The message to be drawn from this blog is that the dithering Euro bosses have done it again. Amidst all the bluster about stability and moving forward together all they have done last week (at the EU Summit) was further undermine the prospects of their region. The new rules that have seemingly been agreed upon will not be achievable and will generate even more financial instability as growth deteriorates further. In early 1968, amidst all the lunacy of the Vietnam War, an American general told a New Zealand reporter that the US decision to bomb a town full of civilians into oblivion was based on the logic that “It became necessary to destroy the town to save it”. Last week’s (December 9, 2011) – Statement by the Euro area Heads of State or Government – invokes that sort of logic except in this case the brutality is of a different degree and style. Neither action was justified in the circumstances that the decision-makers faced.
This UK Guardian article (December 9, 2011) – As the dust settles, a cold new Europe with Germany in charge will emerge – said that the Statement of the EU leaders represented:
… the emergence for the first time of a cold new Europe in which Germany is the undisputed, pre-eminent power imposing a decade of austerity on the eurozone as the price for its propping up the currency.
The Monty Python script would say “who won the War”.
But the whole media discussion has failed to zero in on what a currency actually is and what it is for. “Propping up a currency” for what purpose?
The Germans seem to think that the only purpose is to satisfy the bond markets as does the British (for that matter).
From a Modern Monetary Theory (MMT) perspective, a currency is a vehicle that the issuing government uses to advance its socio-economic program after receiving a mandate via election. It is not a weapon that governments should use to undermine the prosperity of the people.
The EU leader’s Statement said that:
Today we agreed to move towards a stronger economic union. This implies action in two directions:
– a new fiscal compact and strengthened economic policy coordination;
– the development of our stabilisation tools to face short term challenges.
Which could in fact refer to a workable solution – the creation of a true federal fiscal authority which integrates with the central bank and to make major spending and taxing decisions at that level. Should the EMU wish to continue to issue debt (which I would advise against given there would be no reason to do so) they would have to issue at this level.
The ECB and the new federal government would be integrated to ensure that the currency issuing capacity served the fiscal mandate of the federal government. Clearly, the member states cede their fiscal authority to an elected federal government that represents all of Europe and membership is proportional to population.
I already covered some of the discussion in this blog – Tightening the SGP rules would deepen the crisis.
However, when you read on you realise that this is not at all what the Euro bosses envisage. They say:
The stability and integrity of the Economic and Monetary Union and of the European Union as a whole require the swift and vigorous implementation of the measures already agreed as well as further qualitative moves towards a genuine “fiscal stability union” in the euro area.
Now we are reading the language of Germany. If you go back to the mid-1990s, when the Stability and Growth Pact was being debated, the Germans demanded that it be a “stability pact”. It was the intervention of the French that saw growth added.
Now we read “a fiscal stability union” – yes, one that will find it very hard to grow.
The Statement outlined what this fiscal stability union would require in terms of a new fiscal rule:
– General government budgets shall be balanced or in surplus; this principle shall be deemed respected if, as a rule, the annual structural deficit does not exceed 0.5% of nominal GDP.
– Such a rule will also be introduced in Member States’ national legal systems at constitutional or equivalent level. The rule will contain an automatic correction mechanism that shall be triggered in the event of deviation. It will be defined by each Member State on the basis of principles proposed by the Commission. We recognise the jurisdiction of the Court of Justice to verify the transposition of this rule at national level.
– Member States shall converge towards their specific reference level, according to a calendar proposed by the Commission.
– Member States in Excessive Deficit Procedure shall submit to the Commission and the Council for endorsement, an economic partnership programme detailing the necessary structural reforms to ensure an effectively durable correction of excessive deficits. The implementation of the programme, and the yearly budgetary plans consistent with it, will be monitored by the Commission and the Council. A mechanism will be put in place for the ex ante reporting by Member States of their national debt issuance plans.
So member states effectively lose their democratic mandates and instead answer to the Euro bureaucracy and the ECJ.
While the new balanced budget rules will be bad enough, the increased vigilance of the so-called 1/20 rule will in my view be even more damaging to the growth prospects of the Eurozone and probably will be impossible to maintain.
