Tag Archives: Stability and Growth Pact

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.

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Qou Vadis, QE?

Ever since the first rounds of quantitative easing (QE) by the US Federal Reserve, I’ve raised questions about how sound and sustainable this form of monetary policy is? How big is the risk that the greatest economic experiment in modern history may eventually fail? More than three years later, I’m still not sure. The only thing I’m sure of, is that the need for extreme measures is greater than ever.

“It doesn’t matter whether new investment is financed by more government borrowing, quantitative easing or redistribution. What matters is growth.”

George Irvin

(Photo by freakingnews.com)

While Mr. Ben Bernanke in the USA is trying to figure out new and more creative ways to flow the financial system with money in order to kick-start the nation’s economy, European politicians are obsessing over new and creative austerity measures in order to save money and regain the union’s financial balance. But nothing seems to work. 

In 2008 I called for the launch of a so-called “Keynesian war” – but with a twist:

Instead of increasing public spending the traditional way, by investing in infrastructure like transport and housing or by upgrading public institutions like the military, I suggested to aim the financial “guns” at research and education, closing  the gap between the rich and the poor, and developing clean energy.

The “Keynesian war” was launched, all  right. But the ammunition was poured into the banks and other financial institutions who barely manged to save their own asses, in addition to dump the problems on their respective  national governments.

The financial crisis is currently well beyond the stage I regarded as a “worst-case-scenario” only two years ago.

So, where do we go from here?

One thing ought to be clear: It’s no longer a question of method – the only thing that matters is the result.

Honorary professor George Irvin at University of London makes a pretty good summary in his latest blog post at the EUobserver.com.

The Debt Trap 

“Europe is obsessed with the growing stock of public sector debt; fiscal austerity has become the watchword of our time. Little does it seem to matter that fiscal austerity means reducing aggregate demand, thus leading to economic stagnation and recession throughout the EU as all the main forecasts are now suggesting,” Professor Irvin writes.

Even the credit rating agencies are worried, as S&P’s downgrading of France and eight other countries shows. Whether it’s Angela Merkel or David Cameron speaking, public debt is denounced as deplorable, and all are told to get used to hard times.

As Larry Elliot puts it:

“The notion that economic pain is the only route to pleasure was once the preserve of the British public school-educated elite, now it’s European economic policy”.

In Britain, immediately after the general election, the Tory-led coalition decreed that in light of the large government current deficit, harsh cuts were necessary to win the confidence of the financial markets.

But although the current deficit was high, the stock of debt (typically measured by the debt/GDP ratio) was relatively low and of long maturity, the real interest rate on debt was zero (and at times negative) and, crucially,

Britain had its own Central Bank and could devalue. As Harriet Harman argued in June 2010, Osborne’s cuts were ideologically motivated. The aim was to shrink the public sector, and the LibDems—fearing a new general election—chose to go along with the policy.

In the euro zone (EZ), where a balance of payments crisis at the periphery has turned into a sovereign debt crisis, the German public has been sold the idea that if only all EZ countries could be like Germany and adhere to strict fiscal discipline, all would be well.

The ultra-orthodox Stability and Growth Pact (SGP) has now been repackaged under the heading of ‘economic governance’ under which Germany and its allies will vet members’ fiscal policies and impose punitive fines on those failing to observe the deflationary budget rules to be adopted.

Never mind the fact that indebtedness in countries like Spain and Ireland was mainly private, or that the draconian fiscal measures imposed on Greece have, far from reducing public indebtedness, increased it.

Is debt always a bad thing?

In the private sector, obviously not since corporations regularly borrow money for expenditure they don’t want to meet out of retained earnings, while most households aim to hold long-term mortgages.

Public debt instruments like gilts in the UK or bunds in Germany are much sought after by the private sector, mainly because such instruments are thought to act as an excellent hedge against risk.

Remember, too, that when a pension fund buys a government bond, it is held as an asset which produces a future cash stream which benefits the private sector.

So ‘public debt’ is not a burden passed on from one generation to the next.

The stock of public debt is only a problem when its servicing (ie, payment of interest) is unaffordable; ie, in times of recession when growth is zero or negative and/or interest rates demanded by the financial market are soaring.

The question is when is debt sustainable?

Sustainability means keeping the ratio of debt to GDP stable in the longer term.

If GDP at the start of the year is €1,000bn and the government’s total stock of debt is €600bn, then the debt ratio is 60%; the fiscal deficit is the extra borrowing that the government makes in a year – so it adds to the stock of debt.

But although the stock of debt may be rising, as long as GDP is rising proportionately, the debt/GDP ratio can be kept constant or may even be falling.

