Fiscal solvency in Europe: budget deficits and government debt under European Monetary Union.

Caporale, Guglielmo Maria

Introduction

The debate on European monetary union has brought the issue of European fiscal policy into public scrutiny. This note discusses the problems of fiscal policy coordination in Europe over the next decade, and analyses the evolution of debt and deficits over the 1970s and 1980s. We then look more formally at the concept of a sustainable path for public debt and report on some tests that investigate whether or not debt paths in Europe have been on a stable trajectory. The note by Barrell and In't Veld in this Review considers the importance of fiscal solvency in constructing large scale macro models, and casts further light on the issues discussed here.

Fiscal policy issues and EMU

The prospect of monetary union in Europe has led to an increase in interest in the size and evolution of the government debt of the members of the European Community. The Maastricht Treaty on Monetary Union has laid down convergence criteria that potential members of the Union must meet. The Treaty explicitly refers to the need to 'avoid excessive public deficits', and sets the following thresholds which should not be exceeded:

- public deficits as a share of GDP should not be higher than 3 per cent;

- gross public debt should be contained within 60 per cent of GDP.

If these criteria were to be interpreted strictly it is very unlikely that EMU could go ahead according to the prepared timetable with all (or even most) of the member states of the EC as participants. Thus the importance attached to the fiscal indicators may well determine the whole shape of EMU at least in its early years. The EC Commission has expressed repeatedly its concern that the process of formation of the union should involve both keeping the evolution of debt stocks under control and constructing a set of effective fiscal safeguards.

Divergent fiscal trajectories could make the transition to EMU more difficult, because of their implications for exchange rate movements. This can be seen clearly within a portfolio approach to the determination of exchange rates. In such a theoretical framework, the main determinant of the exchange rate is asset equilibrium. If a large amount of public sector debt is issued denominated in one currency, this will change its equilibrium nominal exchange rate, and put downward pressure on it, which will have to be offset by market intervention or higher interest rates. EC countries could find it difficult to resist these pressures in the run-up to EMU. A budget deficit is commonly associated with a current account deficit, and hence a decline in net financial assets (the difference between gross assets and liabilities) for the economy as a whole. Therefore large budget deficits will often raise the risk premium on the currency of the country. If the nominal exchange rate is fixed, this will mean a higher interest differential, which conflicts with the objective of macroeconomic convergence. However, with the establishment of a monetary union assets denominated in different currencies will become perfect substitutes and risk premia will be abolished, thereby eliminating the problems encountered in the run-up to EMU.

Why then should the Community be concerned with the fiscal policies adopted by the individual states once EMU has been created? Should there be consistency between those policies and the common monetary policy at the Community level? The Delors Report (1989) asserted that 'the large and persistent budget deficit in certain countries has remained a source of tensions and has put a disproportionate burden on monetary policy' (paragraph 5), and voiced the concern that '...access to a large capital market may... facilitate the financing of economic imbalances' (paragraph 30). It also advocated 'binding rules... (involving) effective upper limits on budget deficits of individual countries' (paragraph 33).

Deficits have to be financed either by issuing debt or by creating base money. Sargent and Wallace (1981)have argued that persistent budget deficits will eventually result either in monetisation of the outstanding stock of debt, thus depriving the monetary authorities of their autonomy in setting policy targets, or in a repudiation of at least part of the debt. Hence lack of fiscal discipline could undermine the independence of a newly created European Central Bank, which might come under potential pressure to loosen its policy stance if some member states had serious budgetary problems. Its credibility could be affected if agents thought that a softer stance would become inevitable to alleviate the financial difficulties of highly indebted countries running large deficits. One of the consequences would be an increase in interest rates reflecting a revision in expectations incorporating higher future inflation rates.

Fiscal discipline would still be a major concern in EMU even if the European monetary authorities remained steadfast in their anti-inflationary commitment, because those states with unsustainable fiscal positions might have to pull out of EMU, whose irreversibility would then be questioned. As a result, markets could take a different view of the degree of substitutability of the assets issued by the different countries. Furthermore, other externalities would be at work, in the form of pressure on other member states to come to the rescue of those with unsustainable debt/deficit paths. Another possibility is that conflicts would arise 'on issues related to the distribution of ... (seigniorage) among member countries' (Padoa-Schioppa, 1990). Other consequences for the Community as a whole of the lack of fiscal discipline would be a general rise in interest rates and an external deficit for Europe vis-a-vis the rest of the world, with adverse effects on the ECU exchange rate.(1) As to the introduction of binding fiscal constraints, the argument is often put forward in the literature that they may appear to improve welfare, but only if the existence of a trade-off between fiscal and monetary policy is ignored (see Padoa-Schioppa, 1990).

