What is not in the Fiscal Compact?

At 1,395 words, Title III of the Treaty on Stability, Coordination and Governance is a very short document by official standards.  The Fiscal Compact contains just six articles and 11 paragraphs.  Understanding what is in the Fiscal Compact should not be difficult but there continues to be significant misrepresentations of the what the provisions actually mean.

As a response to the causes and consequences of the current crisis the Fiscal Compact is wholly inadequate.   From an Irish perspective it is true that “had the the Fiscal Compact been in place since 1999 it could not and would not have prevented the crisis in Ireland”.  It is possible that, in the run-up to the crisis, a greater adherence to the rules across Europe would have created some additional fiscal space to deal with the downturn but this leniency did not cause the crisis.

As regards the ongoing policy response to the crisis, the Fiscal Compact will make little difference.  At present 23 out of the EU27 (and 13 of the EZ17) are in the Excessive Deficit Procedure so even if the Fiscal Compact is torn up it would not lead to a significant change in policy.

However, when assessing whether the crisis could have been prevented it is important to realise that the Fiscal Compact only covers some aspects of the EU framework on economic policy. For example, the Compact does not mention the 3% of GDP overall deficit limit that was introduced in the Protocol on the EDP in the Maastricht Treaty.

The Compact also excludes some elements of the ‘Six Pack’ introduced last year.  From an Irish perspective, two additions worth considering are:

1. A Government Expenditure Rule
2. A Macroeconomic Imbalance Procedure

The government expenditure rule is included in Council Regulation 1175/2011 and specifies that:

for Member States that have achieved their medium- term budgetary objective, annual expenditure growth does not exceed a reference medium-term rate of potential GDP growth, unless the excess is matched by discretionary revenue measures;

Even though the Commission’s estimates of potential GDP growth at the time meant they estimated that Ireland was running a structural surplus, the potential GDP growth rates were not large enough to allow for the increase in government expenditure that took place since 2001.  Here is a table that retrospectively applies the rule to Ireland.  Larger version here.

From 2000 to 2007 the adjusted measure of government expenditure used by the rule increased by 130% and always exceeded the annual growth in nominal GDP and the 10-year average potential growth rate used as the benchmark in the rule.  If applied, the rule would have limited the increase in government expenditure over the same period to less than 50% “unless the excess is matched by discretionary revenue measures”.

The weakness of deficit and debt targets that are presented as a proportion of GDP is that they can lose their effectiveness in times of strong growth.  The new government expenditure rule is an attempt to address that.

The Macroeconomic Imbalance Procedure (MIP) comes from Council Regulation 1174/2011 and Council Regulation 1176/2011.  The latter regulation sets the process for the detection of imbalances and provides some details on their correction, while the former lays out the sanctions and fines that may be incurred if steps are not taken to correct the imbalance. 

The MIP attempts to broaden economic surveillance beyond the limited sphere of fiscal outcomes as it was imbalances in the overall economy rather than problems with public deficits and debt that precipitated the crisis in countries such as Ireland and Spain.

A scorecard of ten macroeconomic indicators has been devised and each of these has been assigned some threshold values.  The details of the procedure and the underlying documents are available here.  Karl Whelan has written a useful briefing paper on the MIP with particular focus on current account imbalances.

If applied retrospectively here is the scorecard for Ireland for the ten years up to 2010.  A larger version is here.

In 2002, Ireland was exceeding three of the thresholds.  In 2004 this increased to four and from 2005 Ireland was in excess of five of the thresholds.  The external imbalances were the real effective exchange rate, nominal unit labour costs and a declining export market share from 2006.  The internal imbalances are unsurprising and these were real house price growth, the increase in private sector credit and the stock of private sector credit.

We cannot be sure what would have happened if the MIP had been in place and the scorecard is not “applied mechanically”.  There is also a supplementary set of 18 indicators that is used.  However, given the persistent nature of the imbalances in Ireland (albeit measured by somewhat arbitrary thresholds) it is likely that the procedure would have been activated. 

As the MIP has yet to be applied in practice it is hard to know what this would have entailed.  According to the regulations, countries that are subject to a Macroeconomic Imbalance Procedure are required to produce a ‘Corrective Action Plan’.

Any Member State for which an excessive imbalance procedure is opened shall submit a corrective action plan to the Council and the Commission based on, and within a deadline to be defined in, the Council’s recommendation referred to in Article 7(2). The corrective action plan shall set out the specific policy actions the Member State concerned has implemented or intends to implement and shall include a timetable for those actions. The corrective action plan shall take into account the economic and social impact of the policy actions and shall be consistent with the broad economic policy guidelines and the employment guidelines.

The content and format of the corrective action plan are yet to be published.

Neither the government expenditure rule nor the Macroeconomic Imbalance Procedure would have been absolute in preventing the crisis in Ireland.  However, the expenditure rule may have resulted in a stronger fiscal position while the imbalance procedure might have seen the introduction of policies which would have attempted to curb the excessive lending that was provided to the property sector.

It is hard to know what impact these measures might have had on the spending decisions of politicians or the lending/borrowing decisions of private citizens.  The Fiscal Compact would not have prevented the crisis in Ireland, but the broader changes in economic policy at EU level do attempt to address some of the causes.