Tag Archives: Debt-to-GDP ratio

A Tombstone Treaty?

There is no doubt in this bloggers mind that the EU leaders eventually will agree on, and sign, a new fiscal Treaty for the euro zone. But the really interesting question is; will it actually work? Or will this be the document that buries the whole EU idea once and for all?

“The new Treaty provides little enhancement with respect to the Stability and Growth pact and includes measures that are either too vague or likely to be ineffective.”

Massimiliano Marcellino

Well, according to Professor Massimiliano Marcellino at the European University Institute it will not. “This is surely not the right moment to spend so much time in drafting a new treaty that does little to address the most pressing short-term problems of the euro area,” Professor Marcellino writes in a commentary, adding: “But let’s assume for a moment that the Treaty is approved, and without major modifications.”

It’s a perfectly timed commentary, and raises some of the really fundamental questions around the plans for a new fiscal Treaty amongst the euro zone members.

Here’s the rest of the article, published today at the www.eurointelligence.com:

Why We Don’t Need The New Fiscal Treaty

The first goal in the treaty is to “foster budgetary discipline” and Title III of the draft treaty introduces measures aimed at achieving this target.

The key economic indicators used in Title III are the structural balance of the general government, which is required to be balanced or in surplus, and the ratio of the general government debt to gross domestic product (GDP), which in the long run should not exceed 60%, and if it does it should be reduced by an average rate of one twentieth per year.

The problem of a target in terms of structural balance is that this variable is not observable. It must be constructed by cyclically adjusting the actual balance.

There is no consensus about how to measure the business cycle even among economists,  so it can be expected that member states will have very different opinions about the state of their business cycle and hence about the meaning and measurement of “structural balance”.

In addition, it is not obvious from an economic point of view that growth promoting expenditures, such as investment in education and research, should be included in the computations.

Equally problematic is the debt to GDP ratio, considered by many as the prince of fiscal indicators.

However, it is a strange indicator: in the numerator there is a stock variable, the total amount of government debt, and in the denumerator a flow variable, the gross domestic product in a given period.

The latter is considered as an indicator of the capability of the government to repay its debt. But to reflect fully the financial conditions of a government, it would also have to include a measure of the total government assets.

In addition, the value of 60% for the debt to GDP ratio, inherited by the Stability and Growth pact, does not have any serious economical basis. And there seems to be little awareness that reducing the debt to GDP ratio by one twentieth per year, it would require continuous tightening of fiscal policy with negative effects on GDP growth, which would make this policy ineffective while the economic conditions of the country worsen.

Much more preferable are thus targets defined in terms of actual deficits, ratios of debt not only to GDP but also to assets, and more gradual convergence criteria.

The main concern remains however, namely that the procedures in case of a breach of the rules remain very long and complicated, and that the penalty system is unclear and insufficient to prevent future misbehaviour, in particular in the case of a large country.

The second goal of the new Treaty is “to strengthen the coordination of economic policies“, article 9 states that “… the Contracting Parties undertake to work jointly towards a common economic policy fostering the smooth functioning of the Economic and Monetary Union and economic growth through enhanced convergence and competitiveness”.

To this aim, article 11 clarifies that “With a view to benchmarking best practices and working towards a common economic policy, the Contracting Parties ensure that all major economic policy reforms that they plan to undertake will be discussed ex-ante and, where appropriate, coordinated among themselves.”

Here there is quite a bold statement: to work jointly towards a common economic policy.

Taken literally, this has major implications.

But how can we expect that member states are ready to do this after they so utterly failed in the past?

And does this imply that national parliaments should partly give up their authority?

And what happens in case of disagreement on how to foster growth or convergence?

And what is the actual role of other European institutions such as the European Parliament?

Finally, in terms of governance of the euro area, the Euro Summits are welcome but, according to their description in Title V, they seem to be just discussion fora, and in this sense their value added with respect to other existing fora is not clear-cut.

Massimiliano Marcellino

The new Treaty provides little enhancement with respect to the Stability and Growth pact and includes measures that are either too vague or likely to be ineffective.

It also fails to address the current crisis.

Financial markets are more worried about short and medium term solvency than about the enhanced long-term sustainability and policy coordination.

Without bolder actions to prevent a break-up of the euro area this new Treaty is likely to become redundant.

Massimiliano Marcellino is professor at the European University Institute in Florence.

This article is syndicated by www.eurointelligence.com.


Filed under International Econnomic Politics, Laws and Regulations, National Economic Politics

EU’s Bank Rescue Turning Into Political And Economic Catastrophe

Columnist Wolfgang Münchau at Financial Times Deutschland makes a pretty good summary of the financial crisis in relation to the two years anniversary of the Lehman Brothers collapse. According to Münchau, the Irish prime minister Brian Cowen‘s panic reaction in the days that followed is one of the main reasons for the political and economic mess the European Union now has to deal with.

