State interests best served by ratifying fiscal treaty

 

OPINION:IRISH PEOPLE face a challenging decision on whether to ratify the complex European fiscal treaty and an impressive debate is well under way.

 Although it is impossible to be certain what effect the compact underlying the treaty will have on Ireland’s economic fortunes, decisions should be made on the best estimation of Ireland’s prospects with and without ratification.

As others have observed, the rules underlying the compact are already largely in place under the revised stability and growth pact that came into force last December (or in some cases will come into force under new European Union regulations that are separate from the compact).

The compact is about the greater permanence and enhanced enforcement of these existing rules. The revised stability and growth pact already has beefed up European-level enforcement under a system of escalating fines for breaches of the rules. But because of failures of enforcement under previous versions of the pact – especially as they related to large countries – European leaders wish to utilise domestic-level enforcement mechanisms as a first line of defence by embedding the rules robustly in national law. Of course, the content of the rules is critically important if we are contemplating strengthened domestic enforcement. A key rule is that countries must achieve a (broadly) structural budget balance – the deficit adjusted for the economic cycle – over the medium term. If a country does not meet this requirement, or is not following a path towards that balance that is laid down by the European Commission, the compact requires that a correction mechanism is triggered that is enforced under domestic law. The central issue, then, relates to the pros and cons of adding such domestic teeth to the enforcement of already existing rules.

As the recent Irish experience has demonstrated, high and rising debt-to-GDP ratios are incompatible with robust creditworthiness for countries within a monetary union. We simply have no choice but to bring the debt down to safer levels over time. For the most part, the rules demand what we must do anyway to achieve sustainable debt and deficit levels with market financing available at reasonable cost. Moreover, delaying this adjustment will push the burden to younger generations who are already facing added fiscal costs associated with an ageing population.

A concern raised over the compact is that it will prevent the use of counter-cyclical fiscal actions to fight recessions in the future.

However, our recent experience shows that high debt levels and fragile creditworthiness are themselves a severe constraint on recession-fighting efforts – markets will simply not fund the deficits. For the future, moderate debt levels will be essential to create the “fiscal space” for counter-cyclical fiscal policy. The stability and growth pact rules should allow the necessary flexibility for countries that have demonstrated a capacity for longer-term fiscal discipline.

The structural balance concept has come in for particular criticism. It is true that the structural deficit is difficult to measure; this deficit was massively underestimated in the latter years of the bubble. However, a focus on the structural balance actually gives the rules essential flexibility. Notwithstanding the measurement challenges, the measured structural deficit is likely to be less than the actual deficit in a recession. Also, as demand conditions worsen in the economy, the rise in the structural deficit will be less than the rise in the actual deficit, allowing more room for fiscal stabilisers to operate while meeting fiscal targets. Another concern is that high-debt countries will be forced to run an unnecessarily high primary surplus – the surplus excluding interest costs – and run down their debt levels too quickly given the up-front costs of the needed fiscal adjustments. But the stability and growth pact rules appear flexible enough to avoid this occurring.

The European Commission has an important role in the debate over the treaty to explain better how the pact will actually operate, and especially the flexibility accorded to countries that are successfully reducing their debt levels at an acceptable pace. At a European level, stronger fiscal rules look essential to the survival of the euro zone. Late last year the euro zone crisis appeared to be spinning out of control as it spread to Italy and Spain. It became clear that creditworthiness of countries within the euro zone is only possible with strong mutual support mechanisms in place to help countries in funding distress. But it also became clear that there is a limit to the potential liability that stronger countries are willing to take on for weaker countries without more assurance of future fiscal discipline.

It is not a coincidence that the ECB’s massive programme of longer-term funding for euro zone banks – which has also indirectly shored up sovereign debt markets – came after the fiscal compact was agreed by European leaders in December. Although Ireland is now among the weaker euro zone countries, in the future we may be a net provider rather than recipient of support. Ireland too has a strong interest in limiting, through a robust set of rules, the liability we could be forced to take on for other countries.

The European Stability Mechanism (ESM) is one element of strengthened mutual support. There are grounds to criticise the explicit linking of access to the ESM to membership of the fiscal compact. But that linkage is now a fact. While it is possible that other sources of official support would still be available, not having access to the ESM could lead to a “sudden stop” of market and official funding at the end of the current EU/IMF programme. As examined in the most recent report from the Irish Fiscal Advisory Council, the pending fiscal responsibility law will provide important detail of how the new national-level enforcement mechanisms will operate. This Fiscal Responsibility Bill should be published as soon as is feasible to ensure a properly informed debate on the complete new fiscal framework.

On balance, while there are legitimate concerns over the more effective enforcement of the revised stability and growth pact rules that the compact would facilitate, Ireland’s interests appear best served by ratifying the treaty and being part of this compact.


John McHale is professor of economics at the National University of Ireland, Galway and chairman of the Irish Fiscal Advisory Council.

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