Pact seeks to reinforce frail foundations of single currency

Tue, May 8, 2012, 01:00

EU leaders want to signal that they are addressing the euro's design flaws

AFTER TWO years of relentless turmoil in the euro zone, Europe's stability treaty is the centrepiece of a new effort to strengthen fiscal discipline and toughen the enforcement of EU budget rules.

At its core, the pact aims to unwind the build-up of debt and deficits which led to the sovereign debt emergency. By making it more difficult for errant governments to evade the rules, it also strives to ensure there is no repeat of the debacle. This will reduce national discretion over budgetary policy, increase the powers of the EU authorities and allow more immediate penalties against rule-breakers.

These intrusive measures still seem like big steps to take, even if 20 years have passed since the Maastricht Treaty set the currency union in train and, with it, a new era of economic co-ordination. In the glowering shadow of the debt crisis, a further pooling of sovereignty is well under way. The involvement of member-states in each other's affairs is intensifying rapidly.

While the criticism remains that the treaty entrenches austerity and fails to promote economic growth, the treaty is more a confidence building exercise than a manifesto for the creation of jobs.

The initiative was championed by German chancellor Angela Merkel, the dominant political figure in the debt saga. An unloved creature the treaty may well be, but its swift adoption by EU leaders is a clear mark of the chancellor's ascendancy. It is she who sets the tone, pace and parameters of Europe's response to the crisis.

Although much of the treaty falls within the sweep of newly enacted "six-pack" legislation to toughen Europe's economic governance, there are new elements as well.

One is the obligation on participating governments to adopt a permanent golden rule to limit their debt and deficits, a measure inspired by Germany's 2009 constitutional debt brake.

Another is the requirement to introduce an automatic corrective mechanism to reverse any deviation from an EU-approved recovery plan if deficit targets are broken.

Moreover, any euro zone country which fails to ratify the treaty will not be entitled to aid from the European Stability Mechanism permanent rescue fund.

The treaty's objective is to reinforce the frail foundations which underpin the currency. In essence, EU leaders want to signal to the outside world that they are setting right the design flaws which lie behind the biggest crisis in five decades of European integration. A further, undeclared aim is to keep the German public and the European Central Bank sweet.

The disruption on debt markets continues, of course. The outlook for Spain and Italy remains in the balance, with a consequent threat to the wider euro zone. Greece may yet need a third bailout and Portugal may need a second. Ireland's return to private debt markets next year is far from assured.

On its own, the treaty does not constitute a magic formula to overcome such strains. Neither does it tackle grave lapses in financial regulation which helped to spur property bubbles and, inexorably, the banking crash. Nor does it confront the competitiveness gap between prosperous and poorer countries. These are dealt with in other political initiatives.

What the new treaty does do, however, is to set on a higher plain long-standing legal obligations on governments to ensure order in their public finances. It also serves to toughen these obligations, the basic aim being to replace a discredited, lax system with something altogether more stringent.

TO GET TO THIS POINT, Europe has travelled far down a long and rocky road.

The Greek debt explosion and all that followed it demonstrates that the weakness of one member state in a currency union is the weakness of all. Glaring economic disparities between the euro zone countries - which include modernised giants of global industry like Germany and minnows such as Portugal - underscore the danger.

Europe's leaders were alive to such threats from the very beginning of the euro project and put in place mechanisms to prevent the creation of a transfer union, in which wealthy member states would subsidise poorer ones.

From the outset they adopted a rules-based system to keep national debts and budget deficits in check and resolved that there would be no bailouts for member states in the event of a crisis. For good measure, they banned the printing of money by central banks to finance government expenditure and made no provision to issue debt with a joint euro zone guarantee.

In short, all member states were expected to stand on their own at all times.

At a summit in Dublin in 1996 they agreed the terms of a stability and growth pact which compelled member states to keep their deficits below 3 per cent of national output and their public debt below 60 per cent of output. The deal included a solemn commitment by the governments of Europe not to seek any derogation from the deficit rule unless they faced a serious recession.

Member states did not keep their promises, however. Thanks to political whims and vagaries, the pact failed. Despite rampant ill-discipline, no government was ever fined for breaching its writ and finance ministers failed to exert peer pressure over each other. Inbuilt scope for political discretion ensured otherwise.

THE ROT SET IN EVEN before euro notes and coins were introduced in 2002. The then Irish minister Charlie McCreevy faced down an EU reprimand calling for a higher surplus and lower expenditure in his 2001 budget. Within the boom-time Fianna Fail-PD coalition, the case was made that fiscal policy was the preserve of individual member states.

