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Fiscal Policy in the European Union
This page intentionally left blank
Fiscal Policy in the
European Union

Edited by

Jesús Ferreiro
Giuseppe Fontana
and
Felipe Serrano
Selection and editorial matter © Jesús Ferreiro, Giuseppe Fontana and Felipe
Serrano 2008
Chapters © individual contributors 2008
Softcover reprint of the hardcover 1st edition 2008 978-0-230-20399-0
All rights reserved. No reproduction, copy or transmission of this
publication may be made without written permission.
No portion of this publication may be reproduced, copied or transmitted
save with written permission or in accordance with the provisions of the
Copyright, Designs and Patents Act 1988, or under the terms of any licence
permitting limited copying issued by the Copyright Licensing Agency,
Saffron House, 6-10 Kirby Street, London EC1N 8TS.
Any person who does any unauthorized act in relation to this publication
may be liable to criminal prosecution and civil claims for damages.
The authors have asserted their rights to be identified
as the authors of this work in accordance with the Copyright, Designs
and Patents Act 1988.
First published 2008 by
PALGRAVE MACMILLAN
Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited,
registered in England, company number 785998, of Houndmills, Basingstoke,
Hampshire RG21 6XS.
Palgrave Macmillan in the US is a division of St Martin’s Press LLC,
175 Fifth Avenue, New York, NY 10010.
Palgrave Macmillan is the global academic imprint of the above companies
and has companies and representatives throughout the world.
Palgrave® and Macmillan® are registered trademarks in the United States,
the United Kingdom, Europe and other countries.
ISBN 978-1-349-30161-4 ISBN 978-0-230-22826-9 (eBook)
DOI 10.1057/9780230228269
This book is printed on paper suitable for recycling and made from fully
managed and sustained forest sources. Logging, pulping and manufacturing
processes are expected to conform to the environmental regulations of the
country of origin
A catalogue record for this book is available from the British Library.
Library of Congress Cataloging-in-Publication Data
Fiscal policy in the European Union / edited by Jesus Ferreiro,
Giuseppe Fontana and Felipe Serrano.
p. cm.
Includes bibliographical references and index.

1. Fiscal policy European Union Countries. I. Ferreiro, Jesus. II.

Fontana, Giuseppe, 1968- III. Serrano Pérez, Felipe.
HJ1000.F564 2008
339.5’2094 dc22 2008029926
10 9 8 7 6 5 4 3 2 1
17 16 15 14 13 12 11 10 09 08
Contents

List of Figures vii

List of Tables ix

Notes on the Contributors xi

Introduction
Jesús Ferreiro, Giuseppe Fontana and Felipe Serrano 1

1 Fiscal Federalism in the European Union:

How Far Are We?
Rui Henrique Alves and Oscar Afonso 6

2 Is There Compatibility between the Stability and

Growth Pact and Automatic Fiscal Stabilizers?
Sabrina Rostaing-Paris 25

3 Stabilization Capacity and Fiscal Policy in the EMU

Jorge Uxó González and M. Jesús Arroyo Fernández 53

4 Fiscal Adjustment and Composition of Public

Expenditures in the EMU
Jesús Ferreiro, M. Teresa García-del-Valle and Carmen Gómez 84

5 Public Capital and Economic Growth: a Spurious

Empirical Link?
Gwenaëlle Poilon 109

6 Has France Become a Deficit Running Country?

Jérôme Creel, Guy Gilbert and Thierry Madiès 129

7 How to Deal with Economic Divergences in the EMU?

Catherine Mathieu and Henri Sterdyniak 157

v
vi Contents

8 A Scheme to Coordinate Monetary and Fiscal Policies

in the Euro Area
Carlo Panico and Marta Vázquez Suárez 184

Index 209
List of Figures

2.1(a)–(k) Primary cyclical balance and output gap in

European countries from 1992 to 2006 36
2.2 Primary cyclical balance vs. output gap 37
2.3(a)–(b) Comparison between the size of automatic
stabilizers and the reference value with respect
of the sign of the output gap in Germany and
France since 1992 45
3.1 Inflation dispersion in EMU 57
3.2 Average inflation rate, 1999–2006 57
3.3 GDP rate of growth (average, 1999–2006) 58
3.4 Differences between GDP and trend (rates
of growth 1999–2006) 59
3.5 Differences between GDP and trend (rates of
growth, sum 1999–2006) 59
3.6 Different cyclical position and single monetary
policy in EMU: Spain and Germany 63
3.7 Real interest rates 64
3.8 Real exchange rates ULCE (1999 = 100) 65
3.9 A restrictive demand shock when the
competitiveness effect is weak (country 1) 71
3.10 A restrictive demand shock when the
competitiveness effect is strong (country 1) 74
4.1 Evolution of public expenditure and taxation
between the periods 1990–8 and 1999–2005
(% GDP) 91
4.2 Size of public social expenditures before EMU
(1990–8) and after EMU (1999–2005) (% GDP) 96
4.3 Evolution of productive and unproductive
public expenditures according to the
functional classification (% GDP) 104
6.1 Government budget balance, % of GDP 130
6.2 Net and gross public debt, France, % of GDP,
and nominal GDP growth 132
6.3 Various fiscal surpluses, France, % of GDP 135

vii
viii List of Figures

6.4 Cyclically adjusted government primary balance,

% of potential output 136
6.5 Estimated non-tax revenues and acquisitions and
disposals of non-financial assets 144
List of Tables

1.1 Financial perspectives for the period 2007–2013 15

2.1 Summary table of compliance conditions 41
2.2 Automatic fiscal stabilizers, 1992–2006 42
2.3 Periods of compatibility between automatic
fiscal stabilizers and a balanced or surplus
budget in EMU countries since 1992 43
2.4 Periods of compatibility between automatic
fiscal stabilizers and a budget deficit lower than
3 per cent of GDP 46
2.5 Periods of compatibility between automatic
fiscal stabilizers and a balanced structural
budget combined with a budget deficit limit in
EMU countries since 1992 47
3.1 Alternative fiscal policy rules 69
3.2 Stabilizing and destabilizing mechanism and
model parameters 72
3.3 Stability conditions with different fiscal policy rules 73
3.4 Value of model parameters used in the simulations 77
4.1 Evolution of fiscal deficit and public expenditure
(% GDP) 91
4.2(a)–(c) Evolution of the size of public expenditures
(in % GDP) between the periods 1990–8 and
1999–2005 by kind of expenditure
(economic classification) 93–5
4.3 Public expenditures (in % GDP) by kind of
expenditure (functional classification) 98
4.4 Evolution of public expenditure between 1990–8
and 1999–2005 102
4.5(a)–(b) Evolution of productive and unproductive public
expenditure (% GDP) 103
5.1 Government net capital as a percentage of GDP 110
5.2 Government net capital as a percentage of
private non-residential net capital 110
5.3 Studies based on a Cobb-Douglas production
function in level 113
5.4 Studies with first differences 114

ix
x List of Tables

5.5 Augmented Dickey-Fuller stationarity test 117

5.6 Johansen test results 118
5.7 Estimation results using first-differences for France,
Germany and Italy 118
5.8 Johansen test results 121
5.9 OLS results with individual effects 122
5.10 Final results with GMM 124
6.1 Discretionary fiscal policy over the electoral cycle in
France (1978–2005) 138
6.2 Fiscal deficits and the political cycle: contributions
to the cumulative change in general government
surplus (in percentage points of GDP) over the
last three decades 140
6.3 Fiscal deficits and the business cycle: contributions
to the cumulative change in general government
surplus (in percentage points of GDP) over the
last three decades 143
6.4 Contributions to the rise of general government
net financial liabilities (in percentage points of GDP) 144
7.1 GDP growth rates and GDP per head 159
7.2 Unemployment and employment rates 161
7.3 Inflation and real interest rates 162
7.4 Taylor rules and effective central bank rates 164
7.5 External positions and savings ratios 166
7.6 Fiscal policies 167
7.7 Public finance sustainability in 2006 168
7.8 Employment protection indicators 170
7.9 Economic performance disparities in the EU-15 170
7.10 Disequilibrium index 171
Notes on the Contributors

Oscar Afonso is Assistant Professor in Economics in the Faculty of

Economics at the University of Porto. He has a PhD degree from the Uni-
versity of Porto. His research interests are in the areas of macroeconomics
and international trade. In particular, he is now working on the subject
of wage inequality and economic growth. He is the author of a num-
ber of papers on those subjects in refereed journals (Applied Economics,
Economic Modelling, Intereconomics, International Economic Journal, Journal
of International Trade and Economic Development) and of chapters in edited
books.

Rui Henrique Alves is Invited Lecturer in the Faculty of Economics at

the University of Porto, Portugal, where he teaches European Economics,
International Economics and Macroeconomics. For some years, he has
also been adviser of the Portuguese Exchange in the area of training and
education. He holds an MSc degree in Economics and is currently waiting
for the approval of his PhD thesis in European Economics. His main areas
of research include political and economic organization of the European
Union, fiscal federalism, fiscal policies and macroeconomic effects. He
has published a book and several articles concerning these areas.

M. Jesús Arroyo Fernández has a PhD in Economics from the Univer-

sidad de Alcalá (Madrid, Spain). She is Associate Professor of Economics
(with tenure) at the Universidad CEU San Pablo, Madrid, Spain. She
teaches Macroeconomic Policies and Applied Economics. Her main
investigation lines are monetary and fiscal policies in EMU, activist fiscal
policy rules and new normative macroeconomics. She has published a
number of articles in specialized journals and she is author of some con-
tributions to books on economic policy.

Jérôme Creel has been a Deputy Director at Observatoire Français des

Conjonctures Economiques (OFCE, Sciences Po) in Paris since 2003, and
a Professor of Economics at ESCP-EAP European School of Management
since 2007. He has been the Academic Dean of the European Studies
Programme at Sciences Po since 2006, and was a Junior and then Senior
Economist at OFCE, starting in 1998. He holds a PhD from the Uni-
versity of Paris-Dauphine in Economics (summa cum laude). His works,

xi
xii Notes on the Contributors

published in leading journals in the field of macroeconomics, have dealt

with monetary and fiscal policies in the EMU, including coordination
issues, the economics of EU enlargement and institutional economics,
notably related to the Constitutional Treaty and delegation issues.

Jesús Ferreiro is Associate Professor in Economics at the University of

the Basque Country, in Bilbao, Spain. He has a PhD from the University
of the Basque Country. His research interests are in the areas of macro-
economic policy, labour market and international financial flows. He
has published a number of articles on those topics in edited books and
in refereed journals such as Economic and Industrial Democracy, Economie
Appliquée, Ekonomia, European Planning Studies, International Review of
Applied Economics, and the Journal of Post-Keynesian Economics.

Giuseppe Fontana is Professor of Monetary Economics at the University

of Leeds (UK) and Associate Professor at the Università del Sannio (Italy).
He has recently been awarded the 2008 L. S. Shackle Prize, St Edmunds’
College, Cambridge (UK). He is a Life Member Fellow at Clare Hall (Uni-
versity of Cambridge, UK), and a Visiting Research Professor at the Centre
for Full Employment and Price Stability (University of Missouri Kansas
City, USA), and the Cambridge Centre for Economic and Public Policy
(University of Cambridge, UK). He has recently published Money, Time,
and Uncertainty with Routledge.

Teresa García-del-Valle is Associate Professor of Statistics at the Uni-

versity of the Basque Country, in Bilbao, Spain. She has a PhD from the
University of the Basque Country. Her research interests are in the area of
applied statistics. She has published a number of articles on this topic in
books, edited books and in refereed journals. She has been Invited Profes-
sor in several Latin American universities, such as Universidad Autónoma
Juan Misael Caracho (Tarija, Bolivia), Universidad Nacional Autónoma
de México (México, D.F.) and Universidad del Salvador (El Salvador).

Guy J. Gilbert is Full Professor of Economics at the Ecole Normale

Supérieure at Cachan (Department of Social Sciences). He is a member of
the Centre d’Economie de la Sorbonne-Paris I University, and a member
of Paris School of Economics. His major field of research is public eco-
nomics and the economics of public finance. He has published several
books and numerous articles in academic journals, relating to taxation,
fiscal decentralization and fiscal federalism.
 Notes on the Contributors xiii

Carmen Gómez is Lecturer in Economics at the University of the Basque

Country, in Bilbao, Spain. She has a PhD from the University of the
Basque Country. Her research interests are in the areas of macroeco-
nomic policy, labour market and international financial flows. She has
published a number of articles on those topics in edited books and in
refereed journals such as Comercio Exterior, Economic and Industrial Democ-
racy, Economie Appliquée, and Problemas del Desarrollo.

Thierry Madiès is Full Professor of Economics at the University of

Fribourg (Switzerland) and a member of the Council of Economic
Analysis of the French Prime Minister. His field of research concerns
public finance and international economics.