In the blog – Tightening the SGP rules would deepen the crisis – I concentrated on the deficit rule and showed that the SGP was justified ex post based on computations that severely under-estimated the likely output gaps that the EMU nations might experience in a serious downturn.
The analysis at the time estimated that the average Output Gaps during recessions in the EU over the period 1975-97 was around 2.9 per cent. So a 3 per cent output gap was considered to be a severe recession.
In that blog, I showed that even when the output gap is below 3 (the OECD upper end for a safe budget outcome), the budget outcome is well above the Maastricht SGP and would warrant pro-cyclical fiscal policy being imposed (that is, austerity) and fines. Further, when the output gap is 3 per cent or close to it, there was significant violation of the SGP rules.
Moreover, even the cyclical swings in the budget outcomes during the current crisis have in many cases driven the budget outcome beyond the SGP rules.
In other words, the existing SGP criteria are already impossible to keep within during a significant downturn. And now the Euro bosses want to tighten them even further and invoke pro-cyclical fiscal reactions earlier.
While the budget rules are inoperative, the so-called 1/20 rule will be even worse. This rule says that EMU member states have to keep their gross public debt ratios below 60 per cent of GDP. If the ratio is above that level then the rule will require that the state has to reduce the gross debt ratio by 1/20 of the difference between the current level and the 60 per cent threshold – every year!
The following Table uses Eurostat government finance data and shows the public debt ratios as a percentage of GDP. As noted the shaded areas indicate violation of the SGP criteria and the 1/20 rule should be triggered.
The data shows you how far outside the rules most EMU nations are and in the many cases the violations are not just the result of the downturn. Nations have established public debt levels commensurate with their political-economic mandates and it would be hard to label the majority (if any) of these nations profligate or worse “out of control”.
Has anyone actually done some analysis of what shock to the budget that would require each year? I did a some casual analysis today to give readers some idea of how much the contraction in net public (discretionary) spending would have to be.
The following Table shows the results of the most cursory analysis. The second column shows the 2010 debt to GDP ratio (produced in the previous Table) for each Euro nation. The third and fourth columns show the current budget outcome (negative is deficit) in terms of percent of GDP and in millions of Euros.
The fifth column then shows what the application of the 1/20 rule would mean in 2011 (in millions of Euros) for each of the nations that exceed the 60 per cent rule. The final column expresses the 2011 adjustment in terms of the nation’s 2010 nominal GDP.
The analysis is a clearly far-fetched (underestimates the damage) because it assumes that from 2011 each nation is producing a combination of growth and primary budget balance (in addition to the nominal interest rate and inflation rate) to ensure the 2010 debt ratio doesn’t rise!
So with real growth likely to be close to negative in most of these nation and real interest rates close to zero or slightly negative, all the adjustment to “stabilise” the debt ratio would have to fall onto the primary budget balance.
If you think about the 2010 budget deficits (shown in Columns 2 and 3) and add what would be required to get not only a budget balance but also satisfy the 1/20 rule you start to encounter impossible numbers even if the adjustment was staggered over some years.
For example, the move back to surplus will kill growth for some years and may not even be achievable in the limits of social stability. The public debt ratios are likely to rise for some years until growth is robust enough. With pro-cyclical fiscal rules being imposed there is no prospect of growth in the foreseeable future.
In which case the adjustment imposed under the 1/20 rule would be even more harsh than my simple calculations would suggest.
I could also simulate various (feasible) growth, interest rate and inflation scenarios for each of the nations and what that exercise would show was that the primary budget surpluses that would be required under the 1/20 rule would be impossible to achieve and that the process of trying would take years and undermine growth for the decade ahead.
Was the UK Prime Minister exercising sound judgement?
Answer: definitely but probably for all the wrong reasons.
The UK Guardian (December 9, 2011) – The two-speed Europe is here, with UK alone in the slow lane – claimed (consistent with the title) that:
The result is that Europe is advancing towards its integrated destiny, with Britain in its rear-view mirror. The two-speed Europe has arrived, with Britain in a slow lane of one. Whatever the letter of the rules, the reality is that big decisions affecting Britain’s economy will now be taken in rooms in which Britain is not present and has no say. Soon, foreign-owned banks may wonder what sense it makes to be based in London, out on the margins. Cameron and his party are toasting what feels like a victory. In time, it may come to taste like defeat.