The creation of a monetary union will inevitably affect the setting of fiscal policy. Even if only monetary policy becomes the responsibility of the new Community institutions, with fiscal policy remaining in the domain of national governments, the fact that they will no longer be able to monetise debt has implications for policy choices. Fiscal policy may play a more important role as a stabilisation tool in EMU. In the standard Mundell-Fleming framework, in which sticky prices are assumed (see Frankel and Razin, 1987, for a discussion of later modifications to the Mundell-Fleming model, concerning in particular price determination) fiscal policy is most effective when exchange rates are fixed and there are free capital movements, conditions which will be fulfilled in EMU. Because in a fixed rate system a fiscal expansion does not lead to a rise in interest rates and to an appreciation of the exchange rate, some countries might resort more frequently to fiscal measures to respond to shocks, especially if they are country-specific. Such budgetary policies could result in a looser overall fiscal stance, especially if the fiscal authorities failed to distinguish between temporary and permanent shocks. It is often claimed that fiscal policy is the appropriate policy response only to the former, whereas the latter require factor price adjustment, either on its own or in combination with migration (see Bayoumi and Masson, 1992).

In a recession the ability of national governments to conduct countercyclical macroeconomic policies will be limited by the fact that they can not print money to finance their fiscal deficits and meet their maturing obligations. A well-functioning EMU may require a centralised mechanism to at least coordinate fiscal policy across member states. Previous experiences of international coordination suggest that such arrangements are rather ineffectual as a means of counteracting cyclical fluctuations, mainly because the time lags normally associated with fiscal policy become even longer when agreement has to be reached at a supra-national level before national governments can carry out the agreed policies. While fiscal coordination may be apt in the case of a prolonged recession, the arguments for centralised decision-making are less convincing when fiscal tightening is called for, because national governments are not likely to be willing to adopt unpopular policies to follow the directives of the central EC authorities. On these grounds, therefore, it is difficult to argue in favour of a permanent EC body exercising control over national fiscal policies.

There is, nevertheless, a rationale for some degree of control by the central EC authorities. As already pointed out, market discipline might become weaker and national governments might be tempted to resort to borrowing to a larger extent if the possibility existed that the European System of Central Banks (ESCB) would intervene in the case of a financial crisis and bail them out. Although the ESCB may claim that it would not intervene in such a case, such a possibility cannot entirely be ruled out in the face of an imminent threat of default. This, in turn, would make it easier for governments to finance rising budget deficits, and would result in fiscal policies more expansionary than compatible with the monetary stance set by the ESCB, and consequently in undesirably high real interest rates and exchange rate for the Community as a whole. It is also to be noticed that the EC authorities will not be able to offset excessive spending by national governments by tightening their fiscal stance, in the way central authorities at a national level normally do in the presence of out-of-target spending by the local authorities, as their fiscal powers will remain limited (see the fiscal federalism literature, e.g. Sachs and Sala-i-Martin, 1991). Furthermore, the adoption of a single currency will mean that currency risks will disappear, with potentially lower real interest rates reflecting only the concern that the government might default. This will mean a weakening of market discipline, as small increases in real bond yields will be sufficient to bring about huge inflows of international capital. These considerations suggest that some degree of coordination of fiscal policy would not be inappropriate. From a purely political perspective, however, intervention by the EC central authorities could be ineffective, if member states do not have the political will to cede substantial fiscal powers, and the budgetary resources of the EC authorities remain small.(2)

The European experience

Our discussion so far has shown that government solvency is a crucial issue for Europe. In order to establish the extent to which fiscal retrenchment is needed in the European countries wishing to join the monetary union, and to give a realistic assessment of the prospects for EMU, we first examine the evolution of public finances in the Community over the last two decades, and then discuss a formal test of the sustainability of present fiscal policies. Some broad tendencies are discernible for the EC as a whole. In the 1970s, despite the fact that total revenues as a share of GDP rose substantially, there was a marked widening of public deficits brought about by a sharp increase in total government spending. In the following decade, especially in the second half, the tendency of public spending to grow as a share of GDP was restrained and even reversed in some countries. At the same time, revenues increased. As a result, the 1980s witnessed a significant reduction in budget deficits. Charts 1 and 2 plot debt to income ratios for seven of the major European economies, and Charts 3 and 4 plot the deficit/income ratios.

