Here‘s an article I wrote for this month’s Business and Finance. After the excessive focus on the relatively unimportant issue of the €3.1 billion March 31 promissory note payment, it tries to focus on the bigger picture in relation to Ireland’s debt problems.
Twenty five countries in Europe are expected to pass the Fiscal Compact, thus committing themselves to via an international treaty to having a maximum cyclically adjusted budget balance of 0.5 percent of GDP.
There are two steps to calculating cyclically adjusted budget deficits. The first to to figure out the gap between output and its “potential” level; the second is to estimate the sensitivity of the deficit to movements in the output gap. Neither step is trivial and sensible economists can arrive at quite different answers.
There has been an interesting debate in the US blogosphere over the past few weeks about calculating output gaps. See, for instance, this post from Tim Duy. There hasn’t been much debate in Europe about this issue (partly because, as the folks from Bruegel put it, Europeans can’t blog!) but if anything the issues are more complex given the variety of different structural issues facing European economies. Certainly, if past history is anything to go by, there is no reason to expect cyclical adjustment calculations to be anything other than controversial.
For example, see below for the Commission’s estimated output gap for Ireland in 2007 versus their latest series (data source here). In 2007, the Commission estimated that Ireland’s output was 0.2 percent below its potential level. Now, with the benefit of hindsight, the Commission estimates that Ireland’s output was 3.7 percent above its potential level in 2007.
Interestingly, the Commission are projecting the Irish output gap to have disappeared by next year, despite an unemployment rate of 13.6 percent. We have yet to find out which body will be charged with calculating Ireland’s cyclically adjusted deficit by the fiscal responsibility bill required to implement the treaty. However, I doubt if they will agree with this particular aspect of the Commission’s analysis.
Quite a few people on the internets have flagged Gavyn Davies’s article “You can’t solve a debt crisis with more debt” as worth reading. I’ll add my two cents endorsement of it as one of the most sensible articles written about the global “debt crisis”.
The article is unusual in drawing to people’s attention that one person’s debt is another person’s assets and that simple moralising about debt levels being too high can forget to ask the deeper questions of who owes what to whom and for what purpose. Expect to see very few articles of this type as Europe, and in particular Ireland, debates the Fiscal Compact.
Nama Wine Lake asks “What did Michael Noonan get in return for an agreement which may leave this country stranded without practical funding options from 2013?” i.e. what did he get in return for signing a treaty that stated that Ireland could only obtain further bailout funds if it signed the fiscal compact?
Phrased that way the answer is clearly, “damn all”. Still, I’ll take up the challenge of answering a different question “Why Did Noonan Sign the ESM Treaty?”
The simple answer is that no matter how the game played out, Ireland wasn’t going to get further bailout funds without signing up for new fiscal rules. Since the Merkozy summit in August, Mrs. Merkel was determined that binding fiscal rules were required in the Eurozone as cover for whatever else she may have to agree to. So far, what she’s agreed to is less momentous than many imagined last Autumn (a slightly expanded ESM and not too much grumbling about LTROs and weakened collateral rules) but talk of Eurobonds or ESM-as-a-bank are usually only a wobble away (which reminds of this tweet.)
If Ireland had objected to signing a changed ESM Treaty with the “poison pill” clause about the need to have signed the Fiscal Compact, then I’m pretty sure the original ESM Treaty could just have been mothballed and a new institution put in place by a non-EU treaty just like the Compact.
Even if the old ESM Treaty could have been left unchanged, loans can only be dispensed by ESM if a qualified majority of member states approved. What chance Ireland’s appplication for funds succeeding if it was the country that wrecked Mrs. Merkel’s plans of quid pro quo?
I’m also not so sure that the addition of the poison pill clause was quite as secretive as NWL and Vincent Browne seem to think.
The idea that ESM access was the inducement for many countries to sign the new treaty was mentioned often enough in the run-up to December. The requirement for signing the Compact to access ESM was then mentioned in the preamble of the treaty text on January 31. In the subsequent days, Vincent treated his viewers to some classic monologues about how this claim that the Compact had to be signed to obtain ESM funds was a lie, a lie, a terrible monstrous lie. Only it wasn’t. Two days later, I posted the ESM Treaty on the Irish Economy blog here, noting that VB show viewers might be interested.
Irish governments have made some terrible mistakes in recent years. I don’t think signing the revised ESM Treaty was one of them.
This morning I attended a meeting of the Executive Council of the Irish Congress of Trade Unions to speak about the Fiscal Compact treaty (yes I did a presentation at IBEC on Wednesday and no, I’m not on a campaign to bring back social partnership.)
I expanded on my opinion that, despite its flawed nature, Ireland’s best interests were served by signing the treaty. (Another speaker was more negative about whether ICTU should support the Treaty).
One issue I discussed (and will probably discuss more in the future) is whether there could be an EU or IMF-sponsored bailout if Ireland doesn’t sign the treaty and fails to regain market access. My sense is that there would be no political will in Europe for a bailout for a country that would not sign the Compact.
In relation to the IMF, I’d recommend people go to pages 98-100 of this report from December 2010. You’ll see the following “Overall, the proposed access would entail substantial risks to the Fund. The Fund would be highly exposed to Ireland in terms of both the stock of outstanding credit and the projected debt service, for an extended period and in a context of high overall debt and debt service burdens.” An IMF-only deal for Ireland in 2013 would greatly magnify these risks. A small-scale sticking plaster deal following a large fiscal restructuring and a rapid austerity programme might be a possibility.
I don’t want to talk too much about the ICTU meeting but my sense from the questions I got (I left before any internal discussion) was that the attendees were considering the issues in a very thoughtful manner. It will be interesting to see how they decide to campaign.