Catherine Mathieu is a Senior Economist, Analysis and Fore-

casting Department, OFCE (Observatoire Français des Conjonctures
Economiques), Paris. Her current research areas include: European
macroeconomic analyses, UK economy, and macroeconomic forecast-
ing. She is Chairwoman of the ‘Medium term prospects and structural
changes’ working group, AIECE (Association of European Conjuncture
Institutes) and a member of the EUROFRAME group of research institutes.
Recent publications include: ‘A European Framework Designed for Stabil-
ity or Growth?’, co-authored with Henri Sterdyniak, European Economic
Policies: Alternatives to Orthodox Analysis and Policy Concepts, Metropolis-
Verlag (2006); ‘Comment expliquer les disparités économiques dans
l’UEM?’, co-authored with Henri Sterdyniak, Revue de l’OFCE, 102 (2007);
and ‘Le modèle social européen et l’Europe sociale’, co-authored with
Henri Sterdyniak, Revue de l’OFCE, 104 (2008).

Carlo Panico is Professor of Economics at the University of Naples

‘Federico II’ (Italy). He has articles published in the Cambridge Journal
of Economics, Contributions to Political Economy, Economic Journal, Metro-
economica, and the European Journal of the History of Economic Thought and
has published monographs on the theory of growth and distribution and
on the theory of money. His research interests are the influence of mone-
tary phenomena on growth and distribution and the history of economic
analysis (among other authors, Marx, Marshall, Keynes, Myrdal, Harrod,
Sraffa and Kaldor), the development of ‘British monetary orthodoxy’ in
the nineteenth century, the formation of the European Monetary Union,
the relationship between central bank independence and democracy, the
debate on the Marshallian supply curves, the coordination of policies
within the European Union, the influence on regional development of
xiv Notes on the Contributors

the institutional framework and of the different forms of planning gov-

ernment intervention.

Gwenaëlle Poilon is a PhD student in the programme ‘Economic Gov-

ernance’ directed by Jean-Paul Fitoussi in the Institut d’Etudes Politiques
de Paris; her research centre is the Observatoire Français des Conjonc-
tures Economiques (OFCE). Her dissertation deals with the Stability and
Growth Pact; more precisely, on the Golden Rule of Public Finances that
has been proposed as a reform for the actual Stability and Growth Pact.
Her research interests are European economic policies and education and
health topics.

Sabrina Rostaing-Paris is a Lecturer at the University of Bordeaux 4.

She has a Masters degree in Macroeconomics from the University of Aix-
Marseille 2, France. Her areas of interest are macroeconomics, public
finances, fiscal policy and the economy of the European Union.

Felipe Serrano is Professor in Economics at the University of the Basque

Country, in Bilbao, Spain He is the head of the Department of Applied
Economics V at the University of the Basque Country. His research inter-
ests are in the areas of social security, the welfare state, labour market,
innovation and economic policy. He is the author of a number of arti-
cles on those topics in edited books and in refereed journals such as
Economies et Sociétés, Ekonomia, European Planning Studies, International
Review of Applied Economics and the Journal of Post-Keynesian Economics

Henri Sterdyniak is Head of the Economics of Globalization Depart-

ment at OFCE (Observatoire Français des Conjonctures Economiques),
Paris, and Professor of Economics at the University of Paris-Dauphine.
He is a member of the Steering Committee of AFSE (Association Française
de Science Economique) and of EUROFRAME (European network of eco-
nomic institutes). He has published many articles on macroeconomics,
economic policy, monetary and international economics, European
economy, fiscal and social issues. Recent publications include: ‘A
European Framework Designed for Stability or Growth?’, co-authored
with Catherine Mathieu, European Economic Policies: Alternatives to Ortho-
dox Analysis and Policy Concepts, Metropolis-Verlag (2006); ‘Comment
expliquer les disparités économiques dans l’UEM?’, co-authored with
Catherine Mathieu, Revue de l’OFCE, 102 (2007); and ‘Le modèle social
européen et l’Europe sociale’, co-authored with Catherine Mathieu, Revue
de l’OFCE, 104 (2008).
 Notes on the Contributors xv

Jorge Uxó González has a PhD in Economics from Universidad Com-

plutense de Madrid. He is Associate Professor of Economics at the
Universidad CEU San Pablo, Madrid, Spain, where he has been Dean of
the School of Business and Economics and Chief of the Department of
Economics. He teaches Macroeconomic Policies and Applied Economics.
His main investigation lines are monetary and fiscal policies in EMU,
activist fiscal policy rules, new consensus on macroeconomics and new
normative macroeconomics. He has published a number of articles in
specialized journals such as Applied Economics, Hacienda Pública Española,
and Pensamiento Iberoamericano, and he is author of several contributions
to books on economic policy.

Marta Vázquez Suárez has a PhD in Economics from Santiago de Com-

postela University, Spain. After her graduation in Economics Sciences
in 2002, she received a scholarship to do a postgraduate course, com-
bining it with teaching economics and with her investigation about
foreign investment, trade and growth in Spain for the Santiago Uni-
versity. Afterwards she oriented the research towards the developing
economies, combining the investigation work carried out at universities
in Mexico, Spain and Italy.
Introduction
Jesús Ferreiro, Giuseppe Fontana and Felipe Serrano

In contrast to what happened during the golden age of Keynesian policies

in the 1950s and 1960s, today fiscal policy has lost relevance, both in the
short term as an instrument to stabilize the business cycle, with mon-
etary policy gaining relevance, and in the long term with supply-side
policies playing a predominant role. Two reasons explain the downgrad-
ing of fiscal policy. The first reason is a practical one, namely, the need to
reduce the high levels of public deficit and debt, fiscal imbalances gener-
ated by the mix of increases in public spending and cuts in taxation and
a tight monetary policy leading to high real interest rates. The second
reason is related to the dominance of neoclassical theories, which main-
tain that both fiscal imbalances and the large size of public revenues and
expenditures have a negative impact on economic activity and growth
in the short and long term.
The institutional framework and the rules of fiscal policy operat-
ing in the European Union (EU) are built upon this theoretical basis.
The Maastricht Treaty has imposed the reduction of fiscal imbalances
as the main objective of national fiscal policies. The fear of a relax-
ation of fiscal discipline has led to the approval of the Stability and
Growth Pact (SGP). The SGP has lowered the discretional leeway of
fiscal policy in the short term, and in this way has, de facto, subordi-
nated fiscal policy to monetary policy. However, this strategy has not
escaped problems and criticisms. Thus, as a consequence of the massive
violation of the criteria of excessive deficits, the Stability and Growth
Pact was reformed in 2005, in order to give, at least in the short run,
more flexibility to national fiscal policies. More recently, the world-
wide turmoil in the financial markets has generated support for a high
level of fiscal activism, in order to alleviate the negative impact on the
economy.

1
2 Fiscal Policy in the European Union

Pari passu with these problems, the criticisms of the current framework
of fiscal policy in the European Union are growing. The criticisms take
different forms: the lack of formal coordination between a single Euro-
pean monetary policy, whose only objective is price stability, and several
national fiscal policies, which are the only available tools to smooth eco-
nomic fluctuations; the lack of a federal budget that could contribute
to solving the asymmetric shocks in the European Union, thus alle-
viating the coordination problems arising from an increasing number
of national fiscal policies (nowadays, 27); and, lastly, the dissatisfac-
tion with the theoretical models underpinning the use of fiscal policies.
The various chapters in this book discuss these issues and provide a
critical perspective on the current role of fiscal policy in the European
Union.
Chapter 1, by Rui Henrique Alves and Oscar Afonso, argues that the
current framework of fiscal policies in the European Union is far from
what would be an ‘optimal’ fiscal policy from the perspective of the the-
ory of fiscal federalism and the subsequent distribution of competences
among the different levels of government. The result is that fiscal policies
in the EU are inefficient in terms of their capacity for macroeconomic
stabilization due, mainly, to three reasons: the problems with the defi-
nition and implementation of fiscal rules (like the SGP), the insufficient
degree of coordination of national fiscal policies, and, lastly, the small
size of the Community budget. Only by solving these problems will the
effectiveness of fiscal policies in the EU be improved. However, these
changes require a significant reform in the general institutional and polit-
ical framework of the EU, a reform that deepens not only the economic
but also the political integration of the EU.
In Chapter 2, Sabrina Rostaing-Paris deals with the internal incon-
sistency of fiscal policies in EMU countries. On the one hand, active
discretionary fiscal policies are rejected, leaving the working of automatic
built-in stabilizers as the only tools to smooth economic fluctuations. On
the other hand, the Maastricht Treaty and the Stability and Growth Pact
involve the existence of a rule-based fiscal policy that limits the size of
fiscal deficits. These objectives could be contradictory, thus leading to a
potential trade-off between the economic and fiscal stabilizations. The
empirical analysis made by Rostaing-Paris leads her to conclude that such
a trade-off does exist in the European Monetary Union, and, therefore,
if fiscal policy is to play a role in smoothing business cycles, fiscal rules
(i.e. SGP) must be reformed, with the new fiscal rules setting objectives
not in terms of the size of fiscal deficits but in terms of cyclically adjusted
budget balances.
 Introduction 3

Chapter 3, by Jorge Uxó González and M. Jesús Arroyo Fernández,

argues that the existence of fiscal rules, such as those imposed by the
Stability and Growth Pact, limits the effectiveness of fiscal policy to sta-
bilize economic fluctuations. In as much as the EMU does not suffer
asymmetric shocks this limitation would not be a serious problem. How-
ever, Uxó and Arroyo show the permanence of significant divergences
among EMU countries in terms of the inflation rates and the position
in the business cycle. In this situation, a single monetary policy can
be destabilizing. Uxó and Arroyo support a more active fiscal policy,
not only in terms of the working of the built-in stabilizers but also of a
more active discretionary policy, as the more effective tool to correct the
impact of asymmetric shocks in EMU.
Chapter 4, by Jesús Ferreiro, Teresa García-del-Valle and Carmen
Gómez, focuses on the analysis of the composition of fiscal adjustments
and of public expenditures. The models of the expansionary fiscal consol-
idation argue that fiscal adjustments based on cuts in public expenditures
are not only more lasting than those based on tax increases but also they
can contribute to accelerate the economic growth in the long run. How-
ever, the public policy endogenous growth models argue that it is the
composition of public expenditures (and revenues) that really matters for
economic growth. Thus, for fiscal adjustments to be growth-enhancing,
they should involve a recomposition of public spending towards pro-
ductive expenditures. Ferreiro, García-del-Valle and Gómez argue that
although EMU countries have based their fiscal adjustments on public
expenditures, the quality of public expenditures has not improved since
in most countries productive expenditures have declined.
Chapter 5, by Gwenaëlle Poilon, analyses the impact of public capital
on long-run economic growth. This is a relevant point in the analysis
of the role to be played by fiscal policy in the EU. Thus, the Lisbon
Agenda strongly supports public investments, mainly in infrastructures
and new technologies, as a driving force for economic growth, and many
economists and politicians argue in favour of a golden rule for public
finances. The chapter reviews the empirical research on the impact of
public capital spending on economic growth, focusing on the method-
ological issues and the treatment of econometric problems surrounding
public capital estimations. For Poilon the empirical analysis of the impact
of public capital and investment suffers from serious mis-specifications
leading to biased results. To solve these problems, mainly that of endo-
geneity, Poilon makes use of dynamic panel estimation techniques. With
that technique she concludes that public capital does have a produc-
tive role. The size of the estimated coefficient is also more realistic than
4 Fiscal Policy in the European Union

those obtained in the literature and the results turn out to be robust.
This empirical result confirms that the link between public capital and
growth is not only theoretical but also empirical, justifying the priority
given in the Lisbon Agenda to public investment.
In Chapter 6, Jérôme Creel, Guy J. Gilbert and Thierry Madiès present
an overview of public deficits and debts in France over the last three
decades with a special focus on the problem of sustainability of pub-
lic finances. Their contribution identifies the causes of deficits and debt
accumulation, concluding that fiscal imbalances in France are not only
explained by economic reasons (the gap between real interest rates and
the rate of economic growth, and the low economic growth registered
in the 1990s) but also for political reasons, that is because of the imple-
mentation of pro-cyclical policies related to the electoral cycle. Finally,
the authors deal with changes made to improve short-term fiscal imbal-
ances and show that recent structural measures have been undertaken
in order to enhance the transparency of the budgetary process to meet
public deficit and public spending targets and, consequently, to increase
the efficiency of fiscal policy.
Catherine Mathieu and Henri Sterdyniak argue in Chapter 7 that since
the launch of the euro, persistent and even rising disparities among
member states have made it difficult to implement short-term or struc-
tural common economic policies. The chapter gives an overview of
euro-area disparities in terms of growth and inflation and imbalances,
mainly unemployment and current accounts. For the authors four ele-
ments explain these disparities: the benefits of the single currency for
catching-up countries, the weaknesses of the euro area economic policy
framework; the implementation of non-cooperative domestic policies
which have induced excessive competition and insufficient coordina-
tion and hurt mainly the larger economies; and the crisis of the European
continental model in a global world. The existence of binding fiscal rules
was based on the assumption that EMU would lead to economic con-
vergence among member states that would reduce the need for active
fiscal policies. Four strategies are discussed: increasing market flexibility;
moving towards the knowledge society of the Lisbon Agenda; renational-
izing economic policies; and introducing a more growth-oriented policy
framework. In any case, the role of national fiscal policies should be
enhanced, setting objectives in terms of achieving high rates of economic
growth under the restriction of maintaining public expenditures and
taxation at levels compatible with the current European social model.
The final chapter, by Carlo Panico and Marta Vázquez Suárez, ana-
lyses from a post-Keynesian perspective the problems of coordination
 Introduction 5

