On the Potential Pitfalls of the EU Fiscal Pact: A Simulation Study of the International Dimensions of Fiscal Austerity

The main purpose of this study is to analyze the macroeconomic dynamics and stability of an artificial monetary union consisting of two industrialized economies with the similar economic structure (for the sake of concreteness, Germany and France) under a stylized debt brake rule using an estimated semi-structural dynamic macroeconomic model. The rationales for fiscal budgetary rules are briefly discussed and the functioning of a particular type of budgetary rule–the German debt-brake–is explained in detail. In this context, the two main pitfalls of such a rule are discussed: the accurate estimation of potential output and the international dimension of the implementation of such a rule in the context of the euro area. Next, a stylized two-country macroeconomic model of a monetary union along the lines of Flaschel et al. (2008) and Proaño (2009) is discussed and implemented for the evaluation in terms of macroeconomic stabilization of a stylized debt rule under the assumption that the fiscal authorities do not directly observe the actual output gap of the economy. Finally, conclusions are drawn from this study.