The last FIRSTRUN deliverable, D1.7 Summary report of the FIRSTRUN project has been published today.

Executive summary:

FIRSTRUN, or Fiscal Rules and Strategies under Externalities and Uncertainties, is a Horizon 2020 project that has investigated fiscal policy coordination in the EU. This report provides a brief overview of the project and its key findings.

One important research theme of the project has been the effects of cross-country spillovers from economic policies. In addition to spillovers from changes in the level of government spending or taxation, which influence aggregate demand, the project has studied spillovers from “structural fiscal policies”, such as pension reforms, which influence the supply side of the economy.

Both the empirical and model-based results are in line with the view that during “normal times”, fiscal spillovers from changes in the level of government spending or taxation are relatively small. However, spillovers may be much larger during “crisis times”, when the borrowing of many households is constrained and when monetary policy is also possibly constrained by the (effective) zero lower bound. Spillovers also increase when national fiscal policies are coordinated. These results underline the importance of fiscal coordination under special circumstances.

Certain structural reforms also have non-trivial spillover effects via international capital markets. These spillovers do not necessarily require policy coordination from the efficiency point of view, but they do have redistributive implications, e.g. their effects on the extent to which capital market integration benefits different countries.

A related issue is how exactly fiscal policies should be coordinated in a currency union to stabilise output growth and maximise average welfare. The analysis, based on a two-country DSGE-model characterised by country-specific price rigidities and distortions, suggests that the optimal solution would be to use fiscal policies to reduce net export gaps. This result stems from country-specific nominal price rigidities, which imply destabilising fluctuations in the terms of trade over the business cycle.

Another stabilization mechanism relates to cross-country risk-sharing. The FIRSTRUN project has considered private and public risk-sharing mechanisms and compared cross-country risk-sharing in the Economic and Monetary Union (EMU) to risk-sharing across states in the United States. The results show that there is still relatively little cross-country risk-sharing via private capital markets in the EMU. One reason for this is that the cross-border ownership of productive assets remains very limited.

The project has also paid close attention to what is known as “real-time uncertainty”, i.e. uncertainty about the current state of the economy. Real-time uncertainty appears to be very relevant for fiscal policy, because it is particularly difficult to distinguish between cyclical and structural components in economic growth in real time. As a result, the first estimates of variables such as the output gap or the structural deficit, which are key variables to consider when setting the stance of fiscal policy, are often later substantially revised. This has important implications for the optimal fiscal policy as well as the implementation of various EU fiscal rules.

A large part of the FIRSTRUN research was dedicated to evaluating the new, enhanced framework of EU fiscal governance. For example, the approach has been to consider how the new fiscal rules would have constrained fiscal policies during past economic booms and busts. Such analysis requires a clear and comprehensive view of the information that was available at the time the rules would have been applied.

In this regard, one of the main results is that the use of the structural deficit for steering fiscal policy tends to lead to pro-cyclical fiscal policy. Essentially, this is because the output gap method used to assess the structural deficit has a very limited capacity to track cyclical changes in real time.

The project also considered alternative measures for estimating the structural balance, such as the expenditure rule used in the preventive arm of the Stability and Growth Pact (SGP) and the so-called bottom up assessment method used in the corrective arm. The results show that at least in the past, these methods would have been conducive to better fiscal policy than the output gap method.

In a similar vein, FIRSTRUN researchers analysed whether the Macroeconomic Imbalance Procedure (MIP) would have been able to detect increasing macroeconomic risks prior to the 2008 financial crisis and the subsequent recession. The results show that the MIP would have provided moderately useful alerts in terms of crisis prediction before 2009. However, many of the indicators, especially those related to the financial markets, would have been uninformative. This suggests that the MIP Scoreboard could be simplified.

The project also dealt with political and institutional aspects of EU fiscal governance. It raised concerns regarding the erosion of democratic legitimation in EU fiscal governance. Given that fiscal policy has more direct distributive consequences than other areas of policy which have become more technocratic, this may undermine the implicit contract between voters and national governments. In addition, public trust in decision-makers has been shaken. The concept of throughput legitimacy – validating how the EU level decides on the policy demands to be made on member countries – is suggested as one dimension of legitimation to be explored.

Finally, the project has produced new tools in the form of quantitative economic models for designing fiscal policies and developing fiscal coordination mechanisms in the EU.