The article below was published in today’s Sunday Business Post.
The Irish electorate will soon be asked to express its opinion on the new EU Fiscal Compact Treaty. Although the treaty document is quite short, its content is quite abstract and addresses issues that have been mainly debated so far within a fairly small technocratic circle of economists. So, what are the economics of the fiscal compact?
The economic logic behind the treaty is that a deep commitment to fiscal sustainability provides a key anchor for macroeconomic policy. If the domestic population and international investors are confident that a government will maintain public debt at a level that does not pose default risk, sovereign debt will be considered a “safe asset’’. In turn, this avoids the incorporation of risk premia into the sovereign bond yield, which is an important saving to the government in terms of its debt-servicing bill. Furthermore, a low sovereign yield lowers the funding costs faced by the banking system, in view of the close financial connections between banks and the government.
In addition to these benefits, a stability culture also allows a government to more effectively manage the macroeconomic business cycle. One of the tragedies of the current Irish crisis is that the high level of sovereign default risk has forced the government to implement austerity budgets during a major recession. In the absence of sovereign default risk, a government can “lean against the wind” by running larger deficits during recessions and surpluses during boom periods.
Why does it require a treaty to persuade governments to implement such desirable fiscal policies? The accumulated evidence of the last thirty years is that many governments have suffered from a debt bias. The electoral cycle means that a government may prefer to boost short-term popularity by raising spending or cutting taxes rather than maintaining a low debt level. Such a myopic approach can go on for a long time, since the full costs of a high debt level are only revealed during crisis periods that occur only rarely.
An important contributory factor to fiscal instability is the failure to run sufficiently-large surpluses during boom periods. Although Keynesian principles dictate that governments should pro-actively raise taxes and moderate public spending to avoid overheating during a high-growth phase, the temptation during booms is to spend the extra revenues, in view of the political pressure to meet the many demands for the various types of public spending and the electoral popularity of tax cuts.
Burned by previous crises, some emerging market economies have proven that it is possible to overcome these obstacles. For instance, Chile and Ireland showed similar movements in the fiscal balance during the crisis. In the Chilean case, the swing was from a surplus of 10 percentage points of GDP to a deficit of 4 percentage points of GDP, which did not trouble the bond market in the same way as Ireland’s move from a zero fiscal balance to double-digit deficits. Chile’s ability to run such a large surplus during the pre-crisis period was facilitated by a fiscal responsibility law that mandated the government to “look through the cycle” and thereby save boom-time revenue windfalls in anticipation of future rainy days. Closer to home, Sweden’s good macroeconomic performance during the crisis is also partly credited to its fiscal law, which was introduced in the wake of its banking crisis in the 1990s and facilitated the running of significant surpluses during the pre-crisis period.
Accordingly, the intention behind the fiscal compact is that a legal/constitutional framework can provide a government with a commitment mechanism to help it avoid the twin problems of debt bias and fiscal pro-cyclicality. During booms, the legal commitment insulates the government from political pressures to increase spending and cut taxes. During recessions, investors can be relaxed about the emergence of fiscal deficits, in the knowledge that the legal commitment means that the government will ensure a reversal in the fiscal balance once economic recovery takes hold.
The importance of fiscal stability is even greater for members of a currency union, since the absence of national currencies means that fiscal policy is the main policy instrument available to manage domestic macroeconomic cycles. In addition, the current crisis has vividly highlighted the strength of contagion effects, by which fiscal weakness in one member country raises funding costs for other member countries. It is now appreciated that domestic legal commitments are more likely to induce fiscal discipline than external rules such as the Stability and Growth Pact, since only the domestic system can effectively hold a government to account. With a domestic legal commitment acting as the primary line of defence, the external rules should only come to the fore in the event of extreme fiscal misbehaviour and a breakdown in the domestic system.
These factors provide a strong economic rationale to support the treaty. Still, it is important to fully acknowledge that the implementation of this new fiscal system raises many concerns. In particular, it is economically-sensible that the treaty expresses the medium-term budgetary target in terms of the structural (that is, non-cyclical) fiscal balance, since this allows the fiscal balance to automatically decline during recessions without forcing a government to amplify the downturn by introducing austerity measures. However, the calculation of the structural balance is inevitable imprecise, given the difficulties in accurately measuring the cycle (especially for highly-open economies such as Ireland).
At one level, the centrality of the structural balance concept calls for greater efforts to do a better job in measuring it. In this regard, the trend in the European discussion is to emphasise the importance of allocating this task to well-resourced independent research institutions, in order to avoid the perception that a government might tweak its estimates for political purposes. In the Irish case, this would necessitate a major initiative to build the required analytical capacity.
Still, at another level, it is important to appreciate that the range of plausible estimates for the structural balance will always be considerable, such that the government will need to factor in a prudential margin in its budget calculations in order to avoid over-committing resources on the basis of medium-term growth forecasts that subsequently turn out to be too optimistic. In related fashion, a “correction” plan will be needed by which deviations of budget outturns from budget forecasts are gradually reversed over time.
It is also important to recognise that the Fiscal Compact facilitates other European-level reforms. First, strong national fiscal discipline is a pre-requisite for jointly-issued Eurobonds, which require a high level of mutual trust among the member countries. Second, the corollary to tight national constraints on public debt is that the fiscal responsibility for banking systems must be shared at a European level. Third, as has already been decided, only countries that ratify the fiscal compact will be eligible for financial assistance from the European Stability Mechanism. Fourth, by reducing the risk of sovereign defaults and thereby improving the quality of government-backed collateral, the Fiscal Compact enables the ECB to maintain its extraordinary level of medium-term liquidity support to troubled banking systems.