Portugal was the first country to breach the 3 per cent deficit limit, in 2001. In 2002 both Germany and France - Europe's principal powers - broke the limit and each did so again in 2003 and 2004. The Netherlands and Greece broke it in 2003 and Italy followed in 2004. It smelled of a free-for-all.

Soon enough, the Berlin-Paris axis started agitating to loosen the pact. To the ECB's great displeasure, reforms to water down the rules were agreed in 2005.

The new measures, intrinsically forgiving, handed member states much greater leeway to run deficits and made it more difficult to sanction rule-breakers.

Where the ECB saw increased risk and warned of higher interest rates, the counter-argument was made that the old rules were too rigid and that they hampered economic growth.

This was the system which was in place when the credit crunch struck global bank markets in August 2007, an eruption which ultimately led to a fully-fledged debt emergency in the euro zone.

In the first phase of the financial crisis, stricken banks leant on sovereign nations and the ECB for special aid. In the second, weakened governments would themselves turn to stronger nation states for help.

It became clear soon after Greece admitted in late 2009 that it had produced bogus public accounts that Athens would require emergency aid if it was to avert an uncontrolled default and remain in the single currency.

To do that, however, EU leaders would have to ditch the no-bailout clause. This they eventually did - with huge reluctance, and only after months of dispute and delay - by setting up an ad hoc credit line for Greece in the spring of 2010.

Days later, an outburst of market contagion led them to create a temporary bailout fund for any distressed euro zone country. In due course the European Financial Stability Facility would be followed by the permanent ESM, which comes into force this summer.

Separately, the ECB resolved to buy sovereign bonds on the open market. In the top echelon of the bank, this desperate effort to help ailing governments maintain a semblance of confidence in their debt was especially contentious.

NONE OF THESE MEASURES WERE sufficient to prevent an EU/IMF bailout for Ireland in November 2010 and the rescue of Portugal six months later, interventions which followed a crippling loss of credibility in the eyes of private investors.

All of this created immense political tensions in Europe. Just as the provision of rescue loans proved controversial in some donor countries, the tough austerity measures sought in return for aid are no less welcome in Dublin, Athens and Lisbon.

MEANWHILE, EUROPE set about another revision of the stability and growth pact. The "six-pack" laws, in place since December, took their name from the fact that they embraced five separate regulations and one directive.

These measures provide for the adoption of a binding country-specific medium-term objective in respect of the annual budget balance and they reinforce the procedures to be taken against countries which breach their targets. The laws also allow for increased surveillance to detect and tackle excessive imbalances in property prices, personal debt and other key indicators. At the heart of the package is the provision for greater quasi-automatic fines against recalcitrant governments, an implicit recognition that the previous sanctions regime failed abjectly. These penalties can be imposed in a gradual way, and may eventually reach 0.5 per cent of national output. To guard against any political wavering, the law makes it more difficult for governments to block sanctions against each other. Any European Commission proposal to impose such a penalty can be stopped only if a qualified majority of member states votes against it.

In recent months Olli Rehn, Europe's economics commissioner, has deployed these laws to prise new budget measures from Belgium, Poland, Cyprus and Malta. He is also seeking to fine Hungary for its failure to take "effective action" to tame its deficit.

Furthermore, Mr Rehn has initiated separate legislation to toughen the external oversight of the single currency countries. This new package, on which agreement is expected this year, comprises two regulations and is known as the "two-pack".

It would compel euro member states to share draft annual budgets with the EU authorities and would empower the commission to reject the draft if it shows "serious non-compliance" with the stability and growth pact. It will also require bailout recipients to remain under intensive external scrutiny long after their direct aid programmes expire. Such measures fall within the ambit of existing treaties, meaning treaty change will not be required.

None of this, however, was enough to appease Dr Merkel. Faced with a restive Bundestag and pressure from European and global powers to boost the resources of the EFSF and ESM, she moved last year to demand a new treaty-based system of governance. She got her treaty in the end but she did not get constitutional limits on debt. The agreement allows the brake to be applied by way of legislation.

Questions remain as to whether the treaty becomes, in the long-run, a quid-pro-quo to extract German support for jointly guaranteed eurobonds or a new mandate for the ECB. Berlin still says no, however, and shows no sign of any rethink.

This is all about good behaviour. The problem is that good behaviour won't solve the debt crisis.