This note deals exclusively with the fiscal policy set-up and the debt problem, both in the past and the future, but not with the wider economic policy question, whether the predominance of fiscal policy instruments is appropriate or adequate. I have argued frequently that other than budget balance objectives must also be contained in the umbrella of a future successive Eurozone governance.
The Eurozone is faced by a dual problem: how to deal with the crisis and how to prevent similar constellations causing future crises. The first is the “legacy problem”, caused by insufficient fiscal discipline in the run-up to the crisis when the fiscal rules (budget deficit of no more than 3% of GDP, debt levels below 60% of GDP) were continuously violated, and were deepened during the crisis. The “crisis countries”, Greece, Portugal and Ireland all increased their budget deficits and debt levels as a result of stimulus programs and bank bailout programs, but also because they encountered falling GDP levels which by definition drive the debt ratio up. The other Eurozone countries encountered similar patterns, if at a significantly lower level. Most recently, budget balances have been reversed in nearly all Eurozone countries, in the crisis countries as a result of the austerity conditionality conditions imposed by the “donor” countries and the IMF.
There is increasing consensus by economists – unfortunately not shared by the relevant politicians – that the legacy problem, i.e. the high debt levels of the crisis countries (on average 140 % of GDP) and the “quasi-crisis countries” (@ Charles Wyplosz) Italy and Spain (average 110%) can only be solved by significant debt restructuring, which will enable these countries to regain access to the financial markets for their financing. This would require the installation of a Sovereign Debt Restructuring Mechanism at the international level (it could start with the Euro Area), to enable countries to restructure their unsustainable debts in an orderly manner. All other “solutions” just buy time, will not work by themselves and will, as we see now, defy their purpose by leading to deeper and longer recessions in these countries, thereby once more increasing their debt ratios. (Wyplosz shows that the output gap of the 3 crisis countries between 2008 and 2011 has fallen from zero to around -6%).
Going forward, there are essentially two options: to impose a regime on the Eurozone members which credibly will create incentives for each country to maintain fiscal discipline (the original idea of the un-enforced Stability and Growth Pact); or a regime, derided by its critics as a “transfer union” where – given discipline – a bailout mechanism exists in the form of the European Stability Mechanism (ESM) or the European Central Bank as a “lender of last resort”. Either option has its own problems. The Eurozone ministers seem – not unusually – be loath to choose between these relatively clear-cut options, and go a middle way. They have – once more – stricter fiscal discipline by the recently agreed “Fiscal Compact” and the “European Semester”, which involve among others the obligation for each country to impose its own disciplinary mechanism on its sub-authorities (the notorious “debt brake”), but have also installed the EFSF, and now the ESM as a bailout mechanism (amount around 700 bn €) to lend to countries who have only excessively expensive access to the financial markets. The existence of the ESM, as has been proven amply, is interpreted by its critics as a violation of the Maastricht Treaty “no bailout” clause, which forbids one country standing in for another country’s debts. A strict no-bailout clause would most likely require the ESM to be discontinued, at least once the legacy problem is solved. If it existed in the future, so its critics argue, “moral hazard” would lead countries to engage recklessly in ever increasing debt financing, because they know that they will be bailed out by the ESM.
Wyplosz, in an interesting contribution (“Europe’s Quest for Fiscal Discipline”, unpublished, Geneva 2012) points to the US federal model, where each of the 50 states is responsible for its own debt (all states have a legal obligation for balanced budgets), and where the federal government does not (or hardly at all) bail them out. This has led to average debt/GDP ratios of U.S. states of 8.3% of their respective GDP. In contrast, the centrally monitored and enforced federal model of Germany has left its 17 states for 32% average debt levels. Wyplosz sees (correctly) similarities between the Eurozone Stability and Growth Pact with the German model and pleads for a more U.S.-like model with decentralization, but strict no bail-out.
Of course, Wyplosz ignores in this analysis the over-all role of the Federal Reserve System of the US which has the ability, and has acted, as a lender of last resort during the present crisis, thus vioilating the strict no-bailout conditions. It is of course also true that the US federal government controls more than 50% of total US government expenditures, wheras the EU Commission controls only a miniscule part of the total government expenditures of its member states. Thus, the US Federal government plays a much larger counter-cyclical role for the total US economy than the EU Commission can do, and can thus counteract the pro-cyclical effect of states’ fiscal rules.
The second option of the EZ, much more “radical”, would be to make the European Central Bank, or the ESM a fully functioning lender of last resort, which could create unlimited amounts of money to help fund state budgets in need, without the counter-productive imposition of self-defeating austerity conditions on states in recession. Clearly, this would require co-ordination between a centralized European Fiscal Authority (which would have the final say on national state budgets) and the ECB, with a view to preventing inflationary monetary financing and reckless spending by states. The even further-going option would be – as I have argued before – to take sovereign financing completely out of the hands of private financial markets and turn it over – also in non-crisis times – to the ECB/ESM. Again, such an option would require a very strong supervisory and disciplinary role for the ECB/ESM, basically handing over to them the final fiscal decisions.
The message is clear: We need to separate the legacy problem from the future problem. Their inter-mingling, as is being done by the Eurozone authorities right now, blurs responsibilities and/or prevents a constructive way out of the crisis. The recognition that the present middle way is costly, politically dangerous and frequently counter-productive needs to be conveyed to the European population. The small steps taken since 2010 (large as they are propagated by the Eurozone authorities) buy at best time, but increase the eventual costs of crisis workout. The two options for the future governance structure of Eurozone fiscal discipline also need to be spelled out and communicated. Populations should be involved in making the choice for one of the two.