In the study carried out for the Federal Ministry of Finance, the Ifo Institute reviewed the role of fiscal policy under the conditions of the Stability and Growth Pact. This Pact and the previous Treaty of Maastricht give high priority to fiscal consolidation. Nevertheless it is desirable that the so-called automatic stabilizers of the fiscal system are operating during cyclical up- and downswings. With a relatively low structural deficit or a structural surplus the ceiling of 3 % of GDP for the actual deficit would not be violated during downturns. If GDP falls below trend-GDP by 1 percentage point the deficit/GDP ratio increases in EU countries on average by about ½ percentage points and in some Nordic countries by almost 1 percentage point.
During the cyclical downturns of the 1990s many European countries attempted to reduce fiscal deficits in order to meet the Maastricht criteria or the Stability and Growth Pact. Hence automatic stabilizers were not or not fully operating during these periods. In the meantime most countries have reduced deficits considerably or have achieved a fiscal surplus and they are no better prepared to let automatic stabilizers work during the downturn without violating the 3 % deficit ceiling.
There is the view that fiscal consolidation during a downturn may stimulate growth as the so-called non-keynesian effect (better supply conditions via improved confidence and lower interest rates) are more important than the keynesian effects (lower demand). In the literature some cases have been found for the dominance of non-keynesian effects. Our analysis with a vector-autoregressive model (VAR) suggests, however, that in the case of Germany keynesian effects dominate in the short-term while non-keynesian effects are more important in the medium-term. For the United States the same results have been found with a similar model.
The study also explores the interrelationships between fiscal policy and other macro policies in particular monetary policy and between macro policies and structural policies. It finds that pro-cyclical macro policies, in particular fiscal policies together with unfavourable structural conditions in the labour market may have increased unemployment in Germany and in other European countries. Improving labour market flexibility by structural reforms in particular by tax reforms and social policy reforms together with a more appropriate macro policy would therefore help to reduce unemployment in Germany and in Europe as a whole. Some European reap already the benefits of structural reforms.
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