Consider the following example. Suppose the real rate of interest on debt is 2% (say 5% nominal but with inflation at 3%, so 5 – 3 = 2). That means government must pay €12bn per annum of interest in real terms. But as long as real GDP, too, is rising—say at 2% per year—there’s no problem since real GDP at the year’s end will be €1020bn.

Even if the government were to pay none of the interest, the end-of-year debt/GDP ratio would be 612/1020 or 60%; ie, the debt ratio remains unchanged.

By contrast, if real GDP growth is zero, the ratio would be 612/1000 = 61.2; ie, the debt ratio rises only slightly. 

The rule is that as long as the real economy is growing by at least as much as the real rate of interest on debt, the debt/GDP ratio doesn’t rise.

Moreover, this holds true irrespective of whether the debt ratio is 60% or 600%.

But there’s a catch.

In a modern economy, the public sector accounts for about half the economy.

If a country panics about its debt ratio and cuts back sharply on public sector spending, this reduces aggregate demand and may lead to stagnation or even recession.

When a country stops growing, financial markets decide that its debt ratio may rise and so become more cautious about lending and demand a higher bond yield (ie, interest rate).

The gloomy prophecy of growing public indebtedness becomes self-fulfilling. This is exactly the sort of “debt trap” which faces much of the EU and other rich countries. The way out cannot be greater austerity.

What works for a single household or firm doesn’t work for the economy as a whole. A household can tighten its belt by spending less, saving more, and thus ‘balancing the books’, but an economy cannot.

If everybody saves more, national income falls.

Of course, Germany and some Nordic countries can balance the government books because an export surplus offsets domestic private saving. But the Club-Med countries cannot match them.

When no EZ country can devalue, to ask each EZ country to balance the books by running an export surplus is empirically and logically impossible.

Even if all could devalue, what would follow is 1930’s-style competitive devaluation.

The way out of the ‘debt trap’ is the same as the way out of recession: if the private sector won’t invest, the public sector must become investor of the last resort.

It doesn’t matter whether new investment is financed by more government borrowing, quantitative easing or redistribution (some combination of the three would be optimal).

What matters is growth.

By George Irvin

George Irvin is a retired professor of economics and for many years was at ISS in The Hague. He is now honorary Professorial Research Fellow in Development Studies at the University of London, SOAS.

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The EU End Game: Decision Time

Here’s another important article in the run-up to EU’s top leader meeting next weekend. The author is Marco Annunziata, chief economist of GE capital.  In this post Mr. Annunziata calls for solidarity within the euro zone and makes a powerful attack on the proposed French-German “Pact for Competitiveness”. He warns of political instability and a break-up of the single currency system. GE’s chief economist defends Brussels actions so far, because there has been no other alternatives. However, now the time has come for the big and difficult decisions.

“We’re all in it together – this is what EU policymakers must be thinking as they near the crucial summit of 24 and 25 March.”

Marco Annunziata


The global financial crisis, which many of them at first brushed off as a US problem, has turned into an existential crisis for the euro zone. Markets are pricing in a significant risk of sovereign default for its weakest members, two of which have had to be rescued with the help of the IMF, and the idea that the single currency area might break apart suddenly seems less far-fetched. Yet the clearest lesson of the turmoil in Europe’s sovereign debt markets is that the currency union is irreversible,” Mr. Annunziata writes.

The unprecedented measures and sacrifices of the last twelve months are tangible proof: EU policymakers have committed hundreds of billions of euros to a mutual support mechanism, swallowed the bitter pill of calling on the IMF, and seen the ECB break taboo after taboo, culminating in its direct purchases of government bonds.

These have been accompanied by heated debates and bitter disputes every step of the way, most recently resulting in Mr. Weber’s decision to relinquish the presidency of the Bundesbank and with it the prospect of succeeding Mr. Trichet at the helm of the ECB.

“There is no doubt that European policymakers’ actions have been tremendously controversial and painful. They have been taken because there is no alternative.”

With the establishment of a single currency, economic and financial integration have leapfrogged policy coordination to an extent that has only recently become fully apparent.

This is especially true in the financial sector: not only have cross-border financial institutions become an important reality, but cross-border asset holdings have greatly increased the degree of interdependence—and of mutual vulnerability.


A euro zone break-up—even the limited spin-off of a few countries—would have a tremendously disruptive impact on banking systems, credit growth and economic activity across the area.

“The fact that investors nonetheless still fear a breakup tells us how serious the challenges are.”

They stem from the anomalous nature of the euro zone: less than a full-fledged union, but more than a loose federation.

ECB President Trichet is fond of pointing out that the Euro zone’s aggregate fiscal position is sounder than that of the US or the UK; but the weakest euro zone countries have come to resemble shaky emerging markets of decades past.