Finally, I’d note that I’ve had some feedback from people confused by my “sign this flawed treaty” argument but all I can say is that this isn’t a simple black or white issue. And I’m prone to being a “shades of grey type” at the best of times.
The excellent Seamus Coffey has a useful post on the implications of the Fiscal Compact rules for the ability of governments to run counter-cyclical fiscal policy,
Seamus correctly points out that it is still possible to run counter-cyclical policy while maintaining a structural balance of 0.5 percent. Here’s Seamus’s example:
One could debate the specific figures in this example but the point is well made. The country in this example only breaks the 3 percent deficit limit when the output gap is 6 percent. That’s a fairly big output gap, as seen from the figure showing the CBO’s estimates of the US output gap. Interestingly, the IMF estimates 6 percent as the maximum output gap for Ireland (see page 26) because they view the pre-crash economy as having been well above its potential level.
So all is good with this fiscal rule, right? Well, let’s think about the debt-GDP ratio in this economy. In the long-run, the debt-GDP ratio for a country that has deficit ratio of d and a growth rate of nominal GDP of g will converge towards d/g. Here‘s a note providing this formally but it’s not so complicated: If we keep adding one unit of debt for every four units of GDP then our debt-GDP ratio is going to tend towards one-quarter.
The Fiscal Compact specifies that the maximum cyclically-adjusted budget deficit should be a maximum of one percent. In any economy that grows at a nominal rate of four percent (say two real, two nominal) this will imply a maximum debt-GDP ratio of 25 percent of GDP. A government that does not want to be constantly flirting with warnings from the Commission or its own national budgetary body set up to enforce the Compact, will probably shy away from going too close to the one percent, so in practice these rules would send the economy on a path towards the elimination of public debt.
So while the Treaty may not kill Keynes, you could argue that it does attempt to kill public debt.
It is in this context that I have argued that the rule place limits on the sensible usage of counter-cyclical fiscal policy. In my recent VoxEU article on this topic, I said that the “rules will also severely limit the ability to use fiscal policies for stabilisation purposes in a manner consistent with moderate long-run debt levels.” The qualifier about moderate debt levels is important.
Consider Seamus’s example. Suppose a country with a nominal GDP growth rate of four percent had a government that wanted to stabilise its debt-GDP ratio at 60 percent. This country could run an average deficit of 2.4 percent. In Seamus’s example, such a country would pass the 3 percent deficit limit as soon as there was an output gap of 1.2 percent, which is smaller than is triggered in almost every recession.
An alternative and consistent set of rules that focused on keeping debt ratios stable at 60 percent would, using Seamus’s theoretical figures, allowed this country to run a deficit of 5.4 percent at the bottom of the cycle when the gap is 6 percent and then to run a surplus of 0.6 percent at the top of the cycle when the gap is a negative 6 percent.
The underlying premise of the figures used to implement the proposed “golden rule” seems to be that “public debt is bad”. Now I don’t want to go all MMT here but it’s not a huge insight that one person’s debt is another person’s asset. One has to wonder have the designers of these rule thought about the future structure of the economy, what pensions funds and other savings vehicles are supposed to use instead of government bonds and what the world looks like when public sector and private sector are both attempting to reduce their debt levels over time.
One might quibble with objections to the Compact rules based on their very long-run implications, when we know from Keynes what happens in the long run. However, the implications are not just short-run.
For example, consider the Netherlands. This country looks very like my stylised “well behaved” country above. According to the EU Commission, the Netherlands had a cyclically adjusted budget deficit of 2.5 percent in 2011 and it tends to grow at an average real rate of 2 percent, consistent with 4 percent nominal growth. Its debt ratio in 2011 was 64 percent.
So this country is doing just fine: They are on a course consistent with a stable debt ratio of about 60 percent. Yet the Fiscal Compact rules will insist that they reduce their deficit by a further two percentage points over the next few years. This example can be repeated across other countries to varying degrees. The point is that the new rules are likely to mean tighter fiscal policy in Europe than is necessary in the coming years, something that will make it all the harder for those countries that need to undertake fiscal retrenchment to obtain the growth required to reduce their debt ratios.
And even if the implications were only long-run, a treaty isn’t just for Christmas. It’s something that, once signed, we will be stuck with for a long time. While the self-interest of countries like Ireland may be best served by signing up for this flawed treaty, the wider European public should focus on getting us a better treaty before this one comes into force.
People outside Ireland wondering how the Treaty referendum campaign is going to go could do worse than to check out the Vincent Browne show from last Wednesday. I was one of three people who appeared alongside Eamon O’Cuiv from Fianna Fail but didn’t get to say much.
Not to worry, Eamon’s comments were interesting. He has resigned as Fianna Fail’s Deputy Leader because he cannot back a Yes vote for the Treaty. While I will be supporting a Yes vote, it can’t be denied that Eamon made a number of cogent points in his appearance. Despite early polls indicating more people supporting Yes than No and despite the potentially serious consequences of a No vote, this is not going to be an easy treaty to pass.
Here‘s an article I wrote on the Fiscal Compact for VoxEU. It’s an amended version of this article published in the Irish Times (which in turn is a copy of my comments at this Oireachtas commitee–hey, it’s a low marginal cost business.)
The amended version changes the last few paragraphs with a view to VoXEU’s EU audience. I think the balance of arguments favour Ireland signing the Treaty and retaining access to the ESM and an Irish No vote is unlikely to have much influence on changing the flaws in the Treaty.
However, I think we still need a wider European debate about the Compact. It has not come in to force yet and it should not be too late to amend some of its more restrictive aspects.