EU picks the wrong solution for the wrong crisis
SERIOUS MONEY:THE SO-CALLED “fiscal compact”, as advocated by Europe’s policymakers towards the end of last year, is virtually certain to be subjected to intense debate in the days and weeks ahead as the referendum nears. Unfortunately, the latest plan to save the fragile monetary union is the wrong solution for the wrong crisis.
The EU’s leadership continues to view the crisis through the narrow prism of lax fiscal policies and excessive debt accumulation among the euro zone’s periphery, and insists that painful fiscal austerity is the appropriate course of action. Indeed, the new fiscal compact approved by the European Council strengthens the Stability and Growth Pact, which was barely enforced during the single currency’s early years.
The new plan establishes a target for debt reduction – a 1/20th reduction of debt in excess of 60 per cent each year – and sets a stringent target for the structural budget deficit that must not exceed half of 1 per cent of GDP. The latter measure does not preclude cyclical variations in the deficit, but such variations are to be capped at 3 per cent by the existing Excessive Deficit Procedure.
Surveillance procedures are to be significantly stepped up to support the new measures, with the European Commission being granted a greater role in inspecting national budgets. Those countries found to be running an excessive deficit will be required to submit an economic partnership programme that details reforms to be implemented to correct the fiscal position.
This new treaty is not required in the current environment, given that financial markets and the associated increase in government borrowing costs have already forced countries to take corrective action. More importantly, it does nothing to address the crisis and could further undermine confidence in the medium term, since it severely limits the ability to implement counter-cyclical fiscal policy at times of economic weakness.
It is important to appreciate that the euro zone’s member states surrendered their monetary sovereignty upon admission to the single currency. They became currency users rather than issuers and lost the ability to set their own monetary policy and exchange rates. They did retain fiscal policy flexibility insofar as investors remained willing to absorb new issuance at reasonable rates, but the fiscal compact will virtually eliminate this option and, in the absence of federal transfers, stability is likely to be eroded even further over time.
Europe’s policymakers refuse to accept that most of the troubled countries in the euro zone’s periphery face not just one, but two major problems – excessive public debt alongside unsustainable levels of external debt. Indeed, the availability of low-priced credit from banks in the euro zone’s core following the launch of the single currency more than a decade ago allowed the periphery to run large and persistent current-account deficits that sparked a disturbing increase in the level of external debt, both public and private.
Policymakers consistently argued that intra-regional trade imbalances were not relevant in a monetary union, but this belief proved to be embarrassingly wide of the mark once the Great Recession prompted a dramatic reassessment of risk premiums. Previously, the periphery had depended upon the willingness of member states with current account surpluses to fund their external deficits at reasonable rates of interest. Once the financial crisis struck, this source of capital evaporated and the buyers’ strike left the troubled countries with little option but to seek official assistance to fill the gap.
Harsh fiscal austerity programmes were imposed by the troika upon Greece, Ireland and Portugal, while the IMF continually advised that said countries should cut nominal wages in order to restore international competitiveness.
Lower incomes and higher tax rates virtually ensured a sharp drop in domestic demand. It was hoped that an improved external position would reduce the economic pain. Unfortunately, most of the improvement in the trade accounts of both Greece and Portugal to date has been a function of falling imports rather than a buoyant export sector.
Importantly, fiscal austerity across almost the entire euro zone as envisaged by the new plan is likely to reduce aggregate trade activity and, as a result, the periphery will be unable to export its way back to health. Thus, the fiscal compact could well contribute to no improvement in either the currently excessive public debt ratios or the unsustainable levels of external debt found in most of the periphery.
The Irish have little option but to vote Yes when the so-called fiscal compact is put to the public vote because financial support from the European Stability Mechanism is conditional upon ratification. Close analysis, however, reveals that the new measures are bad policy and could well contribute to further instability in the future.