“We are now in the paradoxical situation where the survival of the banks is more assured that the survival of those who saved it.”

Wolfgang Münchau

“The anniversary of the collapse of Lehman Brothers was without a doubt the single most symbolic moment of the financial crisis. But, at least for Europe, it was not the quintessential turning point. That came on Tuesday, 30 September 2008, when Brian Cowen, the Irish prime minister, gave a blanket guarantee for the entire banking sector. His decision bounded the other euro zone leaders into following suit. The rest is history.”

Here’s the rest of the commentary:


Wolfgang Münchau


I would go as far as to classify the decision as one of the most catastrophic political decision taken in post-war Europe.

This not so much because of the decision itself – it was necessary to stop the rot at the time – but because of a lack of action to embed the decision into a strategy to solve the problems of the banking sector – lack of capitalisation, abundance of toxic assets, poor management, and of course, excessive size.

The consequences of that strategy will only become apparent in the years to come. We saw a small glimpse last week when Ireland’s recognised the black hole inside the banking sector, which will cost the country a cool 32 per cent of GDP this year alone.

I myself recently estimated that the cost of Irish bank rescue would ultimately run up to about 30 per cent of GDP, which seemed a shockingly large number to some of observers. As it turns out, I was unrealistically optimistic – as I so often am.

The Germans, too, are notorious optimistic about the underlying states of its banking sector, large parts of it are not properly capitalised.

The fundamental error committed by Europeans governments at the beginning of the crisis was the failure to shrink the banking system, and to force the bondholders to share the cost of the rescue operations.


Brian Cowen


My explanation is that the banks must have succeeded in scaring the politicians into believing that forced bond-to-equity conversions would signify the end of civilisation as we know it.

Why not just default? History has shown that countries recover from default relatively quickly. But in Europe, default is considered such a gigantic blemish, that Europeans go to extremes to avoid it.

Latvia marched through one of the most brutal economic depressions in modern history.  A currency devaluation would have eased the pain, but it went against official dogma.

Ireland and Greece, too, preferred to cripple their economies for generations to come in order to avoid the political blemish of a default, or even an agreed rescheduling of the sovereign debt. Both countries are fundamentally insolvent – if you assume, as I do, that there will be zero growth for five, or even ten years, with further steep declines in asset prices.

Even the Greeks, with a debt-to-GDP ratio approaching 150 per cent, want to get through this without default. This week’s Greek budget law is very optimistic for 2011, but this is going to be a long haul.


George Papandreou


It would be much easier to accompany this process with at least a partial default. But Europeans detest the whole idea.

The euro zone was built on the trinity of No Default, No Exit, No Bailout, a logically incoherent combination, but one that nevertheless has deep roots. Of the three, the EU reluctantly agreed to drop the latter, while defending the first two to the death.

The single most absurd spectacle of it all, almost comic in fact, is the debate that is raging in Brussels.

The big issue there is whether sanctions against deficit sinners should be automatic, or subject to a political vote.

It is an almost exact re-run of a debate that took place before the euro even started.

Twelve years later, during which the EU failed to impose sanctions on a single occasion, not even to Greece, this is still the main issue of debate.

So while Ireland and Greece are burning, the EU has taken the eyes off the ball, and reverted to the more familiar ideological debates.

The fact that Ireland was, until very recently, never a deficit sinner, does not seem to impress anyone. Ireland, but also Spain, went from virtuous to almost bankrupt over night.


Angela Merkel


All the proposals I have yet heard discussed in Brussels have in common, that, if applied retroactively, they would not have made a single bit of difference to the present situation.

The big issue in the euro zone is not narrow fiscal discipline but national solvency, which is much broader concept.

Because of the blanket guarantees, it is no longer possible to separate private and public debt.

There is just plain and simple debt.

We are now in the paradoxical situation where the survival of the banks is more assured that the survival of those who saved it.

By Wolfgang Münchau

President of Eurointelligence ASBL, and associate editor and columnist of the Financial Times.

Related by the Econotwist’s:

Irish Finance Minister: Concerted Attack On The Euro Zone

Ireland And Portugal Close To Collapse(Update)

EU To Extend Greek Aid

Summer’s Over; Greek Protests Continues

Default Now Or Default Later; Greece Still Withholding Critical Data

Morgan Stanley: Governments WILL Default

EU Member States Disagree On Debt Figures

Bundesbank: Ireland Will Destroy The Euro Zone

The EU Stress Test: Working The Media

A European Revolution by December?


Filed under International Econnomic Politics, National Economic Politics