The emergence of sustained budgetary disequilibria in the 1970s was mainly a consequence of the two oil shocks and of the inadequate policy response adopted by most governments. Monetary policy accommodated the inflationary pressures rather than trying to moderate the increase in labour costs, and the unemployment rate kept growing. Consequently, social security spending and current expenditure in general rose sharply, whereas capital expenditure was hit. The increase in the burden of taxation was not sufficient to offset the explosion in expenditure. The deficit/GDP ratios rose rapidly, and so did interest payments. High inflation meant higher effective interest rates on public debt but a fail in the value of outstanding debt relative to GDP at current prices.

Conversely, the 1980s saw a widespread process of budgetary stabilisation, which owed much to cyclical factors as well as increased revenues and slower growth in spending. Swelling budget deficits were increasingly perceived as a severe constraint on growth, as an exceedingly high percentage of domestic saving went to finance them rather than private investment. Hence a reduction in borrowing became the main objective of fiscal policy. The slowdown in the growth of public expenditure was obtained mainly by keeping the public sector wage bill under control, and reducing public investment and subsidies. Major reforms to tax systems were introduced with the aim of achieving medium-term targets such as higher productivity and growth. They included a reduction of personal income tax rates, and a broadening of the corporate and consumption tax base, which for many countries meant a switch to VAT. The improvement in net positions was reflected in a slight fall in the burden of interest payments and in the ratio of public debt to GDP. Obviously, fiscal retrenchment was not pursued with the same intensity in all countries. But the Community average net borrowing, after reaching a peak of 5.5 per cent of GDP, had declined to 2-9 per cent by 1989 (source: Commission of the European Communities, 1991).

The trend in EC public finances appears to have changed again in the present decade. The average budget deficit has increased to 4.1 per cent of GDP in 1990, and 4.4 per cent in 1991 (source: Commission of the European Communities, 1991). Recent macroeconomic developments are partly responsible for this budgetary situation. A noticeably weaker growth performance has had adverse effects on current expenditure and receipts, and a generalized increase in long-term interest rates, resulting from the deterioration in inflationary expectations and the excess of demand over supply of funds, has affected charges on public debt. However, it is also clear that fiscal stance is now looser in most EC countries, obviously so in the case of Germany, which is incurring the cost of German unification. As a result, general government contribution to national saving has turned negative (- O. 1 per cent of GDP in 1990, - 0.6 per cent in 1991. Source: Commission of the European Communities, 1991).

We now turn to country-specific developments in the 1980s. In order to see what the main factors were determining the evolution of debt in individual countries we decompose the change in the stock of outstanding debt as a ratio to GDP, db, in the following way:

db = dB/YP - (B/YP)*(PdY/YP) - (BlYP)*(YdP/YP) =
= dn/YP - (BlYP)*(dY/Y) - (BlYP)*(dPlP)=
= d - by - bp (1)

where B is gross debt, Y stands for real GDP, P is the GDP deflator, b and d represent outstanding debt and deficit as a ratio to GDP, and y and p the growth rate of GDP and of prices respectively. We have assumed that the whole of the defidt d flows onto the bond stock. This inevitably makes our calculations imprecise. Our decomposition enables us to establish to what extent a fail in the debt income ratio reflects low deficits or rapid real income growth, or whether it is the consequence of inflationary policies. The results are reported in table 1 (see also Charts 1 to 4).

The country which appears to have been most successful in reducing its debt burden is the UK, whose gross debt declined from 54.5 to 35-8 per cent of GDP. Most of the reduction seems to be due to rising prices, but real GDP growth also contributed to improving the British financial position. Other important factors were a fall, by considerably more than the OECD average, in subsidies, social security and capital transfers (see Oxley and Martin, 1991). Public sector relative wages also declined, as did debt interest payments, the only case in the OECD area apart from Switzerland. In the other major European economies (Germany, France and Italy) and in three other countries which already had severe debt problems (the Netherlands, Belgium, Ireland) the debt/GDP ratio rose in the 1980s. The increase was slight in Germany and France, more pronounced in the Netherlands, even more so in Italy, Belgium and Ireland. Our decomposition reveals that the effect of inflation on the debt stock was less in Germany than in France. In Germany there was a considerable reduction in government consumption and investment, and capital transfers were also cut.