between monetary and fiscal policies in the euro area. For Panico and
Vázquez the coordination of macroeconomic policies is necessary to deal
with both cyclical problems and structural problems. The authors argue
that despite the need for a true cooperation between monetary and fiscal
policies, the current institutional framework of the euro area does not
favour it. On one side, the European Central Bank defends its indepen-
dence in order to counteract the supposed deficit-bias of national fiscal
policies. On the other side, the national political authorities resist giving
up their autonomy in smoothing the business cycle via the management
of fiscal policies, since the only objective of the single monetary policy
is price stability. This lack of coordination has negative effects both in
terms of the economic performance of EU and EMU economies and in
the legitimacy of the construction of the European Union. The proposal
of Panico and Vázquez is to reform the current organization of policy
coordination in the euro area, whose central element is the transforma-
tion of the Eurogroup into a Euro Area Fiscal Agency, an institution able
to combine political and technical abilities and endowed with formal
decision authority on matters regarding policy coordination.
The chapters in this book were first presented at the special session
on fiscal policy at the 4th International Conference ‘Developments in
Economic Theory and Policy’ (Bilbao, 6–7 July 2007), an annual con-
ference organized by the Department of Applied Economics V of the
University of the Basque Country, Spain, in collaboration with the
Cambridge Centre for Economic and Public Policy (CCEPP), Department
of Land Economics of the University of Cambridge, UK. We thank the
participants and contributors to the conference, and the University of the
Basque Country that hosted the event. Financial support from the Uni-
versity of the Basque Country, International Papers in Political Economy,
the Basque government and the Círculo de Empresarios Vascos is grate-
fully acknowledged. Finally, special thanks must go to Amanda Hamilton
and Alec Dubber at Palgrave Macmillan, who first suggested this volume,
and for their encouragement and support throughout.
1
Fiscal Federalism in the European
Union: How Far Are We?
Rui Henrique Alves and Oscar Afonso

1 Introduction

Almost 60 years have gone by since Robert Schuman’s famous speech

(Schuman, 1963), in which he described the ‘European federation’ as
the ultimate goal of the integration process that was beginning at that
time. However, the results of this process are clearly different for the two
perspectives that comprise it: economics and politics.
In economic terms, advances have been made at a good pace, and the
European Union (EU) is now in the most advanced state of economic
integration possible, with the single currency, free movement of goods,
services, capital and people and several common policies. However, these
advances have not been matched in the political field, where the Union
has, in fact, failed to establish a strong entity and to develop common
actions with a similar impact.
This divergence is a fundamental trait of the present EU situation,
which might be characterized as a crossroads. Along with the above-
mentioned advances, there are four aspects in which the results fall
well short of what would be desirable, or four fundamental deficits in:
(i) ‘competitiveness and economic growth’, even if the situation seems to
be changing recently; (ii) ‘political weight’, with the EU often behaving
as a ‘dwarf’ on the international political scene; (iii) ‘legitimacy and par-
ticipation’, in view of the poor scrutiny of some European institutions,
ambiguity in the sharing of competences between member states and
the EU and indifference of citizens facing the process of integration; and
(iv) ‘capacity for decision and action’, faced with unsuccessful institu-
tional reforms and the permanence of a poor-sized community budget.
These ‘deficits’, particularly the last three, show that the goal of creat-
ing an expanded space of European solidarity, which would give rise to

6
 Fiscal Federalism in the European Union 7

a political entity and a true European citizenship, remains well out of the
EU’s reach. Fifty years after the Rome Treaty, the weight of national inter-
ests is often still predominant, which means that these ‘deficits’ will be
difficult to overcome unless there is a significant change in the Union’s
politico-institutional organization model. That is to say, unless there is
a rebalance in the two sides of the integration process, with a deepening
of the political field.
In a previous study (Alves, 2007) we argued that this rebalance would
involve the EU becoming an organization capable of dealing efficiently
with the need for unity in clearly supranational fields, without endan-
gering European diversity, and that the most suitable model for doing
so would be that of a ‘Federation of Member States’, with highly
decentralized competences.
Such an evolution would have to be accompanied, at the level of eco-
nomic organization, by a growing approximation to the ‘rules’ of the
theory of fiscal federalism. This is the context in which this chapter is
presented, as its main topic is the comparison between the present pro-
cess of defining and implementing fiscal policies in Europe and the one
that should result from the application of those ‘rules’, thus with a focus
on the function of macroeconomic stabilization.
If we add to this comparison some elements related to the functions of
supply of public goods and services and redistribution and to the exercise
of democratic legitimacy, it becomes possible to analyse the gap between
the method of economic organization in the European Union and that
which should correspond to a ‘Federation of Nation-States’.
That is the overall aim of this chapter. It begins with a brief look at
the literature on fiscal federalism, establishing its fundamental traits
and possible implications for the European case (section 2). The chapter
continues by presenting the essential elements of the European Union’s
economic organization, with particular emphasis on the discussions
concerning fiscal discipline and the size of the community budget (sec-
tion 3). The path is then open to analyse the essential question: how
far is this economic organization from that resulting from the theory of
fiscal federalism (section 4)? It concludes with some final remarks and
implications for the future (section 5).

2 The theory of fiscal federalism: what major lessons

for the EU?

As Oates (1999) points out, the use of the term ‘federalism’ in economics
is somewhat different to its normal use in political science. In the latter,
8 Fiscal Policy in the European Union

it refers to a political system with a constitution that guarantees a set

of principles and proceeds to the sharing of competences between the
various levels of power. In the case of economics, all public sectors are
relatively ‘federalized’, given that all of them provide public goods and
services and have some autonomy of decision: it deals, then, essentially
with the questions that involve the vertical structuring of the public
sector. In this context, the fundamental aim is to find the most suitable
way of sharing responsibilities and of using instruments through the
various levels of ‘government’, so as to optimize their performance.
As there are clearly no rules or rigid formulas that determine a situation
of ‘fiscal optimum’, which is highlighted by the diversity of fiscal struc-
tures in the various federations (similarly, in fact, to the case of political
and institutional structures), the literature in the framework of so-called
‘fiscal federalism’ has attempted to find some guidelines for the vertical
structuring of government.
The essential purpose of this literature is, therefore, the suitable sharing
of competences among the various levels of government (and not, as it
may sometimes seem, fiscal decentralization for itself alone), or, as Oates
(1998) says, identifying the institutional design that will best allow the
public sector to respond to the variety of the demand aimed at it.
Traditionally, the theory of fiscal federalism is concerned with three
essential aspects: (i) the sharing of functions between the different levels
of government (particularly at four levels (Spahn, 1994): supply of public
goods and services; redistribution of income; macroeconomic stabiliza-
tion; and taxation); (ii) the identification of welfare gains resulting from
fiscal decentralization; and (iii) the use of the instruments of fiscal pol-
icy (particularly issues associated with taxation and inter-governmental
transfers).
Through time, the field of fiscal federalism has been broadened as
other topics emerged, including, among others, questions related to
inter-jurisdictional competition and ‘environmental federalism’ (Enrich,
1996; Oates and Schwabb, 1996), ‘market-preserving federalism’
(Weingast, 1995; McKinnon, 1997b) or decentralization in developing
economies or those in transition (Bahl and Linn, 1992; Shah, 1994).
Briefly analysing these fundamental topics from the theory of ‘fiscal
federalism’, it is possible to find some elements that should be determi-
nant in structuring the competences of the various levels of power within
the EU context, particularly taking into account a possible evolution
towards a federalist model.
The main conclusions of the theory of ‘fiscal federalism’ seem largely
compatible with the idea of the evolution of the EU towards a broadly
 Fiscal Federalism in the European Union 9

decentralized federal model (the ‘Federation of Nation-States’) and for

the need, in this context, to create a ‘European economic government’
that would be responsible for competences assigned, in this field, to the
central level of power.
Similarly, they seem to sustain the idea that it is possible to obtain
significant welfare gains through the creation of such a strongly decen-
tralized federal fiscal system, provided that it is suitably designed and
taking into account aims of equity and efficiency. In this design of
the Federation’s vertical structure at the fiscal and budgetary level, the
aspects below would be decisive for the success of the model, taking into
account the main elements of the available literature.
In the first place, the principle of subsidiarity should be applied in a
clear and transparent way, in what concerns the supply of public goods
and services. In this area, centralization should only occur for a small
number of policies: those that have clear supranational nature (such as
defence, security and monetary policy, among other fields). This would
avoid too much ‘central’ intervention (Oates, 1972), something that may
have happened in the European case within the present institutional
model.
In this field, the (still) marked diversity in demands and national
preferences, plus the (still) low mobility of families should not put
the gains of decentralization at risk (Spahn, 1994): they will probably
even highlight them, since they will not cause exaggerated distor-
tions (Flatters et al., 1974). In fact, even if there were spillover effects,
the advantage of cooperation among the different levels of govern-
ment that are closest to citizens could easily outweigh the centralized
solution.
Still within the context of competence sharing in the scope of the
supply of public goods and services, despite the validity of the decen-
tralization principle, there seems to be a need, in some fields, to take
particular care with certain negative consequences resulting from com-
petition between the Federation members, as it eventually would lead to
poorer standards (Enrich, 1996). In the European case, this would be par-
ticularly noticeable in the fiscal and environmental fields, where these
consequences have recently been established, and would justify greater
centralization and harmonization.
In the second place, at the level of the redistribution function, a combi-
nation of some centralization (Tiebout, 1956) and a significant space for
decentralization would be an optimal solution. Various reasons would
justify this significant space for decentralization: reduced geographic
mobility; failure of some sub-national programmes of redistribution
10 Fiscal Policy in the European Union

(Feldstein and Wrobel, 1998, for the case of the USA); extended aims
of the regional redistribution function (King, 1984); and the added con-
cern with the most disadvantaged that are closer (Pauly, 1973). This last
aspect would have an increased importance in the European case, since it
deals with different countries (and regions), with different traditions, val-
ues and histories (or rather, once again diversity justifying some degree
of decentralization).
In this context, a summary of the main theoretical and empirical ref-
erences in this field seems to suggest that, in the case of the European
Union, the redistribution policy would be maintained at the national
level, particularly with regard to individual redistribution, while there
would also be some space for inter-regional redistribution, namely via
transfers through the community budget.
Thirdly, the literature on fiscal federalism points towards an increased
importance of the fiscal policy for the purposes of macroeconomic
stabilization. It traditionally postulates the importance of a signifi-
cant central budget, which, through the transfer mechanisms between
the states/regions positively affected by asymmetric shocks and the
states/regions negatively affected by the same shocks, seems to exercise
an important degree of stabilization (Spahn, 1994). This has, in fact,
been established through several studies, in the wake of the analyses
of Sala-i-Martin and Sachs (1992), Italianer and Pisani-Ferry (1994) and
Bayoumi and Masson (1995): these authors estimated, based on different
methodologies, a significant degree of stabilization in the absorption of
shocks by the North American federal budget.
The same type of role was mentioned by subscribers to the theory
of optimal currency areas (following the seminal works of Mundell,
1961 and Kenen, 1969). They considered that, once the monetary and
exchange instruments were lost, an efficient response to the negative
effects of specific and asymmetric shocks, in the context of a monetary
union, would only be obtained through one of three mechanisms: broad
flexibility of prices and salaries; strong mobility of labour; or fiscal trans-
fers via a wide central budget. In the case that these do not exist (or,
at least, only in a weak situation), the solution would be to move to
national fiscal policies with high flexibility.
As a result of these elements, and with regard to the EU, it becomes
relevant to discuss the best way of pursuing aims of macroeconomic sta-
bilization, knowing the difficulties at the level of labour mobility and the
flexibility of some labour markets, as well as the significant difficulties
of a political nature in promoting both a broadening of centralization
and expansion of the Union budget.
 Fiscal Federalism in the European Union 11

In the fourth place, at the level of the instruments of fiscal federal-

ism, it is worth highlighting the existence of a set of relevant elements:
the existence of certain guidelines (namely, the criteria defined by
Musgrave, 1983) for a potential design of a ‘European’ fiscal system,
despite criticisms of the traditional criteria and the obvious political
difficulties (Alves, 2000); and the need to promote conditional transfers
for internalizing spillover effects (Oates, 1999).
There is also a need to take into account the problems, namely politi-
cal ones, generated by transfers, whose aim is that of ‘fiscal equalization’
(Usher, 1995; McKinnon, 1997b) and, as such, the concern with a cer-
tain trade-off between the goals of greater homogeneity of the levels of
economic growth and economic and social cohesion and the problems
deriving from the existence of taxpayers and net receivers. Finally, there
is a need for some care in constructing the mechanism(s) of ‘income
sharing’, without the associated transfer system(s) being too broad, so as
not to encourage increasing budgetary laxity.
In the fifth place, some literature, following the pioneering work by
Inman and Rubinfeld (1997) and considering both economic and politi-
cal goals, seems to highlight the idea favourable to a largely decentralized
federal system, indicating the possibility of strengthening citizens’ polit-
ical participation, which could overcome the possible costs associated
with a reduction in economic efficiency. This could be particularly rele-
vant in the European case, where there is a significant challenge in the
field of legitimacy and democratic participation.
Finally, some literature also indicates that, under certain conditions,
federalism could constitute the best system for preserving and develop-
ing the market economy (Weingast, 1995). Taking the European case,
this might point towards a situation where the creation of a Federation
would positively contribute towards strengthening European compet-
itiveness. In particular, it points to the fact that there seems to be a
need for special attention to the problem of fiscal discipline in sub-
central governments (in this case, of the member states). In any case, it
shows that it could be enough to combine the prohibition of monetary
financing of the debt and bail-out behaviours on the part of the federal
government with the non-existence of exaggerated inter-governmental
transfers and with the efficient functioning of credit markets to generate
responsible behaviour in the sub-central fiscal authorities (McKinnon,
1997a). In other words, applied to the European case, it indicates that
it might not be necessary to define rules like those resulting from the
Maastricht Treaty and the Stability and Growth Pact (SGP; European
Council, 1997).
12 Fiscal Policy in the European Union