First, I think Cameron’s claims that he was protecting the “City” (Britain’s financial sector) were spurious. The Europeans can still damage the City if they choose to take on banks and reduce speculative behaviour. I hope they do. The “City” needs to be reduced in size and recognise that banking is a public-private partnership and should work to advance public purpose not line the pockets of a few but socialise any losses.
So if foreign banks migrate out of London, the British population should applaud that move.
Second, there is absolutely no reason why Britain should now be in the “slow lane”. The Europeans “integrated destiny” will be one of slow growth, persistently high unemployment, reduced social protections and generally pretty miserable.
It is often forgotten that the EMU has endured high unemployment for years now as the neo-liberal policy dominance developed. But during the last few decades the unemployed, while denied the benefits of work (income, social inclusion, etc) have been supported by a strong welfare safety net.
The future for Europe under these new fiscal rules and on-going austerity is that the unemployed will rise in numbers but the social protections will decline significantly. A bad combination to be sure.
The only reason Britain will follow the EMU nations down the slow lane if it maintains its ridiculous austerity drive – which is needless given that it has currency sovereignty.
So the on-going malaise in Britain will be entirely self-induced – by poor economic decision-making – and be quite separate from what is happening (or going to happen) in Europe.
Britain is not dependent on Europe for its prosperity.
So while the UK Prime Minister made the correct decision not to sign up for the European fiscal rules his own version of austerity is at present probably more damaging to his own population.
The New York Times article (December 10, 2011) – Euro Crisis Pits Germany and U.S. in Tactical Fight – made an interesting and valid point when comparing the attitudes of the Germans vis-a-vis the Americans. It is equally applicable to a comparison between the EMU nations and Britain.
The article said:
At the heart of the debate is the question of how far governments must bend to the power of markets. Mr. Obama sees retaining the stability of markets and the confidence of investors as a primary goal of government and a prerequisite for achieving any major changes in public policy. Mrs. Merkel views the financial industry with profound skepticism and argues, in almost moralistic fashion, that real change is impossible unless lenders and borrowers pay a high price for their mistakes.
Neither side of this “debate” is doing much about the “banks” etc no matter how much morality or lack of it is abroad.
But the irony of the statement is that the US has the power to deal with the “markets” being fully sovereign in their own currency while the Eurozone nations have only an ad hoc means – the reluctant ECB.
So the financial market sycophant (the US) won’t take on the might of the markets when they can, and the Europeans will find it much more difficult to deal the markets out of the picture.
There’s a short-term crisis that has to be resolved,” he said, “to make sure that markets have confidence that Europe stands behind the euro.
The NYT’s article also said that:
Strong governments can borrow cheaply, mainstream economists on both sides of the Atlantic argue, and have an obligation to intervene more aggressively than they would in normal times to make up for the slump in private demand.
But fails to mention that sovereign governments do not need to “borrow” at all and that means the US rather than Eurozone governments.
That doesn’t mean that Eurozone governments cannot intervene aggressively to make up for the slump in private demand. It just means they need the help and cooperation from the ECB.
In the end, both the Eurozone and the US have currency issuing capacity and should use it to fill the spending gap. The Euro crisis in the short-term is completely the work of the politicians and the central bank who refuse to take the necessary steps to address the problem – a lack of aggregate demand (spending).
The “sovereign debt” crisis in Europe is a misnomer. That manifestation is a crisis of leadership and cooperation (between the politicians and the ECB). Yes, it does go back to the flawed design of the monetary union, but even given that poor decision-making earlier, they still have the capacity to stop the “crisis” in its tracks within about 24 hours and to start repairing the real damage the poor leadership has caused.
Meanwhile back in the real world, the ECB continues its weekly SMP purchases of government debt which effectively holds the bond markets at bay and keeps the system from collapsing. At the same time, the ECB bosses deny they have any responsibility to fix the problem. But then they announce at the end of the each week how much more debt they are holding under the SMP and we know otherwise.
Future generations will be told “It became necessary to destroy Europe to save it” although what ends up in the “saved” form will not be what the children might have expected their parents would bequeath them.
That is enough for today!