The plan agreed last weekend in Brussels appears has been received positively by the markets. Unfortunately, it is too early to conclude that it was a success. Future monetary historians will judge whether it was a brilliant move by Eurozone governments which put an end to speculation or the first step down a slippery path to ruin.
In any case, the ECB is now allegedly purchasing Eurozone bonds “to ensure depth and liquidity in those market segments which are dysfunctional” while at the same time standing ready “to re-absorb the liquidity injected.” While it is unclear at this moment exactly what this means, one interpretation is that the ECB is buying bonds issued by those governments that most brazenly disregarded the Stability and Growth Pact while selling the bonds of the others. While perhaps justifiable by the present emergency, it provides terrible incentives for politicians.
But rather than debating the weekend’s plan, at the moment it is perhaps better to take a step back and ask what we should learn from the current imbroglio and what policies might be helpful in avoiding a repetition of this crisis. Three lessons stand out.
First, those who worried long ago that excessive fiscal deficits and large public debts could pose a serious risk to monetary and financial stability in Eurozone were absolutely right.
As we have seen, a large contractionary shock can push heavily indebted Eurozone governments to the brink of default even though, in good times, debts and deficit appear manageable. The Stability and Growth Pact had good intentions, but ultimately it proved ineffective. Financial markets have brought these developments forward at a speed even experts have found astonishing.
Second, the no-bailout rule of the Maastricht Treaty was simply not credible.
Not supporting Greece risked leading to a sovereign default, which could have triggered a second wave of instability in the European banking sector. The bankruptcy of Lehmann, which triggered the largest recession since the 1930s, demonstrates all too well that a sudden default of a large player can inflict an extraordinary degree of “collateral damage.” The no-bailout rule thus stands in direct conflict with objectives of ensuring financial stability at home.
Third, precisely because the no-bailout rule is ineffectual, we need a new and better mechanism to limit fiscal deficits in Europe.
Lessons from a failed Stability and Growth Pact
To make the new regime work, we need to understand why the old Stability and Growth Pact failed. The Pact wrongly assumed that governments are in full control of their revenue and spending, and that they would set aside short-term political desiderata in the interest of long-run fiscal stability since it would clear too all when this led them to break the rules.
In practice, budget outcomes depend largely on the business cycle. Sharp recessions are associated with a drop in tax revenues and rises in spending on unemployment and the safety net. Given this uncertainty, governments can easily hide politically motivated spending. Moreover, it became difficult to enforce the Pact when politicians argue, correctly, that deficits are largely due to circumstances beyond their control, in particular since there is plenty of scope for creative bookkeeping and dubious financial transactions that reduce reported deficits.
The central problem with the Pact is that it was a line in the sand that was simply not credible. Treating a government responsible for a 3.2% deficit very differently from one with a 2.8% deficit seems arbitrary and unreasonable. Since governments with deficits below know that they might easily exceed it if the economy weakens, it was difficult to gather political support to enforce the rules.
Outside reviews of national fiscal policies and a sequence of trigger points
To be effective and to restore credibility, a new Pact must raise the level of transparency on how governments are really following the rules. This must involve auditing national accounts by non-political experts – something to which Germany, France, and others have objected, as it implies a loss of sovereignty. But that is just the point. The likelihood of an outside review of fiscal policy will provide excellent incentives for politicians to keep their fiscal house in order.
Such a transparency regime would involve a sequence of trigger points, starting at budget deficits well below the present SGP deficit limit of 3%. Like a set of warning lamps, each trigger would involve a further tightening of the transparency requirements. For instance, a country with a deficit/GDP ratio of less than 1% might be required to report detailed fiscal data to the European Commission. If the deficit ratio reaches 2%, it would be required to submit plans for fiscal consolidation. If the deficit ratio reaches 3%, the European Commission will send observers for on-site, real-time monitoring of the fiscal accounts. The gradual tightening is meant to give sufficient warning before the fiscal supervision of the Stability and Growth Pact sets in.
To implement this transparency regime, an independent committee of fiscal policy experts must be entrusted with the task of monitoring fiscal developments in the Eurozone, vetting governments’ justifications of fiscal deficits, assessing and publicly commenting on proposed consolidations.
It would need to be small and manageable, with a mixture of legal experts, former finance ministers, senior central bankers, and academic economists from across the Eurozone. It would need to be taken seriously in the political sphere. A board with members with the likes of Mario Monti, Hans-Werner Sinn, Lucas Papademos, Peer Steinbrück, Charles Wyplosz, and Paul De Grauwe would be a good start.
To reign in fiscal deficits, the system needs teeth. The obvious suggestion – to tax fiscal deficits directly – is not credible. A tax on marginal debt finance above 60% of GDP would be more sensible. As recently suggested by Guido Westerwelle, the deficit tax could be implemented by withholding EU transfers or agricultural subsidies, or a surcharge on the VAT. This type of measure would put pressure politicians to tell the truth and get fiscal houses in order well in advance of such crisis periods. Obviously, the Stability and Growth Pact failed to force Greece to clean up its fiscal act – a central condition for admission to the Eurozone.
Had national and EU politicians performed due diligence back in 2000, we wouldn’t have the problems we do today. If the euro is to survive the current decade, Greece cannot happen again.