3 Fiscal policy in the EU: the present situation

Having analysed some major lessons that the theory of fiscal federalism
may contain for the EU’s economic organization, and before moving on
to assess the gap between the present situation and that which would
result from an application of this theory, a brief description of the
present organizational context of the euro zone is relevant. This is done
below, firstly by approaching the issue of the European solution for fis-
cal policies, and then with a brief reference to the issue of community
budget size.
In terms of fiscal policy (and, therefore, the macroeconomic stabiliza-
tion in view of specific or asymmetric shocks), the European solution was
provided for in the Treaty on European Union (1992). This foresaw that
fiscal policies would remain in the hands of national governments, albeit
limited by compulsory rules (particularly, restricting the public deficit to
no more than 3 per cent of GDP and the public debt to no more than
60 per cent of GDP), complemented by their coordination at the level
of the Council. It also foresaw the prohibition of monetary financing of
public deficits and instituted a clause of national responsibility for the
public debt (no bail-out).
This solution was designed to maintain a policy instrument that could
be used at national level and, at the same time, to prevent excessive
public deficits from being created and maintained (through restrictive
rules) and to promote some coherence among the various national fiscal
policies and between these and the single monetary policy (through a
coordination mechanism).
In 1997, the SGP came to reinforce this option, particularly in terms
of limiting freedom of activity. Thus, its preventive mechanism assumed
budgetary balance as a medium-term goal, allowing automatic stabiliz-
ers to act and opening up room for manoeuvre with some discretion in
handling fiscal policy, namely when a less favourable economic evolu-
tion occurs. On the other hand, its corrective mechanism established in
a more concrete way the mode of operation for ‘excessive deficit proce-
dure’, in particular defining the sanctions to be imposed and clarifying
situations of exception.
This solution has been the target of wide discussion and great criticism,
at both the academic and political level, particularly prior to 1995 and
after 2000, periods in which there was greater economic difficulty. The
discussion was mostly focused around the way fiscal discipline would be
implemented and controlled (Buiter et al., 1993; Rubio and Figueras,
1998), although the need for such discipline was also questioned by
 Fiscal Federalism in the European Union 13

some authors, namely those who called for more radical reforms along
Keynesian lines (Arestis et al., 2001; Arestis and Sawyer, 2003).
The need for fiscal discipline was linked to the need to preserve the sta-
bility of the monetary union, which would be compromised if countries
promoted excessive public deficits (De Grauwe, 2005). This situation
could determine significant external effects, namely via an increase
in the Union’s interest rate and possible pressures on the central bank in
the sense of making monetary policy more flexible. On the other hand,
the possible incentive to free-riding behaviour determined by the fact
that everyone in a single currency context could share the costs of bad
budgetary behaviour, and the possibility of creating excessive deficits
for political reasons, would constitute additional elements in favour of
a solution that would promote fiscal discipline.
But the way to implement and control fiscal discipline has been the
subject of major controversy, both among defenders of the present rules
(Buti et al., 2003; Begg et al., 2004), and defenders of relatively profound
reforms (Casella, 1999; Creel, 2003; Collignon, 2004; Pisani-Ferry, 2004;
Wyplosz, 2005).
Criticism of the original SGP reached a peak in 2002 when the President
of the European Commission at the time, Romano Prodi, classified it as
‘stupid’ (Prodi, 2002). The critical voices, which reappeared particularly
by the beginning of this century, suggested greater flexibility in rules and
a greater balance between nominal and real aims, namely because of:
(i) the possibility, in a situation of economic crisis, of governments hav-
ing to use restrictive fiscal policies, which would be counterproductive;
(ii) the fact that continued situations of stagnation or poor economic
growth were not considered as exceptions regarding the application of
the excessive deficit procedure; (iii) the possibility that the time period
for correcting excessive deficits was clearly too short; and (iv) the possi-
bility of a differentiation of fiscal rules by taking into account the level
of economic development and the economic dimension of countries
(for example, considering a link between R&D expenses and economic
growth, Afonso and Alves, 2008, argue for such differentiation).
This discussion, and above all the economic difficulties felt by sev-
eral countries at the beginning of the twenty-first century (particularly
France and Germany, the ‘locomotives’ of the euro zone), led in 2003 to
a suspension in the application of the SGP (European Council, 2003) and
two years later to its reform (European Council, 2005). The major features
of such reform included: (i) an extension of the deadline for correcting
excessive deficits; (ii) the need for greater attention to the evolution of
the structural deficit and the weight of public debt on the GDP as central
14 Fiscal Policy in the European Union

elements of fiscal sustainability in the medium and long run; (iii) the
consideration of continued situations of low effective product growth
(below potential) as exceptions to sanctions; and (iv) the inclusion of
various ‘pertinent’ factors that could ease situations that would fit into
the concept of excessive public deficit.
These changes have allowed greater room for manoeuvre for national
governments to deal with specific or asymmetric shocks, in this sense
making the Pact more ‘flexible’, considering the classification of ‘ideal’
fiscal rules proposed by Kopits and Symansky (1998). However, the inclu-
sion of a great diversity of ‘pertinent’ factors that may justify an excessive
deficit could make the Pact less ‘enforceable’ (Alves and Afonso, 2007).
In other words, new doubts have been raised as to its capacity to ensure
the sustainability of public accounts in the euro zone, which are shared
both by defenders of the original SGP (Buti et al., 2005), and by its critics
(Buiter, 2005; Allington and McCombie, 2007).
Another central element is the situation of the community budget in
terms of its size, uses and outlooks. The first important thing to note
is that the EU budget maintains a very small weight, representing little
more than 1 per cent of the Union’s GDP, in a situation that contrasts
greatly with those of federations (or similar political units) with a single
currency, particularly with that of the United States.
Secondly it is possible to argue that not only is the budget small,
but also the major resources seem to be not truly ‘own’, contrary to
what their name suggests. In fact, most of the revenue comes from the
so-called ‘GNP resource’ and the weight of this resource has increased
over the last few years, in view of the successive drop in the importance
of customs duties and agricultural duties and the stagnation followed by
the drop in relevance of the ‘VAT resource’. As this major resource would
not fulfil the criteria for being characterized as a true ‘own resource’
(Cieslukowski and Alves, 2006), the EU remains in a situation of very
limited financial autonomy.
Finally, it is equally significant that a very substantial part of this small
budget is devoted to one of the most controversial (and probably most
unfair) policies in the Union: the Common Agricultural Policy (CAP).
Despite its successive decline in importance in the budget, in particular
after 1985, in favour of the policies for economic and social cohesion,
the CAP continues to represent almost half of the community budget’s
expenses. This leaves very little room for manoeuvre for an increased
common intervention in other areas.
These circumstances do not seem likely to change in the short run, as
can be seen from the analysis of the financial perspectives for the period
2007–13 (Table 1.1), with a very low ceiling maintained for budget size
 Fiscal Federalism in the European Union 15

Table 1.1 Financial perspectives for the period 2007–2013

Values in euro billion, 2004 prices 2007 2013

Value % Value %

Sustainable growth 51090 42.4 57841 45.7

Preservation and management of 54972 45.6 51145 40.4
natural resources
Citizenship, freedom, security and 1120 0.9 1910 1.5
justice
EU as a global player 6280 5.2 8070 6.4
Administration 6720 5.6 7680 6.1
Compensations 419 0.3 0 0.0
Total appropriations for commitments 1.10 1.00
(% GNP)
Own resources ceiling (% GNP) 1.24 1.24

Source: EU site, http://europa.eu.int.

(less than 1.3 per cent of the Union’s GNP) and significant expenses
in the area of agriculture. Some reformulation of fundamental aims
can be seen, particularly for competitiveness and cohesion, following
the attempt at real implementation of the Lisbon Agenda, but keeping
expenses with new challenges in the Union (such as foreign policy and
common defence, the development of citizenship, the strengthening of
the space of freedom, security and justice) at a very disappointing level.

4 Fiscal federalism in the EU: how advanced are we?

If we compare the solution adopted in the context of the Maastricht

Treaty and its subsequent reforms with the main ideas highlighted in the
review of the literature on fiscal federalism, there seems to be quite a large
gap between the present EU framework with regard to the performance in
the field of macroeconomic stabilization (and, in general, between the
definition and execution of fiscal policies) and what should occur in
the context of a true Federation.
This discrepancy is even greater in three areas:

1. The community budget is small – about 1 per cent of the Union’s

GDP – and no significant changes seem to be expected in it for the next
few years. Added to the fact that almost half the budget is destined for
the Common Agricultural Policy, this means that it cannot contribute
to the functions of macroeconomic stabilization that central budgets
assume in the main federations.
16 Fiscal Policy in the European Union

2. Some more recent developments in the theory of fiscal federalism

highlight the relevance of the creation of ‘hard budget constraints’
as a way of preserving and developing the market economy, in
the framework of a highly decentralized federation (Weingast, 1995;
McKinnon, 1997a). Therefore, there could be greater synchroniza-
tion between the theory of fiscal federalism and the solution adopted
for defining and executing fiscal policy in the EU, which is based
particularly on the development and application of compulsory
restrictive rules.
However, both Weingast and McKinnon admit that it could be
enough to combine the prohibition of monetary financing of the
debt and bail-out behaviour on the part of the federal government
with the non-existence of exaggerated intergovernmental transfers
and with more efficient functioning of the credit markets in order to
generate responsible behaviour of the sub-central fiscal authorities.
In the European case, however, as these prohibitions exist, com-
pulsory rules have also been adopted. Nevertheless, as mentioned
above, such rules are not consensual and do not seem to be transpar-
ent enough or applicable in such a way as to promote fiscal discipline
(or ‘hard budget constraints’).
3. The coordination of non-monetary policies in the EU seems to be
insufficient, in a situation that is hardly favourable to obtaining
coherence among the various national fiscal policies and between
these policies and the common monetary policy. In the context of a
federal economic organization, this coherence would be largely guar-
anteed, even in the context of broad decentralization of policies, since
there would at least be institutions that guaranteed the definition of
common fundamental aims and of general paths to follow, as well as
effectively overseeing compliance with the rules.

Considering this discrepancy and admitting that fiscal policies could

still be mobilized for macroeconomic purposes (Solow, 2004) and that
it seems difficult, in the short (and possibly medium) run to pursue this
aim in a (traditional) framework of centralization, with a wider com-
munity budget, the debate mentioned in the previous section and the
lessons of the fiscal federalism theory could indicate the following lines
of evolution, which differ according to the time horizon:

1. In the medium to long run, and in order to bring about and consol-
idate the politico-institutional transformation that would lead to the
creation of a ‘Federation of Nation-States’, it would be difficult not to
 Fiscal Federalism in the European Union 17

keep moving towards an effective reform of the community budget.

