Fiscal Convergence Criteria, Factor Mobility, and Credibility in Transition to Monetary Union in Europe

Economic efficiency considerations lead us to anticipate pressures for the development of a fairly extensive system of fiscal federalism under European Monetary Union. Given the divergent economic environments facing European Community members and the increasing degree of factor mobility, these pressures are likely to be significant. Fiscal unification could lead to sharing debt burdens for efficiency reasons when a portion of the shocks is permanent and taxes are distortionary. We argue that this expectation could undermine the credibility of “no-bailout” clauses of national government debts by the European Community-wide fiscal authority and central bank. Lack of credibility, in turn, provides an incentive to have excessive deficits. This points to the desirability of some form of fiscal convergence criteria as an entry condition to European Monetary Union.