Debts and deficits have always occupied centre stage of the European economic policy debate – the implicit assumption being that fiscal discipline is the relevant condition for the stability of the Union.
But the Greek budget mess was only the proximate cause of the recent crisis. Its main roots were not fiscal in nature. After all, Ireland and Spain – with their low deficits (surpluses in some years) and debt levels (well below 60%) – have had trouble despite having been paragons of fiscal virtue. Their vices, being of a different kind, went unnoticed.
- In both countries an extraordinary credit expansion fuelled growing external and domestic imbalances. The ratio of private domestic credit to GDP doubled in the eight years to 2008; households’ debt as a ratio of disposable income rose by 50 points in Spain and 90 in Ireland in just six years.
- Credit, fed by the domestic banks were able to raise funds in the Eurozone (in Germany in particular) financed a residential construction boom which resulted in excess capacity in the housing market.
Since the euro was instrumental to this unsustainable evolution, the collapse of both countries cast doubts on the solidity and indeed the survival of the single currency.
The European Commission, which had found no reason to worry about the growth pattern of those “converging” countries, now recognises that budgetary discipline is by no means sufficient for the stability of the euro. Two proposed regulations, issued on 29 September (along with those on excessive deficits), deal with “the prevention and correction of macroeconomic imbalances” and set up an “excessive imbalance procedure”. Our view is that the Commission has engaged into an empty and useless exercise (see also on this site the views of Manasse (2010) and Wyplosz (2010) as well as reply from Commission economists (Buti and Larch 2010).
The Commission’s reform proposal: An empty and useless exercise
The regulations envisage “an indicative scoreboard” made up of “an array of macroeconomic and macrofinancial indicators” designed to identify imbalances affecting the economy of a member state or of the Union. The flashing of alert levels would prompt a succession of reviews and recommendations leading eventually to the opening of an “excessive imbalance procedure” – a State refusing to comply with the indications of the Council may be sanctioned with a fine of 0.1% of GDP. There are two key problems with this:
- First, the indicators comprising the scoreboard are unspecified: “measures of the external positions”, “price or cost competitiveness”, “private and public sector debt” are mentioned by way of example only in the presentation.
Identifying the conditions that justify the opening of an excessive imbalance procedure thus becomes – it could not be otherwise – a highly judgemental operation. It is likely to be delayed by endless negotiations in the already lengthy procedure of interaction between Commission and Council.
- Second, unlike for public deficits, it is sometimes difficult to conceive of enforceable corrective actions.
What quick remedy can be suggested when falling competitiveness due to unsatisfactory productivity developments (total factor productivity has been flat in Spain and declined in Italy) is responsible for the external imbalance?
- Third, the Commission’s approach is of no use for prevention: it can only start when imbalances are already pretty big and requires a long time to become effective.
Credit is the key
Leaving public deficits and debts aside, the imbalances policymakers should worry about are those connected to unchecked credit expansion. Keeping credit under control is the only effective preventive action. Limits to domestic credit expansion used to be an important IMF conditionality criterion in the 1970’s. This is not a task for the Commission however, nor is it one for the ECB, whose policy cannot be tailored to an individual country’s problems.
The good news is that we now have two credible candidates to perform that role. The European Systemic Risk Board and, even more, the new supervisory authority for banking (operational as from 1 January) are potentially in a position to discipline, directly or indirectly, the domestic rules and practices which allowed the excesses leading to a crisis in some countries and putting the stability of the whole union at risk. The European Systemic Risk Board and the European supervisory authorities mark an important institutional development in the Union. They offer an opportunity that should not be missed.
Buti, Marco and Martin Larch (2010), “The Commission proposals for stronger EU economic governance: A comprehensive response to the lessons of the Great Recession”, VoxEU.org, 14 October.
Manasse, Paolo (2010), “Stability and Growth Pact: Counterproductive proposals”, VoxEU.org, 7 October.
Wyplosz, Charles (2010), “Eurozone reform: Not yet fiscal discipline, but a good start”, VoxEU.org, 4 October.