Such reform would enable its expansion to levels compatible with the
new demands and new challenges facing the Union and, in particular,
to develop an effective mechanism for stabilization regarding adverse
shocks.
Studies recently carried out by the European Commission (2004)
could, in this field, constitute a good starting point, both from
the point of view of the type of instruments that could shape
new own resources for the community budget, and from that of
a summary of the main problems that would arise in order to
implement them.
Such problems would be associated, on the one hand, with ques-
tions of fiscal harmonization and, on the other hand, with the
necessary substitution of national fiscal burden (as well as national
public expenses by EU expenses), as the only way in which the accep-
tance of European citizens could be considered. It is worth noting,
however, that an enlargement of the European budget does not need
to rely only on such substitution, as a more general strategy towards
economic growth would lead to an increase in fiscal resources.
Recently the President of the European Commission argued for a
reopening of the budgetary debate with no taboos (Barroso, 2007). In
any case, it is not to be expected, nor is it politically desirable (since
it would possibly imply a situation of excessive centralization), that
the community budget should be, even in the long run, similar in
size to the central budgets of certain existing federations (e.g. that of
the United States). In fact, some studies even prior to the adoption of
the Maastricht programme for the single European currency, already
anticipated this situation: MacDougall (1977) mentioned around 5–7
per cent of the GNP; Lamfalussy (1989) referred to about 3 per cent of
the GNP. In either case, however, these values are very different from
those seen today.
2. In the short run, and bearing in mind the political and economic
difficulties arising from what was mentioned in the previous point,
a more efficient resolution of the fundamental issues raised (namely,
efficiency in combating the negative effects of specific and asymmet-
ric shocks, the balance between nominal and real macroeconomic
aims, the strengthening of the coherence of policy mix and the max-
imization of overall well-being) would seem to suggest three more
immediate actions:
(a) The most immediate would be a more credible reform of the Stabil-
ity and Growth Pact, as a relevant mechanism for the supervision
18 Fiscal Policy in the European Union

and maintenance of fiscal discipline. Concerning this point, the

2005 reform seems to have raised the SGP’s degree of flexibility,
but also to have decreased its credibility in terms of its sanc-
tionary nature, in view of the excessive number of causes that
may prevent its application. In this sense, an adjustment of the
existing characteristics, namely considering a more restrictive
and explicit list of ‘escape clauses’, together with the integration
of some measures proposed over the last few years by different
economists would seem to be essential elements. These mea-
sures would include the proposal to evolve towards a pact based
on public debt sustainability also as an incentive to effective
coordination.
(b) The coordination of national fiscal policies, requiring a marked
change in their institutional framework, should be strengthened
and there should be an increasing coherence between national
fiscal policies and the common monetary policy.
As mentioned by Pisani-Ferry (2002), it would be important to
adopt a code of conduct for economic policy and to establish a
compulsory agreement of reciprocal consultation for members of
the euro zone and the Commission before taking the relevant
macroeconomic policy decisions. It would also be important to
transform the Eurogroup into an executive entity with decision-
making capacity through a qualified majority and to transform
the (national) stability programmes into true instruments of coor-
dination and supervision. Finally, it would be important to create
constructive dialogue between the Eurogroup and the European
Central Bank, allowing useful and coherent interaction in terms
of structural reforms and macroeconomic policy.
In this line, a stronger way of change would follow the argu-
ments of Hein and Truger (2005) and Hein and Niechoj (2007).
They argued for an alternative policy model, based on the coor-
dinated development of monetary, wage and fiscal policies, as a
way to achieve steady growth and high employment whilst main-
taining price stability. In such a case, an effective coordination
would even eliminate the need for fiscal discipline rules in order
to avoid the external negative effects from excessive deficits on
one country.
(c) While a more significant expansion of the community budget
is not possible, the effectiveness of the stabilizing response to
shocks of a specific or asymmetric nature may require a limited
mechanism of shock absorption to be created.
 Fiscal Federalism in the European Union 19

Following Goodhart and Smith (1993), in order to be efficient

and not to place excessive difficulties of implementation at vari-
ous levels, such a mechanism should meet several requirements.
Firstly, it should be limited so that community action would
only occur in the event of serious economic difficulties. Secondly,
it should be temporary so that it would not promote depen-
dence and maintenance of the status quo rather than stabilization:
this means that its only source of activation should be negative
changes in economic activity, and it should be suspended as soon
as these changes cease. In the third place, its impact should only
be produced during the stage of minor economic growth, mean-
ing that the mechanism should be based on an indicator closely
associated with fluctuations in real income. Finally, the principle
of subsidiarity should be effective, meaning that help should only
occur where the deceleration of economic activity is caused by
specific national factors.
In this context, it should also be noted that, since the begin-
ning of the 1990s, several attempts have been made to create
a ‘European scheme of fiscal transfers’, which have been aimed
at these kinds of goals (e.g. Melitz and Vori, 1993; Italianer and
Pisani-Ferry, 1994; Hammond and von Hagen, 1998). Although
these have been unsuccessful in terms of policy adoption, some
of them contain significant possibilities to be explored in the
framework that we have just defended.
Also with regard to this, and in a similar way to that mentioned
in section 2 relative to ‘income sharing mechanism(s)’, if this
transfer system existed, it should not be too extensive, otherwise
it could put fiscal discipline at risk, by encouraging increasingly
lax behaviour at the level of public accounts.

In addition, as a result of the lessons of fiscal federalism, evolution

should be marked, at a more general level, by making legal provisions
for a suitable and transparent sharing of competences at the various
levels of government.
In this context, this would ideally result from a true European
Constitution, which would fully provide for the principles of decen-
tralization and of subsidiarity, explicitly placing only the clearly
supranational fields (e.g. defence, foreign policy, monetary policy and
fiscal competition) as ‘federal’ government competences.
In these fields, the unanimous decision rule should be replaced with
a simplified rule of qualified majority: this would mean that decisions
20 Fiscal Policy in the European Union

would be more likely to pass in the central organs of the Union and
would reduce the possibility of creating blocking minorities, thus rais-
ing the Union’s decision-making and intervention capacity, as well as
contributing to a reduction in its ‘democratic deficit’.

5 Conclusion

The objective of this chapter has been to compare the present process of
definition and implementation of fiscal policies in the EU with the main
conclusions of fiscal federalism theory, in order to draw possible lessons
for the EU’s future evolution, namely towards a possible ‘Federation of
Nation-States’.
This comparison supports the idea that the major conclusions of such
theory are broadly compatible with the emergence of a largely decen-
tralized ‘Federation’ in Europe, including the possibility of running
significant positive welfare effects. However, the comparison also shows
that there is still a large gap between the present system and the one that
would result from a wide application of the fiscal federalism theory.
The gap is particularly relevant in the domain of macroeconomic
stabilization, where three elements should be stressed: (i) a deficient def-
inition and capacity of application of fiscal rules (even after the reform
of the SGP); (ii) an insufficient degree of coordination of national fiscal
policies; and (iii) the lack of financial autonomy for the centre, as the
community budget has a very limited dimension. It seems unlikely that
this situation will change in the near future, as the new Lisbon Treaty
does not include important alterations in this field, in line with what
already occurred in the failed Constitutional Treaty.
However, it is important to modify this situation, with changes hap-
pening at two temporal levels. Firstly, in the short run, a more credible
reform of the SGP is required, in order to keep it as a relevant mechanism
for the maintenance of fiscal discipline. In our view, fiscal discipline is
still an important matter within the monetary union, as some countries
(especially the bigger economies, see Afonso and Alves, 2008) could hurt
the general welfare if they created excessive deficits.
Secondly, as some of the literature on fiscal federalism, and/or some
post-Keynesian studies, seems to suggest, a strengthening of the coordi-
nation of national fiscal policies (requiring a marked change in its institu-
tional framework), together with a more profound coordination between
these and the monetary policy, would be the most important change in
the short run. The creation of a limited mechanism of shock absorption
would also be relevant, as it would help to increase the effectiveness
 Fiscal Federalism in the European Union 21

of response to asymmetric shocks, whose occurrence may have been

reduced, but not eliminated, by the creation of the monetary union.
In the medium to long run, however, only a significant increase in the
dimension of the EU budget would give the EU the degree of financial
autonomy necessary to face its new challenges and demands.
In addition, as a result of the lessons of fiscal federalism, evolution
should be marked, at a more general level, by making legal provisions
for a suitable and transparent sharing of competences at the various levels
of government. This would ideally result from a true European Consti-
tution, which would fully provide for the principles of decentralization
and subsidiarity, explicitly placing only the clearly supranational fields
(e.g. defence, foreign policy, monetary policy and fiscal competition) as
‘federal’ government competences.
In these fields, the unanimous decision rule should be replaced with
a simplified rule of qualified majority. This would mean that decisions
would be more likely to pass in the central organs of the Union and would
reduce the possibility of creating blocking minorities. Thus the Union’s
decision-making and intervention capacity would increase, together
with an important contribution to a reduction in its ‘democratic deficit’.
The unsuccessful project of the Constitutional Treaty included several
changes that would put the present situation closer to the one defended
in this chapter, namely the elimination of the three-pillar institutional
structure, the increase in the number of areas with majority voting, the
alteration of the rules for qualified majority and the attempt to present
a distribution of competences between the members and the Union.
Some of these changes have been included in the Lisbon Treaty,
presently in ratification. However, the non-existence of significant mod-
ifications in the economic field, the maintenance of some critical aspects
of the Constitutional Treaty (Alves, 2007), the elimination of measures
that could lead people to imagine a reinforcement of political union, and
even the lack of transparency in the negotiation process still leave the
situation far from what would be desirable.

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2
Is There Compatibility between the
Stability and Growth Pact and
Automatic Fiscal Stabilizers?
Sabrina Rostaing-Paris

1 Introduction

The automatic stabilization issue has been permanently at the forefront

of the scene, since Robert Solow invited the academic community to
reconsider it in 2002. Looking at the criticisms raised against fiscal
activism, rule-based fiscal policy relying on the working of automatic
stabilizers provides several clear advantages. State-contingent tax rev-
enues and expenditures dampen economic fluctuations practically with
no information and implementation lags. Moreover, the impact lag of
automatic stabilizers is generally considered to be relatively short. In
principle, if automatic stabilizers are allowed to operate symmetrically
over the cycle, they do not contribute to structural deterioration in
budgetary positions.
Automatic fiscal stabilizers are components of government budgets
and they operate to smooth the business cycle. For example, in a reces-
sion fewer taxes are collected, which operates to support private incomes
and damps the adverse movements in aggregate demand. Conversely,
during a boom more taxes are collected, counteracting the expansion
in aggregate demand. This stabilizing property is stronger if the tax
system is more progressive. Another automatic fiscal stabilizer is the
unemployment insurance system: in a downswing, the growing pay-
ment of unemployment benefits supports demand and vice versa in an
upswing.
The Stability and Growth Pact (SGP), which constitutes the corner-
stone of the fiscal discipline for all the member states of the Economic
and Monetary Union (EMU), goes in this direction by recommending to
the countries to allow automatic fiscal stabilizers to play freely and to give
up the use of pro-cyclical discretionary policies as soon as the budget is

25
26 Fiscal Policy in the European Union

balanced or in surplus. The fiscal rules laid down in the Maastricht Treaty
and the Amsterdam Council ask each member state of the EMU to reach
a budget balance equilibrium or surplus in the medium term, and not to
run over a 3 per cent of GDP deficit.
Various reasons can be found to justify such a fiscal discipline. The first
concern is about sustainability of public finances, that would be ham-
pered when a government has only a few chances of being re-elected and
which imposes severe constraints on the composition of public expen-
diture for the future government (Alesina and Tabellini, 1990; European
Commission, 1997). This might occur when politicians are opportunists
and sometimes make budget deficits in order to increase their chances
of being elected (Milesi-Ferretti, 1996), and when governments are gen-
erous throughout the cycle and not only during recession (Buti and van
den Noord, 2004). The second concern is about the existence of neg-
ative externalities within a monetary union, because the growing debt
of a member state would lead to a rise in the interest rate of the whole
zone (Brück and Zwiener, 2004), increasing the weight of the debt of
the other countries (Creel et al., 2002) and depressing their economic
activity (Carton, 2005). The third concern is about the need for an effec-
tive policy-mix, between the fiscal policies of each country and between
the fiscal policies of each member state and the common monetary pol-
icy. The fourth concern is about the fiscal preparation of demographic
weight, with the ageing of the European population and its cost. The next
concern is about the credibility and the independence of the European
Central Bank, because in the event of a too important debt in a country,
the ECB should respond to avoid inflationary pressures (Buti et al., 1998).
Moreover, the fiscal theory of price level1 (FTPL) suggests that, as long
as the discretionary fiscal policy ensures the solvency of the public debt,
the monetary policy cannot have the last control on the price level (Buti
et al., 2001; Buti and van den Noord, 2004). Therefore, in order to guar-
antee full independence of the central bank, a monetary union needs
an institutional mechanism which imposes fiscal discipline. Finally, the
last concern is about the free stabilization of the activity, which can be
linked to the theory of fiscal cycles, developed in 1930 by the Swedish
economists Myrdal and Ohlin.
However, compliance with the rule prevails over that of stabiliza-
tion. The use of the automatic stabilizers must then be compatible
with the requirements of the Stability and Growth Pact. In order to
reach such a sound fiscal position, each country has to implement
structural reforms. Therefore, the fiscal consolidation should have an
impact on the tax and unemployment benefits systems. Indeed, a fiscal
 The SGP and Automatic Fiscal Stabilizers 27