Besides, the second half of the 1980s saw a fail in average relative wages of government employees. As for France, a small cut in subsidies and a sluggish growth in public sector wages were more than offset by increases in social security spending well above the OECD average.

In a number of countries the change in the debt stock was driven mainly by accumulating deficits. In the Netherlands developments on the revenue side resulting from GDP growth, deep cuts in government consumption and restraint on public sector pay were not sufficient to prevent persistent huge deficits. As a result, the stock of debt and debt interest payments grew by substantially more than the OECD average. Accumulated debt was even higher in Belgium at the beginning of the decade, and kept growing rapidly before declining slightly towards the end of the eighties. GDP growth did not make a substantial contribution to improving the Belgian financial position. All categories of current and capital disbursements were cut, and public sector wages declined relative to the public sector, but public deficits remained very high as a percentage of GDP, and the cost of servicing the debt grew considerably. The commitment to a strong D-Mark link kept Dutch, and to a lesser extent, Belgian inflation rather low, and hence these countries were unable to inflate away their debt stocks. Italy had the largest deficits in the 1980s, and the debt/GDP ratio shot up, but by less than it would have had it not been for the effects on the government finances of high inflation. GDP growth accounted for much less of the evolution of debt. A look at the structure of government outlays by economic category shows that, with the exception of subsidies, there was no restraint in the rise of both current and capital disbursements. Government salaries also grew by more than in any other EC country. Finally, Ireland relied to some extent on the effects of inflation to make progress towards fiscal consolidation, but the breakdown of expenditures also indicates that cut-backs in government consumption and investment were essential part of the package of measures adopted (see Oxley and Martin, 1991). Moreover, wage developments in the public sector were rather subdued. Deficits over the whole period were large but gradually declining. Hence the debt burden was falling slightly by the end of the decade.

Commenting on the most recent developments, in its latest Annual Economic Report (May 1991) the EC Commission underlines that 'half of the member states show discouraging public accounts, which will require the activation of significant adjustment measures in order to preserve the credibility of the commitment towards monetary stability'. If the convergence criteria of the Maastricht Treaty were to be interpreted in rigid terms, countries like Italy would not be able to participate in EMU. As noted in the Forecasting and Planning Report published by the Italian authorities in September 1991, even if the deficit was reduced to 3 per cent of GDP, the debt/GDP ratio would still reach 94.7 per cent by the end of 1996. In order to fulfill the EC 60 per cent requirement, a surplus of more than 9 per cent of GDP should be achieved by that time, which would require such severe budgetary policies as can not be envisaged. However, it should be said that the Treaty, notwithstanding its aim to avoid excessive government deficits, allows some flexibility. In examining compliance with the budgetary discipline criteria, the Commission is asked to consider not only whether the reference values for public deficits and debt stocks have been exceeded, but also whether the excesses are exceptional and temporary, and whether they have been diminishing and approaching the reference values at a satisfactory pace. On the other hand, the Commission may prepare a report to the European Council even for those countries who fulfil the debt/deficits requirements if it envisages a risk of an excessive deficit. The adoption of thresholds in the protocol which complements the Treaty should play a useful role by inducing potential members of EMU to undertake a more rapid stabilisation of the debt/GDP ratio in order to attain a sounder financial position more compatible with the commitments deriving from the participation in EMU. For instance, the Italian authorities are now aiming at attaining a primary surplus, which would result in a5.5 per cent deficit/GDP ratio by the end of 1994. The fact that some countries fail the rather stringent criteria on debt laid down in the Maastricht Treaty should not necessarily be used as a barrier to entry to EMU, especially if there is evidence that they are attempting to stabilise their position. Hence it is essential to determine whether they would become insolvent if the present fiscal stance remained the same in the future. If they appeared to be on an explosive path, a change either in policy or in some structural features of the economy would be necessary.

Testing for sustainability

We now briefly discuss the theory of sustainability and its testable implications, and present some empirical results for the four major EC countries (Germany, France, Italy, UK), and the three other countries whose fiscal position we have already considered (the Netherlands, Belgium, Ireland). There are three ways of assessing the sustainability of a government's fiscal policy. The first (see Blanchard, 1990) amounts to asking the following question: given current and expected spending and taxation, will it become necessary at some stage to change policies to avoid a debt crisis? The second relies on forecast paths that take account of expected changes in policy (see, e.g., Anderton et al., 1991). The third is based on analysing the past behaviour of the time series involved. Under the assumption that there is no regime shift in the future and hence that the statistical properties remain the same, the absence of stationarity in the time series for the debt stock as a proportion of inccome(3) implies that a country's fiscal position is not sustainable. A non-stationary debt series indicates that there will be a debt explosion unless policies are changed. We adopt the last approach below where we analyse the statistical properties of historical debt series.

