No Credit for Transition: European Institutions and German Unemployment

The Stability and Growth Pact, adopted by members of the European Union, imposes tight limits on government deficits. But since the collapse of Communism, Europe has been faced with the problems of economies in transition: and reunified Germany—the leading economy of the EU‐‐‐combines a prosperous western state and an eastern economy in the process of transition. In a model where unions play a key role in wage bargaining and transition imposes a substantial burden on the national budget, we analyze the implications of balancing the budget for the path of unemployment. Where high but temporary costs are financed by raising taxes on employment to satisfy the Stability and Growth Pact, then the title is a misnomer: relative to a policy of "tax smoothing", the pact increases unemployment and slows growth. In designing fiscal rules for Europe, the benefits of tax smoothing must be weighed in the balance along with the virtues of fiscal discipline. Copyright Scottish Economic Society 2003