consolidation should be done through a reduction of the tax burden

and of social expenditures in order to guarantee a sustainable debt in the
long term.
From a theoretical point of view, there should be no trade-off between
economic efficiency and stabilization. Fiscal reforms should improve
both efficiency and stabilization of the economy. Indeed, several authors
(Brunila et al., 2002; Buti et al., 2003; Martinez-Mongay and Sekkat,
2005) show that such a trade-off depends on the typology of the shocks
hitting the economy. Fiscal stabilization is desirable in the case of
demand shocks because it allows the smoothing of both output and infla-
tion, while in the case of supply shocks, output stabilization may come
at the cost of temporarily higher inflation (in the case of temporary sup-
ply shocks) or may delay structural adjustment (in the case of permanent
supply shocks). Therefore, a reform of the tax system should not only
improve efficiency but also, in the case of supply shocks, improve the
cyclical stabilization. The reason for this is that the tax system can have
distortive effects on economic activity (Gali, 1994). The studies that have
been carried out on this subject have shown that an optimal tax burden
exists (see, for example, Buti and van den Noord, 2003), i.e. a level of
taxation below which its reduction can not only improve economic effi-
ciency, but also make automatic stabilizers more efficient, depending on
the nature of economic shocks.
The empirical literature reveals that in the case of a balanced budget
rule, a default of the stabilization of the business cycle could arise if the
economy of a member state lazes or falls into recession before having
reached the ‘close to balance or surplus’ position (Brück and Zwiener,
2004).
Bartolini et al. (1995), using a structural macroeconometric model,
showed that automatic stabilizers were restrained by restrictive budgetary
policies aiming at fiscal consolidation. Therefore, automatic stabilizers
could not smooth the business cycle. In a similar vein, Paul van den
Noord (2000) pointed out that the cyclical behaviour of tax receipts could
have changed during the 1990s because of the reforms of the tax systems.
Hence, the automatic stabilization properties of tax systems should have
been reduced. The simulations carried out with the INTERLINK model
suggest that in the European Union, if automatic stabilizers had been
able to work freely, i.e. without being counterbalanced by restrictive dis-
cretionary adjustments, the fiscal deficits of 1999 would have been on
average six times higher than their observed level.
As there is no consensus among economists that the compliance with
the rules of fiscal discipline necessarily requires a reduction of automatic
28 Fiscal Policy in the European Union

stabilizers, we have sought to discover whether the current size of

automatic stabilizers is compatible with the compliance to the rules of
fiscal discipline imposed by the SGP.
Most studies focus on the efficiency of the automatic stabilizers. They
try to estimate the degree of automatic stabilization. This chapter tries
to determine the trade-off between fiscal consolidation and the presence
of automatic stabilizers in economies as mentioned above. For that pur-
pose, we first estimate the size of automatic fiscal stabilizers for each
member state of the Economic and Monetary Union, with the exception
of Luxembourg and Slovenia, from 1992 to 2006. We focus on the budget
sensibility to the business cycle. As previous works are based on macro-
econometric models which are not available, we use a simple univariate
regression, already applied by J. B. Taylor in 2000 with US data. To our
knowledge, Favarque et al. (2005) are the only authors to have studied
the size of automatic stabilizers in the European Union countries by using
Taylor’s regression. Differently to their work, we do not use exactly the
same variables. Our econometric method gives the total size of automatic
stabilizers, without making a distinction between the categories of stabi-
lizers. International institutions, such as the OECD2 and the European
Commission,3 specify five elasticities having an impact on the budget
balance, and by summing these elasticities, estimate total fiscal stabiliz-
ers for each country. Our study focuses on the total size of stabilizers and
not on the evolution of each category.
Once we have estimated the size of the automatic stabilizers, we are
able to compare our results with a reference value that allows compliance
with the rules of the SGP. We believe that our approach could provide a
new analysis of the automatic stabilization issue in the framework of the
Stability and Growth Pact.
The rest of the chapter is organized as follows. Section 2 develops
the effects of fiscal consolidation. Section 3 presents the data used. Sec-
tion 4 explains the estimation method developed in two stages. Section 5
reveals the different results found and their interpretation. Section 6
concludes.

2 The effects of fiscal consolidation

First, among the different Keynesian views, fiscal consolidation can have
opposite effects on the economy. Thus, fiscal consolidation can only be
expansionist for the expansionary fiscal contractions theory. And it can
only be neutral within the neo-Ricardian framework.
 The SGP and Automatic Fiscal Stabilizers 29

2.1 Contrary Keynesian effects

We first study the standard Keynesian effects of a fiscal policy. Then we
look at the role of the fiscal policy from the New Consensus point of
view.
The standard Keynesian argument is that fiscal contraction has a tem-
porary restrictive effect through the channel of the aggregate demand,
in a model with rigid prices and wages. In the simplest static model
with fixed prices, an exogeneous reduction of public expenditure (or
a contraction of the disposable income following an increase in taxes)
will cause the traditional Keynesian effects on demand via the multi-
plier mechanism. In the short term, the Keynesian effects prevail and
restrictive fiscal policies have contractionary effects on private consump-
tion and economic activity. Indeed, the Keynesian multiplier rests on
the demand–production–income interaction. The multiplier of public
expenditure is equal to 1/(1 − c), c being the marginal propensity to con-
sume. Thus, public expenditure causes an equal rise of production and
income, which is spent in proportion c, whence there is a new rise of
production and income, always spent in proportion c, etc.
In the case of a monetary union, where intra-zone trade is strongly
developed, the budget deficit of a country can have not only beneficial
effects in the country which makes the deficit but also in the other coun-
tries of the zone through the trade channel. Thus, the other countries
will benefit from the economic revival of the country making the deficit.
By adding into the Keynesian analysis a proportional tax revenue
according to the coefficient t, the escape in tax leads then to a reduced
multiplier: 1/(1 − c + ct), and its magnitude is less than that of the mul-
tiplier of expenditure. The multiplier applicable to the tax is negative: a
fall of tax thus increases revenue through the demand channel. Thus, in
the case of a fiscal consolidation, a rise of tax and/or a fall of the public
expenditure reduces the total income of the economy.
On the other side, economists belonging to New Consensus Macro-
economics, for whom money supply has an endogenous nature, consider
that monetary policy is the main instrument of macroeconomic pol-
icy while fiscal policy is not a powerful macroeconomic instrument any
more (Arestis and Sawyer, 2003). The New Consensus view is character-
ized by the existence of a supply-side equilibrium (the non-accelerating
inflation rate of unemployment, the NAIRU). When unemployment falls
below the NAIRU, the rate of domestic inflation increases.
The aim of monetary policy is price stability. In the long run, monetary
policy affects the inflation rate but does not have any impact on output,
while, in the short run, monetary policy can have an output stabilization
30 Fiscal Policy in the European Union

objective (Fontana and Palacio-Vera, 2005). However, in the long run,

economic activity fluctuates around the supply-side equilibrium. There-
fore, there is no trade-off between inflation and unemployment in the
long run.
In the case of a New Consensus model, fiscal policy is ineffective. The
budget balance can vary along the business cycle thanks to the automatic
fiscal stabilizers but it should be balanced on average over the cycle.
Moreover, fiscal policy must not prevent monetary policy keeping the
price level under control. Therefore, for the New Consensus ideology, a
fiscal consolidation should not have any depressive effect on economic
activity and allows monetary policy to work freely in order to fulfil the
inflation targeting.

2.2 Successful fiscal consolidation

We first present the theory of expansionary fiscal contractions. Then
we expose the experiences of fiscal consolidation which had a positive
impact on the economic activity.

(a) The expansionary fiscal contractions theory

Contrary to traditional Keynesian thought, the expansionary fiscal
contractions theory regards as possible that fiscal contractions have
expansionary effects and that expansionary fiscal policy has depressive
ones. Thus, the expansionary (depressive) effects of the fiscal contrac-
tions (expansions) would result from the impact of the reductions (rise)
of public expenditure.
The expansionary fiscal contractions theory is reinforced by Danish
and Irish experiences in the 1980s, as reported by Giavazzi and Pagano
in 1990. Following their study, other expansionary fiscal contractions in
OECD countries have been discussed in the literature and are summa-
rized in Hemming et al. (2002). The majority of the literature considers
OECD countries in the studies. Two periods of studies appear: from the
first half of 1960 to the first half of 1990, and from 1970 to the first half
of 1990. The conclusions provided are not homogeneous, but this is not
surprising, as the definition of fiscal contractions is different from one
paper to the next. However, other OECD countries besides Denmark and
Ireland experienced expansionary fiscal contractions (Australia, Belgium
and Canada, among others).
According to this theory, a credible and permanent programme of
reduction of government expenditure and taxes will stimulate the rise
of private demand, thanks to expectations of a permanent debt reduc-
tion. The private expenditure will increase sufficiently to compensate for
 The SGP and Automatic Fiscal Stabilizers 31

the direct effects of the fiscal contraction, and then, the most important
impact of the reduction of the deficit can be positive rather than negative
(Barry and Devereux, 2003).
But in order to have an expansionary fiscal consolidation, the level of
government expenditure or public debt must be very high and unsustain-
able (Blanchard, 1990; Perotti, 1999; Briotti, 2005). In such a context,
if the fiscal authorities send the signal of an important and perma-
nent modification of the budget balance, that will involve expections of
durable debt fall (Giavazzi and Pagano, 1996), because, in the case of a
high ratio of debt to GDP, it would seem that there is a stronger probabil-
ity of having anti-Keynesian effects than standard ones (Afonso, 2006).
Bertola and Drazen (1993) and Sutherland (1997) consider that when
public expenditure is sufficiently high, an important fiscal adjustment
is expected to be set up in the future through a reduction of the
public expenditure, thus increasing agents’ permanent income and
consumption.
Alesina and Ardagna (1998) show that a fiscal consolidation can
be expansionary via interest rates. In the case of high levels of debt,
investors ask for a risk premium to hold long-term liabilities. Therefore,
a successful fiscal consolidation would lead to a reduction in real inter-
est rates, then to a reduction in risk premium. And the reduction in real
interest rates has expansionary effects on economc activity.
Lastly, Alesina et al. (2002) show that a fiscal consolidation will involve
a rise in investment, via wages reduction. In a case of a lack of labour
force following an increase in public employment, real wages go up
while private profits decline and investment falls. Hence, if the fiscal
consolidation takes place through a reduction in public employment,
investment should rise and wages should be lower because of a higher
unemployment rate.

(b) Fiscal consolidation experiences

According to Giavazzi and Pagano (1990), Denmark and Ireland expe-
rienced expansionary fiscal contractions in the 1980s. In the 1970s
Denmark suffered from high budget deficits, strong inflation rates and a
depreciation of its currency. Between 1980 and 1982, the national debt
accelerated, rising from 29 per cent to 65 per cent of GDP, the unemploy-
ment rate being 4.2 percentage points higher than the rate in 1979. In
the last quarter of 1982, the long-term interest rates had reached 22 per
cent, and inflation 10 per cent. Therefore, a fiscal programme to recover
a sound fiscal position was set up. In four years, the full-employment pri-
mary budget4 passed to 10 per cent of GDP, of which 2.8 per cent came
32 Fiscal Policy in the European Union

from a reduction in government consumption, 0.4 per cent from cuts in

public investment, and the remainder from the raising of taxes net of
transfers. The primary budget balance then improved by 15.4 per cent.
On the monetary side, the Danish krone was anchored to the German
mark, thus guaranteeing the credibility of its value. The fiscal contrac-
tion was accompanied by an average growth rate of 3.6 per cent of GDP
between 1983 and 1986. This growth was the result of a fast increase in
private consumption and investment. At the same time, complementary
monetary and exchange rate policies were implemented. The German
mark became a nominal anchor of the Danish krone, and the long-term
interest rates fell sharply.
On the other hand, in Ireland, a fiscal consolidation took place in
1982 and had a depressive effect on consumption and private invest-
ment, whereas the budget deficit of full employment had been reduced
by more than seven percentage points of GDP in two years. Vis-à-vis
this failure, the new government made a new attempt in 1987, but it
favoured a reduction of public expenditure and investment rather than
a rise of taxes as in 1982. In two years, the primary full-employment bud-
get deficit was cut down by 7 per cent of GDP once again, the growth
rate went up and the ratio of debt to GDP started to decline for the first
time since the beginning of the 1970s. In that case, fiscal consolidation
was reinforced by an exchange rate policy which stimulated domestic
demand and led to a fall in interest rates.
Giavazzi and Pagano (1990) thus showed that anti-Keynesian effects on
private consumption and investment took place, but only in Denmark.
However, in the case of Denmark and Ireland, the restrictive fiscal pol-
icy took place after a devaluation of the currency, which then involved
gains of competitiveness with respect to the other countries, and the peg-
ging of their currency to the German mark. The authors conclude that
the important expected increase in the disposable income and wealth
of private agents is the explanation for the anti-Keynesian behaviour of
consumption.
Giavazzi and Pagano’s later (1996) empirical study relates to a panel of
nineteen OECD countries from 1970 to 1992. They study the variables of
income, private consumption, investment, taxation and transfers, debt
and public expenditure. The authors show that if the primary struc-
tural balance remained between more or less 5 per cent of potential
GDP, the effects of a fiscal expansion/consolidation on private consump-
tion and investment would conform to the Keynesian analysis. On the
other hand, if the variable exceeded this 5 per cent of GDP value, then
fiscal expansion/consolidation would have anti-Keynesian effects. This
 The SGP and Automatic Fiscal Stabilizers 33

negative correlation would be more obvious in the case of important

consolidations than in that of important fiscal expansions. The authors
conclude that the episodes of fiscal consolidation not only concerned
Denmark and Ireland, but many other countries (Australia, Finland,
Japan and Sweden) could also have made such an experiment. Thus,
such anti-Keynesian behaviours could apply to various countries.
However, to test these behaviours econometrically, Giavazzi and
Pagano increase taxes and reduce public expenditure at the same time.
They thus limit the role of automatic fiscal stabilizers through the reduc-
tion of public expenditure. The rise of taxes, through tax base or tax
rates, will make it possible to avoid more strongly an overheating in the
high phase of the cycle or in the event of expansionary shock on the
economy but do not leave sufficient room for manoeuvre to taxpayers
in a downswing or in the event of negative shock on the economy.
In an article of 2000, Giavazzi et al. estimate national equations of
savings rates for 18 industrialized countries, from 1970 to 1996, and 101
developing countries, from 1970 to 1994. In the case of the OECD coun-
tries, the authors distinguish effects of fiscal policy according to whether
one is in a normal period, in contraction, or in expansion. In particu-
lar, in normal situations, a rise of 1 per cent of net taxes will involve an
increase of 0.44 per cent in the private savings rate; in a period of expan-
sion of 0.22 per cent; and in a period of contraction of 0.03 per cent. In
the same way, the impact of a rise of 1 per cent of public expenditure
involves a fall of private savings rate of 0.9 per cent in a normal period; a
fall of 0.71 per cent in a period of expansion; and a fall of 0.5 per cent at
the time of a consolidation. These results reveal the existence of Ricardian
behaviours in the situation of fiscal contraction, whereas it is not the case
during the two other periods. In this article, the authors indicate that the
majority of the fiscal consolidations were carried out through a rise of
net taxes rather than through a fall of public expenditure.
Van Aarle and Garretsen (2003) take up the study by Giavazzi and
Pagano (1996), but adapt it to the European countries over the transition
period towards monetary union from 1990 to 1998, and then over a
second period from 1970 to 2000. The authors were not able to show the
existence of non-linear effects between taxes and transfers on one side
and private consumption on the other during the phase of transition
towards EMU. On the other hand, they found a short-term non-linear
effect between public expenditure and consumption.
But for Hjelm (2002) and Schclarek (2005) none of the preceding results
is valid. Indeed, while working on panel data, they find that positive
or negative fiscal shocks involve standard Keynesian effects in nineteen
34 Fiscal Policy in the European Union

