The SGP fiscal rule in the case of sluggish growth: Simulations with the QUEST model

In this paper we study why the two largest EMU countries ran into budget deficit troubles during the past recession and which advantage and disadvantage the application of the SGP fiscal rule would have had. For this purpose we reproduce the downturn of the European economy since 2001 assuming two extreme interpretations: (a) on the one hand it could have been a consequence of a negative supply shock (TFP decline over 3 years) or (b) a negative aggregate demand shock (reluctant consumption and investment demand) could have caused the slowdown. These two shock scenarios are implemented into the QUEST model of the European Commission for the three largest Euro area countries-France, Germany and Italy. For both types of shocks we analyze the response of the economy under two alternative fiscal rules: (a) no SGP rule and (b) the SGP rule. Sticking to the SGP rule would have been advantageous (at least in the long-run) in case of the supply shock. In the case of a symmetric demand shock (a quick downturn, followed by an equivalent upturn) the SGP rule would have been neutral over the cycle, although harmful in the very short-run.