Investors are not yet persuaded that they should be looking at the sum rather than at the individual parts.

The solidarity which had been ruled out ex ante with the no-bailout clause (Article 125 of the EU Treaty) has come back ex post in the form of the European Financial Stability Facility.

Euro zone members have realized the need to stand by each other. They are still reluctant to draw the consequences, however, and they continue to send mixed and confusing messages. They should stop hesitating.

“This is the time to cut the Gordian knot of the euro zone’s conflicted identity.”

The most immediate issue to resolve is who should pay the price of unsustainable fiscal policies.


There is broad agreement that sovereign bonds issued after 2013 should incorporate collective action clauses, and be subject to the risk of restructuring. This is a positive step.

Investors should face the risk of losing money if they finance reckless policies. This is not only fair, but efficient: investors will perform their due diligence and demand a higher risk premium as soon as they see policies going off track, which in turn will give governments an incentive to take corrective measures at an early stage.

But debt issued after 2013 is tomorrow’s problem.

What unsettles markets now is that in 2013 some Euro zone countries will have public debt ratios well in excess in 100%, which they might be unable to service.

“If euro zone leaders believe a sovereign default by a member country might eventually be the best way to share the pain, they should prepare for it, and quickly.”

The first priority is to bolster the financial sector. The bank stress tests currently underway represent a rare second chance after last year’s flop—it should not be wasted.

Credible and transparent results quickly followed by concrete steps to recapitalize or resolve the weaker institutions would be the best way to bolster confidence in the banking sector.


The second priority is to provide a credible firewall against contagion risk. The agreement reached last weekend to raise the EFSF’s effectcive lending ability to 440 billion euros is a positive step in this regard—while allowing the fund to buy government bonds on the primary markets makes no substantial difference from the existing set-up.

“If euro zone leaders instead truly believe that a sovereign default on currently outstanding debt is unthinkable, they should say so once and for all. Investors could then be persuaded to look at the aggregate fiscal numbers rather than the individual countries’.”

There is no free lunch though—the funding costs of the stronger members would rise as they openly shoulder the responsibility for their weaker partners. Solidarity, however, must go hand in hand with accountability.


“If euro zone countries stand shoulder to shoulder with each other, they have to play by the same rules. This means burying the Stability and Growth Pact as we know it. It has failed so spectacularly that tinkering with it would be a waste of time.”

Barring as politically implausible the idea of a stronger fiscal union, the best way forward is for each country to adopt similar fiscal rules in its own legislation—ideally in its Constitution.

Balanced budget rules would bolster credibility, and would no more limit the scope for fiscal stimulus than the collapse in market confidence which has already forced consolidation throughout the single currency area.

Political support for such hard budget constraints is hard to muster—but that is no surprise: Fiscal rules need to be strong enough to truly replace a fiscal union; otherwise it is political support for solidarity that will sooner or later disappear.

We need a clearer signal of how the costs of past recklessness will be shared, and we need to see the more fragile banking sectors put on a stronger footing—this is essential to restore a durable stability in financial markets.

We need credible rules that will force countries to live within their means—both to reassure investors and to make solidarity within the euro zone politically sustainable.

And we need to do this quickly, so that Euro zone member countries can then focus on the most important challenge: generating faster growth and holding their own in an increasingly competitive global economy.

“Germany and France have proposed a “pact for competitiveness” that calls for harmonizing pension systems, tax bases, and to some extent wage policies. This is implausibly ambitious, unnecessary and misguided.”

Once subject to hard budget constraints, countries should realize by themselves that pension systems must be made sustainable and wage indexation mechanisms abandoned.

Competition among states will then bring greater benefits than common standards which would most likely be set at the minimum common political denominator.

The euro zone’s recovery has so far surpassed expectations, showing the old continent still has wind in its sails.

Germany has proved that Europe can benefit from the boom in emerging markets—and it has done so not just through wage moderation, but with innovation and greater productivity, generating impressive gains in competitiveness. Success breeds confidence, and German consumer confidence is back at pre-crisis record levels.

“The rest of Europe can—and must—follow Germany’s lead.”

Globalization is not a zero-sum game. But the game has gotten tougher, and Europe now needs to switch gears. Bolstering its financial and institutional set-up is a necessary pre-condition, but the focus must then quickly switch to improving productivity and competitiveness through innovation.

The relative calm now prevailing in euro zone financial markets should not deceive us.

Investors have given them the benefit of the doubt, but if EU leaders fail to deliver, tensions will surge again,  jeopardizing the recovery.

Policymakers in the US and elsewhere are watching nervously.

It’s time for EU leaders to step up their game, to switch their sights from survival to success.

By Marco Annunziata

Chief economist of GE capital

Original post at: www.eurointelligence.com

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