OECD countries. Thus, the effects of fiscal contractions in Denmark and

Ireland would not be transposable to the other countries. The success of
such a consolidation would be due to specific factors. The expansionary
effects of fiscal contractions in Denmark and Ireland would have been
generated by the depreciation of the currency preceding the consolida-
tion which would have led the confidence of the consumers on their
future income.
2.3 The Ricardian equivalence hypothesis
On the basis of the initial intuition of Ricardo, Barro (1974) contributed
to refute the thesis of the effectiveness of fiscal action on the economic
activity variations. The Ricardian equivalence hypothesis implies the
same effect of an increase in taxes and an increase in debt to finance
public expenditure. The economy is therefore influenced only by the
quantity of government expenditure and not by the method of financing
this expenditure.
This theory proposes that a fiscal expansion generates the expectation
of future fiscal contractions, in order to compensate initial looseness.
Thus, public expenditure will be fully balanced by a more important
private saving, resulting from households and firms taking precautionary
measures. Consequently, the fall in the private aggregate demand will
reduce, or bring back even to zero, the expected expansionary multiplier
effects. In other words, in a case of perfect Ricardian equivalence, a tax
cut, leading to an increasing public debt, will be fully offset by higher
private saving. Indeed, economic agents will anticipate higher taxes in
the future to refund the debt. Therefore, their permanent income and
aggregate demand are not affected (Hemming et al., 2002).5 This is even
more the case when the government has adopted a fiscal rule.
Thus, if the fiscal expansion does not have the discounted effects, one
can suppose that a fiscal contraction will not have any effects either.
However, in order for the Ricardian equivalence assumption to hold, a
certain number of conditions must be satisfied, like perfect capital mar-
kets, absence of constraints of liquidity, and altruistic agents able to form
rational expectations. The robustness of the Ricardian equivalence can
thus be called into question when these conditions are not fulfilled,
and remains very much a matter for discussion among the scientific
community.

3 Data and descriptive statistics

The empirical analysis realized in this study is based on annual data of

the primary cyclical budget balance and of the output gap, both of them
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Who made some figure in the piece,
And, at no very distant page,
Was seen to figure on the stage;
The Lady all her points had carried,
Was rich, and had the Pleader married;
Had chang'd her uncle's name of Squeeze'em
To her shrewd husband's, Lawyer Seize'em:
Who, by his cunning and his skill,
Had brought all contests to her will,
When he had got his promis'd fee
Of Beauty, Wealth and Luxury.
To her, with smiles of gay content,
The 'Squire his eager footsteps bent,
And did in lofty tone proclaim
His change of fortune as of name;
And told her it would be his pride,
At a small Fête would she preside,
Which he propos'd in style to give,
Where he would all her friends receive;
For this was now the only way
He had to make his party gay:
And the first flourish of his plan
To figure as a Gentleman.
—She smil'd and said she'd bring him plenty,
Then ask'd at once his cards for twenty.
—The fête was given,—the dance, the song,
And feasting did the night prolong,
Which pleasure gave to full two score,
Whom he had never seen before;—
But, his great object to maintain,
These he must strive to see again;
At all their doors his cards present,
And thus, by various compliment,
To form a circle of such friends
As would secure his serious ends,
In social ease to pass the day,
And often find an evening gay.
—But 'Squire Free-born quickly found
He did not tread on solid ground,
And 'gan to fear he should not see
The way to that society,
Which forms of life the happiest measure:
By mutual interchange of pleasure.
—'Twas but slight chat if he should meet
His new acquaintance in the street;
He seldom found, or more or less,
But gen'ral forms of politesse,
And that, too often, at the best,
Was but in flimsy style exprest.
—Ladies would ask him to the play,
To take his arm and let him pay;
And when to cards, he always lost
More than the wine and biscuits cost.
He found, as yet, but little done—
'Twas neither common sense nor fun,
Where kind regard would ne'er encrease,
And int'rest wak'd the wish to please;
Where words were either cold or hearty,
As he propos'd to give a party;
And a good supper was the charm
That did to transient friendship warm,
For that, alas, no longer lasted,
Than while they thought on what they tasted.
 'Squire Free-born soon began to feel
A relaxation in his zeal
To push away that class among
Who did his evening parties throng,
From whom no fair return was made,
And mod'rate fashion was display'd.
Manners were ap'd, but in a way
That did vulgarity betray;
And the best show that he might see,
Was dash of awkward finery:—
Besides, a rude and rough event
Gave spirit to his discontent.
—He call'd, one day, where, on admission,
The parties were in sad condition;
It was a scene of mutual flame,
'Tween Start-up and his lovely dame.
He was a clerk on public duty,
And she a most conceited beauty:
When, as he enter'd, her sharp tongue
Began in tones both harsh and strong,—
"Pray, Free-born, do you think it breeding,
That he should thus be always reading?
When he does from his office come
'Tis thus he sits hum-drum at home,
As if he thought so low my wit
I'm not for conversation fit;
Nor does he seem to rate me higher
Than to trace figures in the fire!"
—"Call you, hum-drum, that information
So suited to official station,"
He sternly said, "which now engages
Attention to these curious pages!"
—"My mind," she cried, "was in the dark
When I was married to a Clerk:—
O had I join'd a fool instead
 Of one to office breeding bred!
He, who in honour should protect me,
You see, Sir, how he dares neglect me!"
—In terms polite to praise and blame,
Free-born now hop'd to quench the flame,
And therefore offer'd, nothing loth,
To give a little spice of both.

Drawn by Rowlandson
Quæ Genus, interrupts a Tête a Tête.

"Madam, by persons of discerning,

My friend is known for store of learning;
While you are bless'd with those rare charms,
A Prince might wish to fill his arms."
He gently smil'd and so did she,
At this same two-fold flattery,
Which, in a moment, seem'd to smother
The flames of anger 'gainst each other:
He therefore ventur'd to proceed,
But did not now so well succeed.
"You ask me to unfold my thought,
Which is with truth and friendship fraught.
We all well know, in life's great stake,
There's such a Rule as give and take;
A maxim, with your good in view,
I recommend to both of you.
On this, for peace, fix your reliance,
And learn to practise kind compliance.
If he is haughty, soothe his pride,
Nor with disdainful glances chide.
When you are angry, he must chase
All frownings from that lovely face,
With tender words and soft embrace. }
Both of you now are in the wrong,
He with his book,—you with your tongue."
But, ere he could his speech conclude,
With scornful look and accents rude,
Again the furious Dame began:—
"What Impudence is in the Man!
Thus, 'gainst his betters, to let loose
His vulgar tongue in such abuse.
My husband to be thus belied,
Who is my love, my boast, my pride!"
When Start-up foam'd,—"You risk your life,
In treating thus my darling wife;
Who, I proclaim, as 'tis my duty,
Has charms superior to her beauty!"
Then each gave each a warm embrace,
And both star'd in poor Free-born's face,
The one as if he wish'd to beat him,
The other as if she could have eat him.
He then, as suiting her desire,
Threw the base volume in the fire,
When she——"Thus ends a petty fuss
Which may cross those who love like us;
Though I might wish it had not been
By such a saucy booby seen."
—Free-born, but not from sense of fear,
Now thought it best to disappear;
And as they rang the clam'rous bell,
He heard them both the servant tell—
"Discharg'd you shall be, if the door
Is open'd to that varlet more."
—Such vulgar threat the 'Squire amus'd,
For he no more would be refus'd
By those whose silly actions prove
That they could scold, and lie, and love:
But still he rather felt the wrongs
Which had proceeded from the tongues
Of those who had no fair pretence
At what he said to take offence:
A pretty way to make amends
For having treated them as friends;
In short, he thought it best to fly
His late acquir'd society:
Pert Lawyers and such busy men
As in some office wield the pen;
Who, when their daily labour's done,
Put their best coats and faces on;
Leave home, where tallow dimly lights 'em,
For wax, when some dull fool invites 'em,
The plenteous evening to prolong
In lively glee or tender song,
Or in some funny tale to shine,
And give a current to the wine.
There, too, their wives and sisters flow,
Gay, scanty finery to show,
In gawdy trim and furbelow; }
Who can, perhaps, the music play,
And scream the carol of the day;
Nay, work a waltz, while staring eyes
Proclaim their gentle ecstasies.
At length the shawls and wrappers come,
When in their hacks they trundle home.
—Though, after all, whate'er his aim,
Whate'er his fancy chose to claim,
'Twas not amiss;—this first degree
In what is call'd society,
Where step by step he must advance
To higher place in fashion's dance:
But with the folk, he 'gan to find,
Who din'd with him, he never din'd,
And got no more than casual tea
For what his guests thought luxury;
And, in a snug, familiar way,
For all they gave, they made him pay.
Besides, he sometimes felt offence,
At what he thought impertinence:
Such as they were, both great and small,
He cut acquaintance with them all.
His purse had thus indulg'd his whim,
But they ne'er heard again from him.

He now suspected that his plan,

Of turning to a Gentleman,
Was not so easy to be brought
To such success as he had thought.
But still he ventur'd to turn over
New plans by which he might discover
Some means to realize his scheme,
But it, at times, began to seem
Somewhat, indeed, too like a dream. }
 To thinking minds it is not strange
That man is seen so soon to change,
And, when he gets on random chace,
To move so quick from place to place.
If no fix'd principles he trust
Which Reason says are true and just,
The busy world will not restrain him,
Nor in one beaten path maintain him.
Now here, now there, he is as oft
Seen to sink low as rise aloft.
As he moves on, how he will vary
From sober thought to gay vagary;
Nay, seem the tempers to unite
Of Dons 'bout whom historians write;
The one whose name our laughter cheers,
And he who pass'd his time in tears.
What wonder then that we should see
In Free-born, that variety,
Which, in his disappointed mind,
Nature may bid us look and find:
Though he must guess profoundly well,
Who could th' approaching change foretell.

He long since felt it as a folly

To think again on pretty Molly,
But when his project seem'd to fail,
Her image did again prevail;
And humbler views began to find
A passage to his wav'ring mind.
Instead of striving to pursue
What he now fear'd would never do,
He fancied that a tender wife
Might give a charm to rural life.
Molly he fear'd not he could move
To bless a home with married Love,
And that a cottage might be found,
With garden green and meadow ground;
Where he might form his fragrant bowers,
And deck the pretty lawn with flowers;
Beneath a beech-tree read his book,
And sometimes angle in the brook:
Nay, even wield a shepherd's crook. }
Money he had, and so had she,
And, with a due economy,
Far from the noisy world remov'd,
And by each other fondly lov'd,
They might pass on in plenteous ease,
And lead a life of smiling peace.
He slept, and, in a dream, he swore,
He saw his Parent-Friend, once more—
Not looking as he did before, }
But all so smirking, blithe and gay;
When, sitting on a cock of hay,
The prong and rake he seem'd to wield,
As he were master of the field:
He spoke not, but he seem'd to speak,—
"This is the life, boy, you must seek."
—Such was another strong emotion
To aid the new, romantic notion,
And think of nought but Cottage Life,
With pretty Molly for his Wife.
He turn'd this over in his mind,
And ev'ry hour felt more inclin'd
To take the Maiden by surprize,
And this fond dream to realize.
 Sweet Molly now was gone from town
As waiting-maid to Lady Brown,
Who lives a portion of the year
At her fine place in Devonshire;
Nor did fond Corydon delay
To write his mind another day:
While, to amuse th' impatient hours,
He fill'd his room with shrubs and flowers:
Branching Geraniums were seen
To make his ev'ry window green,
And something like a picture wear
Of future scenery he might share.

