Fiscal compact a welcome control of wild public debt

 

OPINION:While the new fiscal compact raises interesting issues about whether Ireland requires a constitutional referendum to adopt this treaty, it is even more important to absorb its implications for the long-term conduct of fiscal policy and the nature of Irish political debate on fiscal issues.

A good starting point is to accept that the terms of the fiscal compact are quite similar to those advocated in the November 2010 report on fiscal governance issued by the multiparty Oireachtas Joint Committee on Finance and the Public Service. (I prepared a background paper for this report)

A similar approach was also advocated in the electoral manifestos of the main political parties, the programme for government and the March 2011 Department of Finance report which outlined the main elements in the upcoming Fiscal Responsibility Bill (due to be published before the end of June).

Accordingly, from an economic viewpoint, the fiscal compact mainly crystallises a reform process that was well under way in the domestic system. The driving force behind this fiscal reform movement is the recognition that governments and political systems find it difficult to keep public debt at a safe level and, in related fashion, ensure that fiscal policy is a stabilising force, with surpluses accumulated in good years to allow deficits in downturns.

There are many theories as to why perverse fiscal patterns are so widespread, ranging from a short-termist desire to avoid raising taxes to pay for public spending, to the fear of electoral wrath if a government tries to deflate a boom through tax hikes or spending reductions. Conversely, a fiscal law that restricts the ability of the political system to ignore excessively high levels of public debt or to destabilise the economy through procyclical deficit policies offers the hope of a more stable and safer macroeconomic environment.

In a sense, this has been tried before in that EU member states were supposed to operate within the fiscal confines of the Stability and Growth Pact. However, it is now recognised that it is neither practical nor desirable for fiscal discipline to be primarily administered at an EU level. EU monitoring is certainly part of the new treaty and backed up by a new set of sanctions. However, this should be interpreted as a second line of defence, which will only be invoked if there is a serious failure in the domestic system of fiscal governance (as in the Greek case).

Rather, the first line of defence in ensuring fiscal discipline should be domestic in nature, with the domestic fiscal law tying the hands of governments by requiring that public debt converge to a prudently low level and providing that average fiscal balances are sufficiently low so as to enable fiscal deficits to safely emerge during recessions by running sufficiently large surpluses during boom periods.

In this sense, then, the fiscal compact represents subsidiarity in action – it is more legitimate for the monitoring of fiscal policy to be primarily a domestic responsibility than remotely conducted from Brussels, albeit within a broader EU framework that recognises the negative contagion effects associated with high public debts and procyclical fiscal patterns in an integrated European economy.

In this spirit, the compact has the potential to strengthen the domestic political system since the Oireachtas can play an important role in ensuring the accountability of the Government in complying with the domestic fiscal law. Moreover, it is critically important to highlight that the compact is silent on the key political question in respect of fiscal policy, which is the debate over the appropriate size and role of government.

The fiscal compact focuses on the sustainability of public finances by requiring that public spending is broadly in line with tax revenues over the medium term. As is underlined by the Scandinavian example, fiscal sustainability is consistent with very different visions of the role of government, since it can be delivered by a high-tax, high-spend government just as much as by a low-tax, low-spend government. Accordingly, the quality of the political debate on fiscal issues can be much improved by focusing on the key issues relating to the appropriate role for government, rather than the secondary dimension of sustainability which can be satisfied by adherence by all parties to the fiscal law.

For these reasons, there are many positive features to the new legislative approach to fiscal policy. Moreover, at a European level, a greater domestic commitment to fiscal discipline on the part of all euro zone countries in particular can rebuild mutual levels of trust among policymakers. It is a necessary condition for other initiatives that can improve the stability of the euro zone such as larger-scale liquidity interventions by the European Central Bank in bond markets, shared responsibility for European financial stability, various types of joint bond issuance and a deeper level of fiscal union.

In addition, paradoxically, greater credibility in terms of medium-term fiscal prudence can also facilitate less fiscal austerity today (at least in some member countries) to the extent that pressure on sovereign spreads is relieved. So, while the fiscal compact in itself is not a silver bullet, it can facilitate an array of positive initiatives.

Finally, it is important to recognise that the successful implementation of the fiscal compact in Ireland requires significant technical and political adjustments. At the technical level, it will be necessary for Ireland to build a domestic capacity that can provide independent, high-quality assessments of structural trends in the economy and the public finances, since only an independent institution can provide the type of medium-term forecasts that will be trusted by the European Commission and the other member governments.

Such a role goes beyond the current advisory mandate of the new Irish Fiscal Advisory Council and could alternatively be fulfilled by the Central Bank, the ESRI or a new agency (similar to the new office of budget responsibility in the UK). At a political level, the philosophy behind the fiscal compact needs to be genuinely embraced by the political system and the electorate – otherwise, the temptation will be to seek ways to undermine it through creative budget accounting and other evasive tactics.