We need a slightly more rigorous definition of sustainability in order to undertake statistical analysis. Following Blanchard (1990), we can start from the government's dynamic budget constraint, which simply says that in each period the change in the stock of public debt is equal to non-interest spending minus receipts plus interest charges on the debt. It can be formulated as follows:

db/dt = g + h - tx + (r-y)b = d +(r-y)b (2)

where b is public debt, g government spending on goods and services, h transfers, tx is taxation, r the real interest rate, y the growth rate of real GDP, and d is the primary deficit, equal by definition to g + h - tx. All the variables are in ratio to GDP. From (2) we can derive the government intertemporal budget constraint, also known as the condition of sustainability of its fiscal policy, which can be expressed as:

[Mathematical Expression Omitted] (3)

where s is the primary surplus, equal to tx - g - b.

According to (3), the present value of taxes must be equal to the present value of spending, including interest on the public debt, plus repayment of the outstanding debt (we are assuming that r-y > 0). Hence debt can not be serviced indefinitely by issuing new debt, and if (3) does not hold a change in budgetary policies will necessarily occur in the future if a debt crisis is to be prevented.

Given the intertemporal nature of the constraint for the government, it is not obvious what the solvency limits are in any one period. Blanchard (1990) develops a new set of sustainability indicators. Let b be the current level of debt. Remembering that the primary surplus s is by definition equal to ix-b-g, where tx is taxes, b transfers and g government spending on goods and services (all as ratios to GDP), we can solve for the sustainable tax rate tx * which satisfies equation (3), which yields:

[Mathmatical Expression Omitted] (4)

The index of sustainability is then given by (tx*-tx), i.e. the difference between the sustainable and the current tax rate; it is simply the size of the adjustment required for the ratio of debt to GDP eventually to return to its initial level. This condition will hold as long as the ratio converges to any constant, not necessarily [b.sub.o.] Blanchard then goes on to consider three different time horizons, respectively one, five and forty years,. and calculates short-, medium- and long-term gaps. The short-term indicator does not require forecasts, and can be constructed using the available data on government finances. The five-year horizon is the appropriate one to take into account cyclical factors which affect the general government financial balances. It requires projections of spending and transfers, and hence it is only as good as the forecasts on which it is based. Finally, to construct the long-term indicator the share of government spending in GDP is adjusted to take into account changes in the age structure of the population and their effects on social security and public health spending. The underlying rough assumption is that spending grows in line with variations in the old-age dependency ratio.

All these indices, however, are derived on the assumption that the difference between the interest rate and the growth rate is positive(4). From (2), it is clear that public debt as a percentage of GDP could grow without bounds if the growth rate of GDP were higher than the real interest rate. This case, known as 'dynamic inefficiency'(5) in the literature, can not be ruled out a priori, as in the 1970s the growth rate was above real interest rates, and even in the 1980s, when interest rates were rather high, the difference between the two was of the order of 1 per cent. However, there is a general consensus that in the medium and long run interest rates exceed the growth rate of GDP. The EC Commission, in its report 'One market, one money', takes the view that debt/GDP ratios above 100 per cent should definitely be stabilised, since debt stabilisation at such a level already requires tax receipts equivalent to 9 per cent of GDP. It is convenient, therefore, to distinguish between a 'weak' solvency condition, given by (3), and a 'practical (or strict)' condition which assumes that only some fixed level of debt/GDP ratio is feasible (for this distinction, see Buiter and Patel, 1992). To satisfy this condition, fiscal discipline is required from individual governments, ruling out some debt/deficit trajectories.

We have shown that, in a dynamically efficient economy, public debt as a percentage of GDP can not grow indefinitely if the government intertemporal budget constraint is to be satisfied. Hence a testable implication of the theory sketched above is that, depending on which solvency condition is to be met, either discounted debt or the debt/GDP ratio should be a stationary series (see Hamilton and Flavin, 1986, and Wilcox, 1989). Therefore, in order to investigate the potential solvency of governments and evaluate the fiscal picture in the EC countries, we use some stationarity tests recently developed by Phillips and Perron (1988). Their Z statistics permit tests of joint hypotheses and are valid under very general assumptions about the process generating the errors. The testing sequence is the following. We first test for the presence of unit roots, and then for a positive drift or time trend. The presence of either a stochastic or a deterministic trend implies that if the present stance of fiscal policy remained the same in the future insolvency would follow. Solvency then requires a change either in policy or in some structural features of the economy directly impinging on the evolution of public deficits.

