Why a tougher Stability and Growth Pact is a bad idea

Paul De Grauwe 04 October 2010

a

A

The European Commission has presented its proposals to strengthen the Stability and Growth Pact (SGP). If accepted by the Council, this will be the third version since the start of the Eurozone.

The first version was a relatively tight set of rules that included sanctions for those countries that failed to bring back their budget deficits below 3%. It ran into difficulties when the German and French governments refused to abide by the rules in 2003. This led to SGP-II in 2005 that was a much-diluted version of SGP-I in that more exceptions to the fiscal rules were allowed. Under pressure from Germany, the European Commission now proposes SGP-III; a considerably tighter version of SGP-I.

There are two innovations in SGP-III. First, the financial penalties are extended to countries failing to bring back their government debt levels below 60%. SGP-I only allowed penalties for countries failing to reduce their government budget deficits. Under SGP-III these penalties will apply both to excessive deficits and debt levels. Second, and probably more importantly, penalties will have a much larger degree of automaticity than in SGP-I. In the latter, it was the Council that had to decide (by qualified majority) if a country that fails to reduce its budget deficit would be sanctioned. Under SGP-III a fundamental step is taken to strengthen the automaticity of the sanctions. Thus, the ultimate decision about sanctions will not be taken by the Council but will be imposed automatically by the European Commission following a set procedure. If accepted, this will certainly dramatically increase the power of the European Commission relative to the Council. The enthusiasm with which Commission President Barroso announced the proposed SGP-III will therefore not come as a surprise.

I want to argue that SGP-III is a very bad idea. I have two reasons to think so. First, it is based on a wrong diagnosis of the causes of the debt crisis in the Eurozone. Second, it undermines a basic principle of democratic societies, which is that there cannot be taxation without representation.

A wrong diagnosis

One of the most surprising intellectual developments in the Eurozone is that so many now accept the view that the fundamental cause of the debt crisis in the Eurozone is to be found in the profligacy of governments who failed to put their budgetary house in order prior to the eruption of the financial crisis in 2007-08. The fact is that the aggregate government debt ratio in the Eurozone declined from 72% in 1999 to 67% in 2007. During the same period the aggregate Eurozone debt of private households and of the financial sector increased dramatically (see De Grauwe 2010). The increase of the government debt occurred after 2007 when Eurozone governments were forced to do two things. First, they had to save the banking system, which through excessive leverage had accumulated unsustainable debt levels. Second, they had to sustain economic activity by keeping spending at pre-crisis levels while tax revenues declined sharply. Thus the fundamental reason of the government debt crisis in the Eurozone is to be found in unsustainable private debt explosion, which forced governments to increase their debt so as to save large segments of the private sector.

One exception to this story is to be found in Greece, of course, whose governments manipulated the data and allowed unsustainable deficit and debt levels to accumulate prior to the financial crisis. But this can certainly not be said of the other Eurozone countries; in particular Ireland and Spain that saw their government debt levels decline dramatically, but are now in the midst of the sovereign debt crisis.

But even if the diagnosis of the debt crisis were right and that thus national governments should be constrained in their capacity to create deficits and debts, the SGP-III method is the wrong one because it goes counter to the core democratic principle that there cannot be taxation without representation.

No taxation without representation

Spending and taxation in the Eurozone are still an overwhelmingly national affair. The decisions to spend and to tax are made by national governments and voted in national parliaments. This also implies that the politicians who spend and tax face national electorates that can sanction them for misbehavior. Thus, the national politicians face the political costs of their spending and taxation decisions.

The problem with SGP-III (and to a lesser extent with the previous SGPs) is that this democratic process is short-circuited by European institutions that do not face the political sanction of their actions. Thus, under the future SGP-III the European Commission will be able to impose sanctions on national governments and parliaments and force them to lower spending and/or increasing taxes, while this institution will not face the political sanction of its decisions. Instead, the national governments and parliaments will face this sanction of the decision that somebody else has taken. This is completely unacceptable for reasons of principle and practice.

The reason of principle is not that the European Commission does not have legitimacy to take these actions. The Treaty of Lisbon gives the Commission the authority to sanction national governments. Thus, there is no lack of legitimacy of the Commission in a legal sense. The point is that the European Commission lacks democratic legitimacy in a political sense, i.e. that it cannot be sanctioned by an electorate for bad decisions in the field of taxation. One of the great inventions of democratic societies is the idea that every decision to tax must be made following a procedure that allows the electorate to have the last word. The SGP-III (and the Lisbon treaty that gives the legal authority to the Commission) undermine this “sacred” principle, and should therefore be rejected.

