Reforming the Stability Pact: Focus on financial supervision

The economic governance of the Eurozone is under repair. After months of work and deep thinking involving several institutions, including the ECB and the governments of France and Germany, the Commission has proposed a reform plan.

The reform is aimed at the two problems that the financial crisis of Greece highlighted:

• First, the Stability Pact and the European surveillance mechanisms have failed.

Indeed, they could not counter the accumulation of imbalances in the public finances and foreign accounts of southern European countries.

• Second, the mistakes of some countries threaten the resilience of the whole system.

To save the common currency project, the ECB and Eurozone members were forced to intervene and rescue the weaker countries.

Any response to these issues must involve a transfer of sovereignty from the national to the European level. This is indeed the intent of the Commission’s draft. Others have commented on this (Wyplosz 2010), and I do not question the general goal, but specific aspects of the reform raises doubts that are important to highlight.

Macroeconomic imbalances

The least convincing part is the one on macroeconomic imbalances. It envisions that the Commission identify the riskiest countries on the basis of such indicators as foreign accounts, competitiveness, private and public debt, and empowers it to issue corrective policy recommendations with potentially wide scope. Monetary sanctions would be imposed on non-complying countries through a procedure that grants the Commission very strong proposal power (only a qualified majority of Member Countries may reject its decisions).

There are many critical points here.

• First, the very notion of macroeconomic imbalance is far from clear.

The current account deficit may be more or less sustainable, depending on how incoming resources are invested. Competitiveness is a relative concept that depends on more than just domestic policies and its lack does not necessarily harm sustainability. Italy is a case in point. it has lost competitiveness in a context of low growth without accumulating a large foreign deficit. Ex ante, it is hard to identify misallocations in investments, speculative real asset bubbles, and the like.

• Secondly, even under a correctly identified macroeconomic imbalance, the proper policy response is anything but obvious.

For instance the policy response would have to address a series of difficult questions. How can a nation regain competitiveness and accelerate productivity growth? How can a nation stop a real asset bubble without precipitating a crisis? These are deep questions on which economists are divided. How could the Commission be sure that the reforms they propose are not mistakes?

Financial supervision

Rather than trying to invade national governments’ autonomy in economic policy, the European authorities should focus on the transfer of sovereignty in the field of financial supervision.

All macroeconomic imbalances are accompanied by excessive debt accumulation. But for every debtor there is always a creditor, and in Europe it is typically a bank. Many of the bad investments in Southern Europe have been financed by national banks, which in turn are financed by other banks from Germany or other Eurozone countries. More cautious supervisory policies, especially at the European level, may have identified and pre-empted the accumulation of these unsustainable situations.

As pointed out by Luigi Spaventa in La Repubblica on September the 30th, the recent institution of a European Authority of banking supervision sets the premises for a more prudent and more alert European policy of credit surveillance. This is the main way to prevent macroeconomic imbalances – much better than having the Commission write out policy prescriptions in black and white.

Control of public finance

The Commission’s proposals also include important innovations concerning the Stability Pact and the control of public finances.

• First, they establish a numerical and operational target for the reduction of the whole stock of debt, not only of deficits.
• Second, they strengthen the Commission’s power to issue sanctions against non-complying countries, as described above.
• Third, they envision reforms of national institutional frameworks for budgetary policies.

In this part, the European Commission’s plan is more convincing. Unfortunately, here the most promising aspect – the third one – is currently left vague.

To encourage more farsighted behaviours on the part of Eurozone nations, it is important to intervene on national budgetary institutions, through automatic mechanisms and new technical bodies independent of political power, that might set goals for the budget deficit and monitor its evolution over time, inform public opinion, and correctly evaluate the effect of economic policies on public finances.

Monetary sanctions would instead be ineffective. Ex-post they are not credible since they are counterproductive. Ex-ante, they would be mainly used against smaller countries and leave untouched those with more influence, no matter how strong the Commission’s power is. As far as operational debt targets are concerned, they are a good proposal but should come together with a general evaluation of the sustainability of public accounts, considering other dimensions such as the pension system.

In times of crisis European institutions have always made significant steps forward. The current European economic governance needs reform. But beware of getting it wrong. There is no need for a Commission that plays stick and carrot to intrude into national governments’ business. There is, instead, the need for a strong transfer of sovereignty to European authorities in the area of banking supervision. And it is important that individual countries reform their national institutional framework for budgetary policies.

Editor’s note: A version of this first appeared in Italian on the ‘Il Sole 24 ore’ site.

References

Wyplosz, Charles (2010), Eurozone reform: Not yet fiscal discipline, but a good start, VoxEU.org, 4 October.