The Fiscal Compact is Unachievable

There is a key element of the ‘fiscal compact’ being signed up to by most members of the European Union which is unachievable for most of the countries involved and striving to meet that objective will be highly detrimental and doomed to failure. It is the notion of achieving a balanced structural budget (technically a structural budget deficit of less than 0.5 per cent of GDP). Note that it is not achieving a balanced budget at some point in the business cycle but it is the structural budget which is to be balanced.

The table below indicates that during the 2000s (prior to the financial crisis), the major EU countries had a structural budget deficit on average in the range 2 to 3 per cent of GDP. A budget deficit of that order of magnitude on average would lead to debt to GDP ratio of about 40 to 60 per cent (with a nominal growth rate of 5 per cent per annum). Seeking to move from a structural budget deficit of the order of 2 to 3 per cent to a balanced one requires not only cuts in public expenditure and significant increases in tax rates, but also an accommodating change in private behaviour with regard to savings and investment, without any clear rationale for thinking that such accommodating changes will take place.

In the ‘fiscal compact’ the concept of ‘structural budget’ is not defined and we have to assume that the term is being used synonymously with cyclically adjusted budget position to mean the budget position which would correspond to the economy operating at some ‘normal’ level of output (relative to trend) – what is now often referred to as ‘potential output’. ‘Potential output’ is itself a problematic concept and slippery to define and measure which raises doubts about the implementation of a rule (of balanced structural budget) relying on such a problematic concept – for example, whose measure of ‘potential output’ is to be used in the calculations of the structural budget position.

Let us for a moment accept that some notion of ‘normal’ or ‘potential’ output can be agreed upon, and consider the implications of the ‘balanced structural budget’ rule. George Irvin in his recent contribution set out the national income accounting relationships involved.

The key relationship can be written:

Budget Deficit = Private Savings – Private Investment + Capital Account Inflow (=Current Account Deficit)

Thus for there to be a balanced structural budget (deficit equals zero), Private Savings minus Private Investment must equal Current Account Surplus, and for the economy to be operating at ‘normal’ (or potential output). Hence for a balanced structural budget, the amount people and corporations wish to save at ‘normal’ output, the amount firms wish to investment along with the current account position should satisfy that equation. But is there any reason to think that the intentions of firms and households with regard to savings and investment will satisfy that equation?

During the 2000s most governments operated with a budget deficit, and also with a structural budget deficit. As compared with the conditions prevailing in the 2000s, the achievement of a balanced structural budget would not only require that there is some combination of lower public expenditure and higher tax rates but also that there is a corresponding change in the ‘normal’ levels of savings, investment and current account position. The direction of change would need to be for higher investment, lower savings and larger current account surpluses.

The table below indicates the averages of budget deficits for four major countries and the euroarea as a whole over the period 2001-2007 with the output gap close to zero on average, and we use these figures to illustrate some of the issues. If, over this period, a balanced budget had been achieved on average (which would be close to but not identical with a balanced structural budget), then (as a matter of national accounting arithmetic) Germany would have needed investment to be 16 per cent higher, or savings 11 per cent lower, or the current account position to have been 2.7 per cent of GDP further in surplus. This is not a matter of investment rising by 16 per cent from one year to another, but of investment being one-sixth higher every year (than it was during the period 2001-2007). Thus if a balanced structural budget is to be achieved, it has to be explained why and how investment is going to be one-sixth higher, and how that would come about without specific government measures. A similar set of arguments can be applied to savings and to net exports.

Economists have long argued over whether the desires to save and to invest would be compatible with each other and with full employment (and more recently with output equal to potential output). The pre-Keynesian answer was that those desires and intentions would be compatible provided that the rate of interest was adjusted to the ‘natural rate of interest’, where, by definition, the intention to save and the intention to invest would be aligned. As a consequence, there would be no need for a budget deficit, and indeed a budget deficit would be seen to crowd out private investment. The Keynesian answer has been that decisions to save and decisions to invest are made by different groups and driven by quite different factors, and there was little reason to think that savings and investment intentions will be aligned. The ‘fiscal compact’ puts into law the pre-Keynesian answer with its insistence that a balanced structural budget can be achieved, and that the market left to itself will achieve it. It seeks to outlaw the Keynesian answer, even though that is the correct one!