The statistical evidence161 appears to be broadly consistent with the conclusions reached by the EC Commission in various studies on the compatibility of budgetary policies in the individual countries with the requirements of EMU, even though such studies take a less rigorous approach, being based on inspection of general trends in public finances. Our results are reported in table 2, which shows whether or not the past behaviour of discounted debt and debt/GDP ratios is consistent with sustainability. A country is deemed to be on a sustainable path if the Z tests indicate that both the unit root hypothesis and the presence of a deterministic trend or positive drift can be rejected. Not all the seven countries being considered satisfy the intertemporal budget constraint. Solvency is not an issue at all in the UK and France. In both countries macroeconomic policy was radically different in the 1980s. In the UK expansionary fiscal policy was abandoned and inflation kept under control by devising a Medium Term Financial Strategy (MTFS). The public sector borrowing requirement moved from a deficit to a surplus, and was renamed public sector debt repayment (PSDR). In France the 'Mitterand experiment' was followed by the adoption of a much tighter fiscal and monetary stance. In 1982 wages and prices were frozen and exchange controls became more stringent. In Germany only the 'weak' condition is satisfied, probably reflecting the budgetary impact of German unification. Ireland also appears to be on a non-explosive path. There the adjustment process started in 1982 under the new Fine Gael-led government, and was based on a strong commitment to a stable exchange rate within the ERM. The countries most in need of fiscal adjustment are Italy, Belgium and the Netherlands. The Italian case is probably the most worrying, because the structure of its political system is such that the necessary reforms, e.g. the overdue overhaul of public pension schemes, are difficult to implement. Even the celebrated 'divorce' between the Bank of Italy and the Treasury, which since the second half of 19 81 has put an end to the obligation for the Central Bank to buy government debt not purchased by the private sector, does not seem to have affected budget dynamics significantly. As noted above, Belgium and the Netherlands have tackled the debt problem more decisively, but fiscal discipline remains an issue there. In the former, an austerity package improving its fiscal position, a devaluation of the Belgian Franc, the introduction of income policies, and the suspension of the widespread indexation provisions was adopted in the early 1980s by the centre-right coalition, but with limited success. In the latter, the devaluation option was not used, the Dutch Guilder being anchored to the D-Mark, and the attempted reduction of the public sector deficit took the form of cuts in expenditure, but again was not incisive enough.

On the whole, it appears that, as regards government balances, some progress has been made towards convergence, as is necessary for a monetary union to be sustainable once it has been formed. However, corrective fiscal action is still required in some countries for them to be allowed to join EMU under the conditions set out in the Maastricht Treaty. The EC's adoption of quantitative criteria to determine the admission to EMU should be seen as a spur towards achieving better balanced public finances. The underlying issue is one of sustainability and we have shown that this requires changes in the conduct of fiscal policy in several member states. If there is evidence that such a change is under way, and that governments are trying to stabilise debt relative to GDP, this would be very encouraging in assessing their commitment to a low inflation union.

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NOTES

(1) For a theoretical model analysing the implications for fiscal policy oi economic and monetary union see Canzoneri and Diba, 1991. They find that discipline can be imposed upon the national governments only ii the European Central Bank is run by a monetary policy rule; in any other scenario, individual governments would be able to exert pressure on the Central Bank, causing more inflation.

(2) Note also that, as a result oi the move to EMU and the elimination of risk premia, differentials between real rates of return on government bonds will narrow. Consequently, there will be a redistribution of income from countries with low public borrowing to highly indebted countries, where the cost of servicing the debt will decrease and holders of long maturity fixed

interest bonds will make capital gains. This could cause serious political frictions among the member states. (3) Or/or discounted debt; see below for a definition of the two solvency criteria.

(4) On this point, see the discussion in Currie and Levine, 1991.

(5) In such an economy the capital stock exceeds the so-called golden rule level, which maximises steady state consumption per capita, and hence the allocation of resources is not Pareto optimal.

(6) For further details see Caporale, 1992.