Economics, 3rd Edition

SELF TEST 

What is fiscal federalism? 

●

 How may it aid in the functioning of a common currency area?

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CHAPTER 36  COMMON CURRENCY AREAS AND EUROPEAN MONETARY UNION  777

 correction mechanism which has to be built into the country’s legal system, will be triggered. Participant 

countries will have been expected to have this legal mechanism enshrined in law by 1 January 2014. 

Member states will be subject to a budgetary and economic partnership programme which will outline 

detailed structural reforms that will have to be put into place if the deficit rules are breached which will 

detail how the country intends to remedy its deficit problems. The rules apply to all 25 countries which 

signed the agreement apart from the Czech Republic and the UK who both opted out of the agreement.

At the time of writing it is by no means certain that these new rules will be any more successful than 

the SGP. Only months into the new treaty there are concerns that France will breach the rules and a 

number of economists have noted that the rules do not make sense. Imposing greater fiscal discipline 

might sound sensible to prevent governments from profligacy and reducing the free rider problem but the 

consequences are essentially simple – if debt is too high the government concerned must cut spending 

and raise taxes. If governments are seeking to balance budgets, account must be taken of the effect on 

the other aspects of the economy.

Recall that savings of households and firms is denoted as S and that in equilibrium, savings equals 

 investment  (S

= I

 

) in a closed economy. If governments have a balanced budgets then tax receipts (T

 

) 

equal government  spending (G): T

= G. The external current account is given by net exports, X − M. If there 

is an  imbalance in private savings and/or government budgets, this shows up in net capital  outflow as we 

saw in Chapter 28. In Chapter 29, we noted the link between the market for loanable funds and the market 

for foreign  currency exchange as S

= I + NX. This can be rearranged to give S − I = NX and rearranging 

the national  accounting formula gives us (S

− I

 

)

+ (T − G) = NX where T − G is the  government deficit. 

If the government is to balance its budget then the sum of the other elements of the economy must also 

balance. Bringing these other aspects into balance is not easy.

If the government is forced to cut spending and increase taxes to bring the budget into balance, national 

income will fall, ceteris paribus. An increase in taxes will have the effect of reducing private saving; if 

saving falls then interest rates rise, investment may decline and the net result is a rise in unemployment. 

In addition, the reduced investment leads over time to a lower stock of capital. A lower capital stock 

reduces labour productivity, real wages, and the economy’s production of goods and services. The political 

ramifications of bringing the budget into balance could be severe for governments and lead to political 

instability which further undermines market confidence.