Our time does like our watches go

Sometimes too fast,—sometimes too slow;
But to the 'Squire, for he was still
A 'Squire, though now against his will,
Old Bald-Pate mov'd with tardy tread,
As if his feet were hung with lead;
But he went on:—An answer came,
Sign'd Molly, with no other name!
He thought it odd, but did not wait
To make it matter of debate,
So quick his hurry to be shown
The passion which the page would own.
He read,—"I've heard, bless Heav'n, my friend!
(With thanks for what you might intend,)
Your serving days are at an end: }
Thus I believ'd, and find it true,
I could no longer think of you.
It seems to be your prosp'rous fate
To come into a great estate;
And so I thought it Heaven's decree,
You ought no more to think of me.
Besides, as you have never wrote,
I fancied Molly was forgot;
When soon a tender lover came,
A learned man, of preaching fame;
He press'd me,—I was not obdurate,
And so, I'm married to a Curate!
The match my Lady much approv'd,
And my good Husband's so belov'd,
Our kind Sir John has given his word
That he shall shortly be preferr'd.

Poor Corydon could read no more,

But, in a rage the letter tore,
And kick'd the fragments round the floor: }
Toss'd some things up, and some things down,
Curs'd both the Country and the Town;
With pots and pans did battle rage—
Drove the geraniums from the stage,
And wish'd no object now to see
Of ruralized felicity.

The country letter turn'd the tide

To rush upon his wounded pride:
At once he thought it more than folly
Thus to have offer'd love to Molly.
Nay, he began to smile at length;
And, to regain becoming strength,
He took to the well-known resort
Of season'd dish and good Old Port:
When as he sat, with uplift eyes,
And, thro' the window, view'd the skies,
He ventur'd to soliloquize. }
 "My genteel folk I have declin'd,
At least, the sort which I could find;
And just as much dispos'd to sneeze
At all my Rural Deities:
But still I've got a heap of Cash,
And, while it lasts, will make a Dash!
But here one firm resolve I make,—
I never will my Elbow shake;
And if I take care not to play,
I shall get something for my pay:
It will not all be thrown away! }
Who knows what Cupid, too, may do?
For I may win if I should woo;
And e'en, in spite of this same Hump,
Fortune may turn me up a trump.
—My standard now shall be unfurl'd,
And I will rush into the world:
Nay, when I have the world enjoy'd,
With emptied purse and spirits cloy'd,
I then can trip it o'er the main:
Valcour will take me back again;
Once more his humble friend receive,
With all the welcome he can give:
We know not what from ill may screen us,
And I, once more, shall be Quæ Genus."
—He spoke, and seem'd to close his plan
Of keeping up the Gentleman.

The Sun had sunk beneath the west,

To go to bed and take his rest,
As Poets feign, in Thetis lap,
Where he ne'er fails to have a nap;
When, with his second bottle rallied,
Our Hero rose, and out he sallied
In search of any lively fun,
That he, perchance, might hit upon.
—As through a court he chanc'd to pass,
He saw a gay, well-figur'd lass,
Who, in her floating fripp'ry shone,
With all the trim of fashion on.
She had descended from a coach,
And did a certain door approach,
With tripping step and eager haste,
When soon th' illumin'd arch she pass'd:
And still he saw, in height of feather,
Small parties enter there together,
While jovial gentlemen appear'd,
Who, as they came, each other cheer'd.
—He asked, where these fine Ladies went?
The watchman said,—"For merriment;
And should a little dancing fit you,
A crown, your honour, will admit you."
—The 'Squire then rapp'd, the door was op'd,
He gave his coin, and in he popp'd:
The music sounded in the hall,
And smiling faces grac'd the ball,
Where, as he lov'd a merry trip
With some gay Miss he chose to skip,
But as they Waltz'd it round in pairs
A noise was heard upon the stairs,
And strait a magistrate appear'd
With solemn aspect; while, uprear'd,
Official staves in order stand,
To wait the laws' so rude command.
—Sad hurry and confusion wait
On this their unexpected state;
When there broke forth, as it might seem,
From snow-white throats, a fearful scream;
Nor, to add horror, was there wanting
Some strong appearances of fainting:
But Justice, with its iron brow
Unfeeling scowl'd on all the show.
In shriller tones the ladies cried,
In diff'rent key the beaux replied,
Though some consoling bev'rage quaff,
Give a smart twirl, nor fear to laugh:
While coarser voices,—"hold your tongue,
Pack up your alls and come along."
Then, of fair culprits full a score,
And of their dancing partners more,
Beneath stern power's relentless rod,
Were rang'd, and order'd off to Quod.
They march'd away in long procession
To take the fruits of their transgression:—
Staffmen did at their head appear,
And watchmen lighted up the rear.
Our Hero felt the ridicule
Of having idly play'd the fool,
And, as he handed on his Belle,
He could not but compare the smell
That rotten root and trodden leaf
Do to th' offended senses give
Of those who, by the lamp's pale light,
Through Covent-Garden stroll at night,
With all the garlands which he weav'd
Ere Molly's letter was receiv'd:
And all the fragrance of the flowers
He thought to cull in Molly's bowers;
Nay, which, but the preceding morning,
His promis'd hopes had been adorning.
It was indeed a noisome change,
O it was strange, 'twas passing strange!
But still the watch-house made amends,
Such as they were, they gave him friends.
Which here, I'm not suppos'd to think
Were such as save from ruin's brink;
But lively sprites who have a taste
To hurry on the stream to waste.
Thus, when the welcome morn was come,
And Justice sent the party home;
He and two blades of certain feather
Propos'd to pass the day together:
The one, more grave, declar'd his breed,
Famous on t'other side the Tweed,
The other lively, brisk and airy,
Boasted his birth in Tipperary;
Though whether this were truly so,
'Tis from their words alone we know:
But they were easy, free and jolly,
Decided foes to melancholy,
And seem'd well-form'd to aid a day
In passing pleasantly away.
—But first the Trio thought it best
To snatch some hours' refreshing rest,
When, as it was in Summer's pride,
They pass'd their jovial hours beside
The crystal Thames imperial tide; }
And as the river roll'd along,
Made the banks echo with their song.
—At length it was a rival jest
Who of the three could sing the best.
—The sturdy Scot the song began,
And thus th' harmonious contest ran.

Wallace, who fought and bled, he sung,

Whose name dwells on a nation's tongue.
The 'Squire, in boist'rous tone declar'd,
And neither lungs nor quavering spar'd,
That Britain triumph'd o'er the waves
And Britons never would be slaves.
Then Erin's Son, with sweeter voice,
Exclaim'd, "I'll make you both rejoice;
 O with a famous song I'll treat you,
And then you both shall say I've beat you
Your verses are old-fashion'd prosing,
My song is of my own composing;
And though 'tis to lov'd Erin's fame,
To all three Kingdoms 'tis the same."
The hearers both politely bow'd,
When he, of his fam'd subject proud,
Pour'd forth his accents deep and loud. }

Drawn by Rowlandson
Quæ Genus committed, with a riotous dancing
Party, to the Watch-House.

Song.
It has long been agreed by all persons of learning
Who in stories of old have a ready discerning,
That in every country which travellers paint,
There has always been found a protector or saint.
Derry down, etc.

St. George for Old England, with target and lance,

St. Andrew for Scotland, St. Denis for France,
St. David o'er Wales, so long known to preside,
And St. Patrick, Hibernia's patron and pride.
Derry down, etc.

He was gallant and brave as a saint ought to be,

For St. George was not braver or better than he,
He would drink and would sing and would rattle like thunder,
Though 'twas said, he was, now and then given to blunder.
Derry down, etc.

But the jests of his friends he took in good part,

For his blunders were nought but th' excess of his heart;
Though there was but one blunder he ever would own,
And that was when he saw all the claret was gone.
Derry down, etc.

He'd fight for his country's religion and laws,

And when beauty was injur'd he took up the cause,
For the gallant St. Patrick, as ev'ry one knows,
Was fond of a pretty girl under the rose.
Derry down, etc

So many his virtues, it would be too long

To rehearse them at once in a ballad or song;
Then with laughter and mirth let us hallow his shrine,
And drown all his Bulls in a bumper of wine.
Derry down, etc.
Then St. Patrick, St. George and St. Andrew shall be
The Protectors of Kingdoms so brave and so free:
Thus in vain will the thunders of Denis be hurl'd,
For our Trio of Saints shall give laws to the world.
Derry down, etc.

Hard went the hands upon the board,

And Erin's praises were encor'd.

Thus when the pleasant song was heard,

Hibernia's minstrel was preferr'd;
Nor from the voice or in the eye
Was there a hint of jealousy:
Nay, while they took their parting glass,
These sentiments were heard to pass.
"The Thistle, Shamrock and the Rose
May challenge all the world at blows:
English and Irish names are known,—
There's Marlborough and Wellington;
And O, what men of glorious name
Do Scotia's annals give to Fame!"
Drawn by Rowlandson
Quæ Genus engaged with jovial Friends: Or—Who
sings best?

With friends like these the 'Squire began

His new career, and thus it ran,
With others whom he chanc'd to light on
In trips to Tunbridge or to Brighton,
Swells at most public places known
And as gay triflers 'bout the town;
Who might, perhaps, at times resort
To Billiard-rooms or Tennis-court,
Where lively grace, and easy skill
Might flatter Fortune to their will.
Freeborn these gay companions sought,
Who soon their brisk disciple taught
How to direct his lively course
By the snug compass in his purse;
In short, who tutor'd his quick sense
In the gay world to make pretence
By modest, well-dress'd impudence. }
—Ye Dandies, Bucks or by what name
Bond Street re-echoes with your fame;
Whether in Dennet, Gig or Tandem,
In five-cap'd coats you bang at random,
With such nice skill that you may break
Your own, or Dulcinea's neck:
Or, when lock'd arm in arm you meet,
From the plain causeway to the street,
Drive Ladies in their morning walk,
While you enjoy your lounging talk:
Then saunter off to pass your hours
In roving through those gaudy bowers
Where purchas'd pleasure seems design'd
To occupy the thoughtless mind:
And, having idled through the day,
To quicken dull night's weary way,
You seek the mask, the dance or play;— }
With you our Hero did contrive
To keep himself and time alive;
But now and then too prone to trace
Those scrapes that border on disgrace,
And threat the unreflecting plan
Of the best would-be Gentleman!
From such as these he was not free,
As we, I fear, shall shortly see,
In this so busy history. }
—To him no social life was known,
His home, his friends were through the town
Who were seen wand'ring here and there,
Caring for no one, no one's care;
Prepared no pleasures to receive
But coin could buy or chance might give;
And would prove lively or were dull,
As the silk purse was drain'd or full.
For though deck'd out with all the art
That Fashion's journeymen impart,
They never pass'd the tonish wicket
Of High-life, but by purchas'd ticket
Obtain'd by the resistless bribe
To Traitors of the livried tribe,
Which, by some bold disguise to aid,
Might help them through a masquerade;
Or, with some sly, well-fram'd pretence
And varnish'd o'er with impudence,
A proud admittance might obtain
With chance to be turn'd out again:
Nor was the luckless Freeborn spar'd,
When he the saucy trial dar'd.
—One night, the hour we need not tell,
Into a trap the coxcomb fell.
As through the streets he rattled on
Lamps with inviting brilliance shone;
The music's sound, the portal's din
Told 'twas a joyous scene within:
The second bottle of the night,
Might have produced a double sight,
And two-fold courage to pursue
The splendid prospect in his view,
He, therefore bade the Hack approach,
And at the door present the coach;
Then made a push, got through the hall,
And quickly mingled with the ball.
—Whether his face was too well known
Among the dashers of the town,
Who do not an admittance gain
Among the more distinguish'd train,
Whose social habits will exclude
The mere street-trampling multitude,
Who, like the insects of a day,
Make a short buzz and pass away:
Or whether the intruding sinner
Eat as he seem'd to want a dinner;
Or if it did his fancy suit
To line his pocket with the fruit;
Or if he let some signal fly,
Not usual in such company,
Or if his spirits were so loud
As to alarm the polish'd crowd;
Whatever was the Spell that bound him,
Suspicion more than hover'd round him;
For, he replied with silent stare,
As he was taken unaware,
When he was ask'd how he came there. }
Nor did he show a visage bold
When, in a whisper, he was told,
But still with steady look express'd
By the stern Master of the feast,
If he wish'd not to play a farce
To make his pretty figure scarce.
—That such a part he might not play
Which menac'd e'en the least delay,
He thought it best to glide away; }
And, to avoid the threat'ning rout,
As he push'd in, he darted out.

A tonish Matron who ne'er fail'd

Where she was ask'd and cards prevail'd,
My Lady Dangle was her name,
And 'twas the fancy of the dame
Still to retain the antique plan
At night to dance in a Sedan
Sedans, so known the fair to coop,
When clad in the expanding hoop,
Snug chairs borne on by sturdy feet,
Once seen in ev'ry courtly street;
And one a most uncommon sight,
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