The practical reason why SGP-III should be rejected is that it will not work. When in the future a national government backed by the national parliament comes into conflict with the European Commission on matters of spending and taxation, the European Commission will loose the battle. I hasten to add that this may not be so for small countries. It will certainly apply to the large countries of the Eurozone.

Thus, the reasons why SGP-III will not work are exactly the same as the reasons why SGP-I failed. It was the same conflict between national governments facing the political sanction at home and the European Commission, which did not face this sanction. The Commission lost this battle, and I would say happily so. It is surprising that the Commission has not learned its lesson, and that it now proposes to tighten the rules of a pact that has been shown to be unworkable. Adding more rules and sanctions in the SGP will not make the latter more workable.

A few ideas

What then are the alternatives to the proposed SGP-III? Clearly, in a monetary union the debts and deficits of national governments are a matter of common concern. But so are the debts and deficits of the private actors. In an integrated monetary area both private and public debts can lead to spillover effects affecting other member countries.

Here are a few principles to be followed when setting up the governance of debts and deficits in a monetary union.

First, as long as decisions to tax and spend remain in the hands of national governments and parliaments the monitoring and control over excessive debts and deficits should be organised at the national level. This can be done in different ways. Others have written about this and made intelligent proposals of how this can be done (see Wyplosz 2005 on the idea of having independent fiscal policy councils at the national level).

Second, peer pressure in the sense of name and shame can be applied at the EU level. The use of automatic penalties, however, should have no place in this procedure.

Third, not only national governments are responsible for unsustainable developments of private and public debt. The European monetary authorities and in particular the ECB bear their part of responsibility. I elaborate on this in the next section.

Responsibilities of governments and central banks

As argued earlier, the fundamental reason of the debt crisis in the Eurozone is to be found in an unsustainable increase in debt levels of the private sector during the decade preceding the crisis. The mechanism behind this development can be described as follows. Market systems are regularly gripped by moves of optimism and pessimism (animal spirits). These have largely a national component in the Eurozone. Thus, while in the early 2000s, a wave of optimism (helped by a strong decline in real interest rates) gripped countries like Spain and Ireland, pessimism prevailed in Germany. These animal spirits have a self-fulfilling property and lead to bubbles and booms in the countries gripped by optimism, and the reverse in the others.

The severity of these booms and bubbles ultimately depends on how they are financed. In particular, these bubbles and booms become intense when they are made possible by bank credit. In fact there is a two-way interaction between bubbles and booms on the one hand and bank credit. When a bubble and boom starts, bank credit tends to increase automatically, mainly because the boom-and-bubble increases the value of assets, in particular of real estate, thereby increasing the value of collateral presented to banks in order to obtain a loan. Conversely the increase in bank credit intensifies the boom and the bubble. This feature has been analysed in great detail by Borio (2003), White (2006), and Brunnermeyer et al. (2009). It is also illustrated in figure 1 which presents the correlation between real house prices and bank credit, using a study of the IMF. It is the combination of bubbles (mainly in the housing markets) and bank credit that makes these bubbles so lethal.

Figure 1.

Source: Kannan, et al. (2009)

The previous analysis leads to the conclusion that the appearance of unsustainable private debt levels is the result of a combination of animal spirits and bank credit. This phenomenon has been very pronounced in Ireland and Spain. This also leads to the conclusion that not only national governments bear responsibility for these developments (because they fail to counteract them by anticyclical budgetary policies) but also the monetary authorities (because they fail to exert a stronger control on bank credit). Since bank credit is a more proximate cause of the bubbles and booms, and since the monetary authorities can control bank credit, it can be argued that the responsibility of the European monetary authorities in the development of unsustainable private debt levels is stronger than that of the national governments. Thus the failure of the European monetary authorities, and in particular of the ECB, in checking the unsustainable private debt developments and the ensuing public debts is at least as high as the failure of national governments.

Defenders of the European monetary authorities will argue that the ECB is helpless in controlling national aggregates, in casu national bank credit. It can only affect system-wide variables, in this case bank credit in the Eurozone as a whole. Even on that count, there is a large responsibility for the ECB. In figure 2, I show the growth rates of total bank credit in the Eurozone during 1999-2009. It can be seen that during the years of bubbles and booms, total Eurozone bank credit increased by more than 10% per year. Surely the ECB could have affected the growth rates of bank credit. In fact it is probably the only one in town who could have done this.

