of publc fnances. I would also help couneac any endency o un-up hghe deb as a consequence of he fall of boowng coss assocaed wh nees ae convegence o lowe levels n he anson o Moneay Unon and access o a lage, deepe pool of capal. We conclude wh a few emaks on possble exensons of ou model and avenues fo fuhe eseach. Fs, would be possble, hough cumbesome, o explcly noduce capal no he model. In hs case, as aleady emphaszed, any ncease n he equlbum nees ae would lead o a lowe pe capa capal sock and possbly gowh and lowe welfae n seady sae. Second, ou model compaes he auaky (closed economy) case and Moneay Unon whle possble addonal affecs fom he global economy ae no aken no accoun. Ths seems jusfed as a fs appoxmaon on he bass of he dffeen scale of bond make negaon obseved, bu could be exploed fuhe boh heoecally and empcally. Thd, we assume symmec, dencal counes. Insead, one could exploe dffeences n govenmen (negeneaonal) pefeences o couny sze. All else equal, he spllove effecs n ou model would sugges ha lage counes (wh popoonally lage effecs on he common nees ae) would be elavely moe dscplned compaed o smalle Membe Saes. Fuhemoe, n he pesence of ules o safeguad fscal dscplne, he model suggess ha smalle counes would be paculaly neesed n he lage counes complance wh hese ules. These suggesons of couse do no ake no accoun polcal economy ype 32