THE EURO AREA FISCAL COMPACT

A new fiscal compact was announced on 9 December  by the  Euro area  Heads of Government,  as a means of protecting the stability and integrity of the  Economic and Monetary Union,  and of the  European Union as a whole.

This is a vitally important goal, especially for Ireland which has gained more than almost anybody else in terms of market access, funds, and influence since it joined the European Union in  1973.

It is most important for Ireland that this fiscal compact be credible with the markets, and also  understandable  by the electorates of all 27  EU member states.

AUSTERITY WAS COMING ANYWAY, BECAUSE OF THE AGEING OF EUROPEAN SOCIETIES.

A fiscal crisis in Europe was always on the cards around now, even if there was no single currency, because of the ageing of the European population.

 Repeatedly, the European Commission has produced reports that said that, with unchanged policies, the debt to GDP ratios of many European states were going to reach  500% by  2050,  simply by virtue of the increased size of the likely  retired elderly population relative to the  working age population.

 During the boom, these reports were ignored by bankers, bank regulators, bond market participants, Finance Ministers, and political parties.

 But if you want to understand the rationale for   German attitudes today, you have only to look at the prospective ageing of its population.

 Germans are worried that the savings they have put aside for their retirement will be devalued by inflation generated by excessive monetary easing by the European Central Bank, or by fiscal irresponsibility by other European states that are unwilling to balance their current budgets.

Critics of Germany do have a point when they say that, in the short term,  Germany is asking a lot of some other  euro area countries(like Italy and Greece) when it demands that they must  suddenly become more competitive, increase their exports, and thereby earn the money to pay off their debts when, at the same time, their major market (Germany) is retrenching and reducing its demand for imports. 

But the motivation for the German caution is the ageing of their own population, as much as it is fear of a repeat of the hyper inflation of the 1920’s. And Greece and Italy also face the ageing of their population too, so they would have had to retrench anyway, whether Germany insisted on it or not.

It is also important to keep a sense of proportion about “austerity”.

 Admittedly expectations and prices have risen in the meantime,  but austerity in 2012,  is not quite the same as austerity was in the  1930’s , or even the 1980s, because  almost all European  countries are starting from a much higher income level that applied in the  1930’s or  in the 1980’s.

IT IS IMPORTANT TO RESPECT BASIC ARITHMETIC

 It is also important to respect basic arithmetic.

 For example, Ireland could not expect to have a welfare state as generous as that of Sweden, at tax levels similar to those of the United States.

 As the late Garret FitzGerald pointed out on many occasions, and it did not add much to his popularity, Ireland is not, overall, a heavily taxed country.   Pay, benefit , and pension levels paid from public funds are also  higher than  those in many  other EU countries for  comparable situations.

 A choice about the distribution of benefits and burdens has to be made, and these are the most difficult questions of all. They are the ones politicians, who are usually trying to build the widest possible coalitions, prefer to avoid if they can.

During the boom these questions were  easily avoided by borrowing, and by funding permanent expenses with temporary revenues.  That is now over.

 Even if the EU had no fiscal rule, the markets have now woken from their long slumber, and are demanding that those, to whom they lend , show how they will balance their books,  and repay what they owe when it is due.

 In that sense, the new EU fiscal compact is almost superfluous, in that  markets will be imposing discipline anyway, euro or nor euro, pact or no pact, Britain in or Britain out.

The choice is between slow, negotiated, and slightly less destructive austerity, imposed by the EU compact, or fast,  and much more destructive,  austerity imposed by the markets.

Therefore, I argue that it is best for Ireland that there be strong and credible EU rules. It is important, however, that these rules be as operational as possible, as credible as possible and as understandable as possible.

In that spirit, I raise one or two questions about the detail of the  proposed compact.

HOW, AND BY WHOM, WILL THE NEW STRUCTURAL DEFICIT RULE BE INTERPRETED?

In paragraph 4 of the EU leaders statement, they say that the annual structural deficit shall not exceed 0.5% of GDP and that that this rule shall be introduced into member states legal systems at “constitutional or equivalent level”. 

This is separate from the Excessive Deficit Procedure, under Article 126 of the existing EU Treaties, which provides for fines if deficits exceed 3%, and which is being strengthened under proposals that come into force this week. It is also separate from other changes, which require no Treaty or constitutional change,  which will  penalise countries for excessive debts as well as  excessive deficits, and which will require  countries to reduce debts progressively by a fixed amount each year

 This 0.5% provision    is something new and different,  not published before, which is   to be introduced into the domestic constitutional arrangements  of all member states.

 The concept of a structural deficit (of 0.5% of GDP) is different from the 3% limit in the Stability and Growth Pact.

If  this part of the pact is to be understandable, workable, and enforceable, one must ask the key  question.

 How easy will  it be to define  the structural deficit at any given time?

