The Crisis, Automatic Stabilisation, and the Stability Pact

Abstract

This paper describes recent trends on the effectiveness of stabilisers in the European Union. Using both macro evidence on the cyclical sensitivity of budget deficit to economic activity and micro evidence on the tax and expenditure profiles, we conclude, in agreement with the recent literature, that the importance of automatic stabilisation has decreased. After remarking that this trend is contradictory with the current economic institutions of Europe, which rely exclusively on automatic stabilisation for the conduct of fiscal policy, we argue that increasing flexibility, one alternative way to reduce cyclical fluctuations, does not seem a viable path. The paper concludes defending the appropriateness of discretionary fiscal policy. We argue by means of a simple model that the theoretical arguments against its use are not conclusive, and we describe a recent stream of literature, based on structural VAR models, that concludes rather robustly for the effectiveness of discretionary fiscal policy in the short and long run.

Keywords: Automatic stabilisers, tax progressivity, unemployment benefits, discretionary fiscal policy, European fiscal institutions

JEL Classification: E6, H2, H3, H6