INTRODUCTION

The past 20 years have seen a general reduction in inflation rates to very low levels everywhere in the OECD (Organisation for Economic Co-operation and Development). The general return to (almost) price stability reflects a shift in monetary policy philosophies from an attitude of actively exploiting the Phillips curve to manage the macroeconomy to a more modest one aimed at stable monetary conditions and low inflation. This shift in monetary policy philosophies has had its repercussions in the move to more independent central banks and the adoption of rules-based regimes such as inflation targeting. In Europe, it has its visible reflection in the European Union (EU) Treaty of 1997 and in the charter of the European Central Bank (ECB), which, for now, has made price stability the principal goal of monetary policy.

The changing pattern of monetary policy has been accompanied by a change in the view most economists take on the inflationary process and the role of monetary policy in it. Twenty years ago, it was widely accepted that the main cause of inflation was excessive money growth and that to keep inflation down, the central bank had to control the growth rate of money. Today's New Keynesian consensus model of monetary policy transmission does not even make the role of money in determining the rate of inflation explicit. Instead, it sees the main role of the central bank as setting an interest rate that affects the output gap, which, in turn, determines the rate of inflation through the Phillips curve.

The European Monetary Union (EMU) includes a new framework for the fiscal policies of its member states. The need to create a genuine institutional framework to deal with public finances in EMU was recognized already in the Delors Report (1989), which called for institutional safeguards of fiscal discipline in the monetary union and argued that a lack of fiscal discipline might undermine the stability of the new currency. The fear that high and rising public debts would undermine the central bank's ability to deliver price stability has left its mark on all important documents and political decisions on the way to EMU.

In terms of technical economic analysis, fiscal policy and monetary policy are indeed linked through the “intertemporal budget constraint,” the requirement that, in the long run, the discounted sum of a government's expected expenditures cannot exceed the discounted sum of its expected revenues. Given an expected stream of expenditures, governments in EMU must adjust taxes to assure that the intertemporal budget constraint holds, since they cannot use the printing press freely to monetize their debts. Otherwise, they will be forced at some point to default on their debts. A fiscal crisis would arise, and pressures would rise on the European Central Bank to bail out the troubled government.

This reasoning leads to the conclusion that EMU needs a fiscal framework preventing the national governments from running up excessive levels of debt that could threaten the common good of EMU, that is, price stability.

This chapter begins from the premise that budgeting procedures have important consequences for fiscal stability. A budgeting procedure that enables a government to commit itself to fiscal discipline is an essential condition. Commitment mechanisms are important during the three levels of the budget process – preparation of the budget within the government (including planning), passage of the budget law through parliament, and execution of the budget.

We examine this proposition in two versions. Following the fiscal institutional approach discussed in the previous chapter, we begin with a consideration of the “centralization” of the budget process in all countries. Specifically, dominance of the prime minister or finance minister over the spending ministers in setting budget parameters, limitations to modifications of the budget proposal by the legislature, and limitations to budget changes during the execution all centralize the budget process.

The previous chapter also developed the concept of “fiscal governance,” which considers whether some set of fiscal institutions is appropriate for one set of countries but not for another. Specifically, some countries benefit from a discretionary system where the finance minister is the most important player at all stages of the budget process. Such countries are known as delegation states because other players in the budget process delegate to the finance minister the power to set, monitor, and correct the budget. Other countries benefit most from setting multi-annual targets that include clear fiscal procedures for what to do under a variety of contingencies.