If something is to go into a constitution, its meaning must be both clear, and constant.

To see the sort of difficulties that might arise, one should look at  a recent  OECD study on Ireland(OECD working paper number 909, by David Haugh published 2 December 2011).  It said

“Rules specified in terms of cyclically-adjusted balances or equivalently balances measured “over the

cycle” are difficult to operationalise and monitor because they depend on forecasting the size of spare

capacity in the economy, which cannot be observed and is particularly difficult to estimate for a small open economy such as Ireland’s.

The Swedish Fiscal Policy Council found it difficult to assess compliance with the government’s target of a 1% surplus over the cycle (Calmfors, 2010).

 Disputes over when the cycle started and finished were among the most contentious aspects of  rule that operated in the United Kingdom until the end of 2008 (OECD, 2009).

Reliance on such measures may also induce policy mistakes. With the benefit of hindsight, initial cyclically-adjusted fiscal balance measures appear to have given an overly optimistic view of the Irish fiscal position prior to the crisis, which may have contributed to a sharp rise in expenditure in 2007 before the crisis hit”

If economists in the OECD have difficulty with this concept of a structural deficit , as indicated in this  quotation, one must wonder what the judges of  the Irish  Supreme Court will make of it.

 My understanding is that economists often radically revise their opinion, afterwards, about what the structural deficit really was in a previous year. That would  make life very difficult for the Supreme Court!

While the European Court will verify the transposition of the new 0.5% rule at national level, it will be the Irish and other national Supreme Courts that will have the job of interpreting it. If something like this is written into the Constitution, the ultimate decision on whether a  budget for any  given year is compliant with the constitution will have to made by   the judges  of the Supreme Court.  This certainly will bring judges into areas of judgement which are not, to put it mildly, their primary expertise.

There is also the question of what sanctions the Supreme Court could impose, if a structural budget  deficit exceeds 0.5% of GDP .

As far as I know, some countries, like France,  have relatively soft sanctions for breaching the constitution,  while other  countries, like Ireland, immediately strike down as null and  void, something that is unconstitutional.  It may seem fanciful at this stage, but one also has to ask what would happen if Britain, which has no written constitution at all were to join the Euro at some future  time?

When is this new arrangement to come into force?

If the provision is intended to influence the markets, the date cannot be pushed too far into the future. The Commission is to propose a calendar for this. Will it be the same calendar for all members, or will countries with the biggest structural deficits get more time?

According to NCB, even if we follow all of the plan, Ireland’s structural  deficit will still be at  3.7% in 2015, which is well above the 0.5% to be written into our constitution.

 According to Deutsche Bank, the structural deficit of the Euro area as a whole stood at 3.2% in 2011, so the rest of Europe has a long way to go too.

I believe this particular proposal needs to be teased out , rigorously and in great detail, and I have no doubt the Irish Government will  be doing  that in the next few months.

A LIFESTYLE CHANGE MAY NOT BE ENOUGH, THE PATIENT MAY ALSO NEED EMERGENCY TREATMENT!

As I said earlier, the ageing of our populations requires us to follow the path laid out in the fiscal compact.

 Keynes General Theory was formulated for a society with a very different demography than the one  Europe has today.  That is why we have no choice, euro or no euro, but face up to the fiscal challenge posed by the statement of the EU  Heads of Government of the   9 December.

But, as I have  said,  we need to get the details right.

 In the meantime, the ECB must act as a normal Central Bank and provide liquidity for the markets.  The risk now is of destructive deflation, not of inflation. Germans may want to protect their savings, but they also need incomes, and their incomes will disappear if the European economy collapses. 

I hope Chancellor Merkel understands that, and does not stand in the way of emergency treatment of the economy by the ECB.

Lifestyle changes are important and necessary, but the patient needs to be alive, if he or she  is to change  lifestyle! 

It is also important that, now that the concept of the economic cycle is to be introduced into our constitutions, we do not pursue unnecessarily procyclical policies. Some have argued, convincingly, that the Basel Thee rules, as applied to banks, are unnecessarily procyclical.  They are dealing with   yesterdays problem, excessive exuberance, which the markets are punishing sufficiently anyway.

The Summit did not address the banking problem at all, and this is a pity. The difficulties of banks are at the heart of the problem. Society needs banks, and some banks are well worth saving, because banks are the repositories of our savings, and the engines of our economy

 But Martin Wolf was right when he wrote in the “Financial Times” last March “The German Government should tell their people that they are rescuing their own savings under the guise of rescuing peripheral countries”.

 I do not have the sense that that has happened yet, and that is why the 9 December Summit is not the final word on the crisis.

Remarks by John Bruton, former Taoiseach, at an event of the Dublin Chamber of Commerce, in DIT Cathal Brugha Street , embargoed for 8am  14 December  2011.