In the political discussions about the origins and causes of the current Eurozone debt crisis the rules of the Stability and Growth Pact often play a prominent role. Also yesterday, when the German Bundestag voted on the proposed Euro rescue fund, the Pact was regularly cited. Let me be clear: this discussion is misguided as the Pact has been an ineffective framework and needs to be reconstructed.
The basic premise of the Pact is that in a currency union, you need fiscal discipline so debt levels of individual countries don’t run wild and put the whole currency at risk. Let me be clear again: This is a justified aim; the problem is only that the Stability and Growth Pact seems to achieve neither stability nor growth. Why is this?
The first point is that the most important targets of the Pact – no more overall debt than 60% of GDP and no more than 3% annual deficit – have no real economic meaning. There is no consensus about when sovereign debt becomes problematic (Rogoff and Reinhart for instance believe a debt to GDP ratio of 90% is the threshold before negative consequences for growth can be expected) or whether a general rule applied to a variety of very different economies makes sense at all.
So if the targets are not based on accepted economic knowledge, how did European policy-makers decide them? The answer is simple: they are based on the Eurozone averages of 1990. Given growth and inflation assumptions at the time, it was believed that the overall debt to GDP ratio could be held constant at 60% (the 1990 average) with an annual deficit of 3%. That’s all, so there is no reason to treat these numbers as if they were part of the Ten Commandments.
The second point is that the original Pact did not foresee special circumstances under which individual countries have good reasons to temporarily go beyond the targets. One suitable example is Germany. It is well documented that Germany missed the Stability and Growth Pact targets on several occasions. And the Pact’s inability to take into account the massive costs of German unification is in large part to blame. This problem led to a reform of the Pact’s flexibility in the mid 2000s, which is now being portrayed as a simple watering down of the targets. But this increased flexibility, which made sense, is also not the reason for the current debt problems.
During the financial crisis, many Euro countries went well beyond the 3% target and nobody seriously argued at the time that keeping the arbitrary Pact rules was more important than bailing out the financial sector and trying to maintain economic stability via stimulus spending. The lesson here was that when push came to shove and a massive crisis affecting all countries needed drastic fiscal measures, the Pact was de facto meaningless and sticking to the rules would most likely have caused a major depression.
It is also an insufficient tool in so far as it does not grasp the origins of fiscal problems. Looking at the current crisis countries, there is no doubt that Greece has been fiscally irresponsible. But the list basically ends there. If you look at Ireland and Spain for instance, you are looking at countries that before the financial crisis were comfortably within the Pact’s criteria and were seen as fiscally prudent. Here the current debt problems are not the result of a history of excessive spending but are moreover the consequence of the economic growth models these countries pursued – and whose associated fiscal risks were not reflected in the Stability and Growth Pact. The Pact did for instance not prevent Ireland from allowing its banks’ balance sheets to grow to a multiple of GDP and generate growth based on a massive housing bubble. And when Ireland was forced to take over large chunks of these balance sheets its budget deficit soared to more than 30% in 2010, i.e. more than ten times the Pact’s allowance.
When looking at these examples it becomes clear that just setting arbitrary fiscal targets is not doing the stability and growth trick. A responsible coordinated fiscal policy with a view to long-term stability and sustainable growth requires a thorough analysis of the broader economic circumstances. Given the inherent uncertainties of our globalised 21st century economic system, this is not a task you can solve by tailoring a fiscal straitjacket using assumptions and averages from 1990. It will moreover be the job of a future economic government for the Eurozone to assess the internal and external economic circumstances and agree on a set of fiscal policies that command real credibility and don’t become counterproductive in individual circumstances or meaningless when broader crises arise. We surely need fiscal stability and sustainable growth but we also need the right tools to achieve it.
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The Germans should be complimented for their restraint and level headed sensibility in this crisis. (Though I never imagined I could ever think such thoughts!) By comparison with the apparent profligacy of PIGS, some northern tribes look positively saintly. Perhaps what we should be asking is to what expent habits can be changed, for better or worse, when the best behaved are punished in lieu of the worst offenders?