Tag Archives: Austerity Treaty?

What is the One-Twentieth Rule and Does It Imply Additional Austerity?

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One of the components of the Treaty on Stability, Co-Ordination and Governance that has received a lot of attention from the No side in the Irish referendum is the so-called one-twentieth rule relating to the debt-GDP ratio. Here I want to describe what the rule is and whether it implies additional austerity than Ireland’s existing commitment to a medium-term objective

What is the One-Twentieth Rule?

The rule is mentioned twice in the treaty. The first mention is in the preamble:

RECALLING the obligation for those Contracting Parties whose general government debt exceeds the 60 % reference value to reduce it at an average rate of one twentieth per year as a benchmark;

The second mention is in Article 4

When the ratio of a Contracting Party’s general government debt to gross domestic product exceeds the 60% reference value referred to in Article 1 of the Protocol (No 12) on the excessive deficit procedure, annexed to the European Union Treaties, that Contracting Party shall reduce it at an average rate of one twentieth per year as a benchmark, as provided for in Article 2 of Council Regulation (EC) No 1467/97 of 7 July 1997 on speeding up and clarifying the implementation of the excessive deficit procedure, as amended by Council Regulation (EU) No 1177/2011 of 8 November 2011.

Unfortunately, neither of these sections are well worded. The problem is the “reduce it” formulation. In both cases, it looks as though the “it” that needs to be reduced by one-twentieth is the debt to GDP ratio itself. In Ireland’s case with a peak debt ratio projected at 120% such a rule would require a reduction in the debt ratio of 6%. Such a rule would be a new and tighter fiscal requirement than already existed.

In fact, however, the one-twentieth rule is not intended to refer to anything new at all. The mention in the preamble is a “Recalling” mention, i.e. reminding people that a one-twentieth rule already exists. And Article 4 concludes by explaining that the rule is supposed to work in a way that is set out in EU Council Regulation 1177/2011, where the rule is worded as follows:

When it exceeds the reference value, the ratio of the government debt to gross domestic product (GDP) shall be considered sufficiently diminishing and approaching the reference value at a satisfactory pace in accordance with point (b) of Article 126(2) TFEU if the differential with respect to the reference value has decreased over the previous three years at an average rate of one twentieth per year as a benchmark, based on changes over the last three years for which the data is available

So the rule relates to an average rate of reduction over three years of one-twentieth of the gap between the debt ratio and the 60% reference value. In Ireland’s case, this would require an average pace of reduction of about 3 percentage point per year after the debt ratio has peaked. This rule is EU law and will still apply even if Ireland rejects the EU treaty.

Does the Rule Imply Additional Austerity?

The one-twentieth rule has been mentioned repeatedly by No campaigners as a source of additional austerity. For instance, here‘s Terrence McDonough:

Debt should be 60 per cent of GDP. If debt is greater than 60 per cent, it will be reduced by 1/20 per year over the next 20 years. This would start in 2018, when the bailout terms expire, and could require up to €5 billion a year in savings to 2038.

Where does this €5 billion a year figure come from? I’m assuming (and am happy to be corrected) that it comes from the following calculation. Our peak debt level will be €200 billion which will imply a debt-GDP ratio of 120%. At current levels of GDP, a debt ratio of 60% would require a level of debt of €100 billion. One-twentieth of the gap between €200 billion and €100 billion is €5 billion.

This “€5 billion a year debt reduction for 20 years” claim has two serious problems with it.

First, the treaty doesn’t make any reference to 20 years and it’s not a complex mathematical point that closing one-twentieth of a prevailing gap does not eliminate that gap in 20 years because the amount of gap being closed gets progressively smaller. So even if nominal GDP remained unchanged at its current level, the debt reduction needed would gradually reduce over time from €5 billion.

Second, and far more importantly, there is literally nobody who expects this rule to be obeyed by reducing debt levels with constant nominal GDP. Even the ECB is committed to having an average inflation rate in the Eurozone of 2% per year, so no nominal GDP growth in Ireland would require continuous ongoing contractions in real GDP of 2% per year.

If this outcome was to come about, the one-twentieth rule would be the least of our problems. In anything close such a scenario, debt sustainability would have to be restored via a major default.

So the rule cannot be thought of in isolation from discussions of potential growth rates of nominal GDP. Seamus Coffey has an excellent post here that discusses this issue. Seamus provides calculations of how much debt can be sustained while complying with the one-twentieth rule. Below is Seamus’s chart illustrating potential debt levels.

[Debt%2520Levels%255B2%255D.png]

What the chart makes clear is that anything better than 2% per year nominal GDP growth (consistent with zero real GDP growth) will allow the one-twentieth rule to be obeyed without reducing debt levels at all.  The €5 billion a year debt reduction scenario is well off the mark. Either we get some level of real GDP growth, in which case debt can rise, or else we will have to default.

Finally, I did some calculations to check whether the one-twentieth rule was in any way more binding that the commitment to a 0.5% medium-term deficit. The answer is no.

The chart below assumes 4% nominal GDP growth (2% real and 2% nominal).  It shows that the debt ratio will fall much faster with a 0.5% deficit (the blue line) than it would be if we were sticking to the 1/20th rule (the black line).