I am not arguing the ECB should have followed a different interest rate policy than the one it did. It could have used other instruments at its disposal, e.g. minimum reserve requirements to control the growth rate of bank credit. This would have reduced the intensity of the expansion of bank credit in these countries experiencing bubbles in their real estate markets.

In addition, the Eurosystem could have used different minimum reserve requirements in different national banking markets, applying higher minimum reserve requirements in countries experiencing much faster growth rates of bank credit (Ireland and Spain). The retail component of the banking sectors in the Eurozone is still very segmented along national lines, making the application of such differential minimum reserve requirements possible.

Figure 2. Growth rates of bank loans in Euro area

Source: ECB

From the preceding analysis it follows that the Eurosystem bears its part of responsibilities in allowing bubbles in national housing markets and the associated increases in private debt to develop. Reforms of the governance in the Eurozone should therefore not only focus on the responsibilities of national governments (and these are serious) but also on those of the European monetary authorities, and in particular those of the ECB. Some more hard thinking about how this can be done will be necessary.

References

Borio C (2003) “Towards a macroprudential framework for financial supervision and regulation?”, CESifo Economic Studies, vol 49, no 2/2003, pp 181–216.

Brunnermeier, M, A Crockett, C Goodhart, M Hellwig, A Persuad and H Shin.(2009): “The fundamental principles of financial regulation,” Geneva Reports on the World Economy 11 (Preliminary Conference Draft).

De Grauwe, P., (2010), Fighting the wrong enemy, VoxEU.org, May,

Kannan, K., Rabanal, P., and Scott, A., (2009), Macroeconomic Patterns and Monetary Policy in the Run-Up to Asset Price Busts, IMF Working Paper 09, 252

White, W (2006) “Procyclicality in the financial system: do we need a new macrofinancial stabilisation framework?”, BIS Working Papers, no 193, January.

Wyplosz, C., (2005), Fiscal Policy: Institutions versus Rules, National Institute Economic Review, no. 191, January.

a

A

Topics:  EU institutions

Tags:  Stability and Growth Pact, Economic governance

Comments

The diagnosis is exactly right. Greece focused attention on government debt, while we should be looking at the sum of private and government debt. We will regret looking at the wrong gauge.
The discussion on taxation without representation is less well thought out. After all, government debt is taxation of future voters without representation. There is a very strong argument for preventing it. The comfort governments can get by borrowing to please present voters at the expense of future voters is a severe drain on economic efficiency. Granted, it is a hard political pill to swallow but not a matter of high constitutional principle. The correct approach would be to prohibit any borrowing with a term extending beyond the term of the government contracting that borrowing.
The decoupling of Ireland and Spain from Germany is not a matter of animal spirits. One can point at several very specific policies by the German government that were meant to discourage consumption and support saving and investment in production capacity. Increasing VAT rates, maintaining a fragmented banking system, bailing out auto makers etc.
Monetary policy at the ECB (or FED) level is totally unsuited to counter such "aggressive competitiveness" policies. Such policies produce surpluses of savings that need to be recycled. Recycling the surpluses builds bubbles. Raising rates to prick bubbles only rewards those who built the surpluses. Raising reserve requirements or taxing interest are better options, especially since savings surpluses in China, Russia and oil exporting countries that are placed in the EU also strengthen bubbles. Even so, raising rates or reserve requirements across the Eurozone would, most likely, have driven even more funds out of low-return Germany into booming Ireland and Spain.
Differentiating at Member-State level would presumably mean different reserve requirements for loans made by a German bank to a customer in Germany and to a customer in Spain. Impossible to enforce, unless one were prepared to follow closely the funds and make a mockery of freedom of movement of capital in the EU.
It is worth repeating that "aggressive competitiveness" policies is a zero-sum game (until such time comes that we can trade with aliens) and that it cannot be countered by monetary policy. Interest rates are counterproductive and reserve requirements end up punishing domestic borrowers for the sins of governments that promote saving at the expense of consumption in their economies. So does taxation of interest.
My hard thinking can see two ways out. Either international policy coordination to manage the building and dumping of savings surpluses or outright capital controls.

Professor of international economics, London School of Economics, and former member of the Belgian parliament.