So the one-twentieth rule already exists and will still apply to us even if we vote No, it doesn’t imply the need to reduce debt by €5 billion per year and in fact is likely to require less austerity than is required by the commitment to reach a medium-term objective of a 0.5% deficit, which we are still required to meet if we vote No.

Will this Treaty Imply More Austerity for Ireland?

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The debate in the opening week of Ireland’s referendum campaign on the Treaty on Stability, Co-Ordination and Governance has largely been driven by those advocating a No vote. These campaigners argue that the treaty will lead to additional austerity in Ireland and hence advocate a No to the “Austerity Treaty”. The Yes campaigners respond by asking where Ireland will get the money to fund budget deficits.  This morning‘s discussion on RTE’s Pat Kenny show between Joan Burton and Mary Lou McDonald largely conformed to this pattern.

What is odd about this pattern is that Yes campaigners have failed to highlight that the treaty does not, in fact, imply additional austerity in the coming years relative to what would occur if there was a No vote, even if the EU did decide to fund Ireland via EFSF or some other vehicle. The fiscal parameters laid down in the treaty are all part of the existing EU fiscal framework that Ireland is already operating within and would continue to operate within after a No vote.

Here I’ll focus on three different numbers that come up time and again in the treaty debate:

  • The 0.5% deficit figure set out in Article 1(b) of treaty.
  • The 3% deficit that Ireland is projected to reach in 2015 according to current projections.
  • The 1/20th per year clause relating to debt reduction set out in Article 4 of the treaty.

The 0.5% Figure

The 0.5% figure does not represent a deficit limit that countries must obey at all times. Rather Article 1 of the treaty says that its terms are respected

if the annual structural balance of the general government is at its country-specific medium-term objective, as defined in the revised Stability and Growth Pact, with a lower limit of a structural deficit of 0,5 % of the gross domestic product at market prices.

So the 0.5% refers to something called a “medium-term objective” (MTO) for fiscal policy, which is already part of the existing Stability and Growth Pact. These MTOs vary across countries depending on their fiscal situation.

Do you want to guess what Ireland’s current MTO is? Yep, you guessed it: a deficit of 0.5%.  Here‘s our latest Stability Programme Update. Go to page 31 and you’ll find this

Ireland’s ‘medium-term budgetary objective’ (MTO) currently stands at -0.5% of GDP.

So anyone who objects to this treaty on the grounds that it would make Ireland’s MTO be equal to 0.5% of GDP can go ahead and vote No if they wish. But Ireland’s MTO will still be 0.5%. Nothing will have changed and whatever role the MTO plays in generating austerity will remain as before. (See this post by Seamus Coffey for further discussion of MTOs.)

The 3% Figure

The No side regularly argue that the treaty requires more austerity because current plans see the deficit reduced to 3% in 2015 but the passing of the treaty would then require the deficit to be reduced further to 0.5%, hence extra austerity due to the treaty.  This claim is wrong in assigning extra austerity to the treaty on three counts.

First, you might recall that 3% is the deficit level that triggers an excessive deficit procedure under the existing Stability and Growth Pact. A plan to stay at 3% would be a plan to remain permanently in an excessive deficit procedure.

Second, as just noted, Ireland’s MTO is a 0.5% deficit and compliance with the existing Stability and Growth Pact would require continued gradual movement towards this target.

Third, deficits of 3% would see Ireland maintaining very high debt ratios for a long time even if the economy returned to growth. See below for a chart showing the debt-GDP ratios that would occur after 2015 with 4% nominal GDP growth for two different fiscal policies: The first maintaining a 3% deficit and the second gradually reducing the deficit to 0.5% after 2017.  It is extremely unlikely any responsible Irish government would choose the black line trajectory over the blue line.

The One-Twentieth Figure

I plan to write a separate post about the one-twentieth rule. For now, I just want to note that this rule also will still be in existence even if Ireland votes No. Last year, the EU agreed a comprehensive set of revisions to the Stability and Growth Pact process. This featured six legislative documents and is known as the “six pack”. Details here.

The first of the new regulations introduced is Regulation 1177/2011, which amends the previous regulation on the excessive deficit procedure. It introduces into EU law the following:

When it exceeds the reference value, the ratio of the government debt to gross domestic product (GDP) shall be considered sufficiently diminishing and approaching the reference value at a satisfactory pace in accordance with point (b) of Article 126(2) TFEU if the differential with respect to the reference value has decreased over the previous three years at an average rate of one twentieth per year as a benchmark, based on changes over the last three years for which the data is available.

So, as with the 0.5% MTO, if you don’t like the one-twentieth rule, voting No does nothing to get rid of it.

Note all of these rules will apply, irrespective of whether the EU decides to offer Ireland a bailout after a No vote, perhaps via the EFSF. The existing SGP rules will not go away just because some people wish they would.

At this point, it is incumbent on the Yes side to explain that, even if future bailout funding could be secured after a No vote, that vote would do nothing to reduce fiscal austerity. The additional point that a No vote does jeopardise bailout funding—and thus could trigger massive and instantaneous austerity—is also worth making. But not at the expense of debating the basic premise of the No side’s “Austerity Treaty” argument.