Guest Post by Timothy King: Keynesian Policies Under the Fiscal Treaty

The Stability and Growth Pact of 1997 permitted Eurozone countries to run a general government deficit of 3% of GDP.   The only economic innovation of the Fiscal Treaty is the replacement of this deficit measure by one that restricts the “structural budget deficit”—the deficit that that would be incurred if the economy was operating at full capacity—to 0.5% of GDP where the national debt is greater than 60% of GDP, and 1% otherwise.

The measurement of the structural budget deficit is to be cyclically adjusted, which will permit larger deficits in times of economic recession.  So far from outlawing Keynesian fiscal policies, as some of its opponents have alleged, this explicit acceptance that deficits may reflect cyclical factors will allow governments to cut taxes and/or increase expenditures as anti-cyclical policies require.  One-off or temporary payments such as those to the Anglo bondholders are also excluded from the deficit calculation.

Much depends, of course on how the adjustments are made.  The IMF, the OECD and the EU, all make estimates of the structural deficit, and the first two of these agencies both regularly publish these together with other data on government lending and borrowing.  I believe all three agencies use very similar methods of estimation.  (Knowing nothing about this topic I found Box 1 in the paper Tony McDonald, Yong Hong Yan, Blake Ford and David Stephan, Estimating the structural budget balance of the Australian Government in the Australian Treasury’s Economic Roundup 2010, Issue 3  (http://archive.treasury.gov.au/contentitem.asp?NavId=&ContentID=1881) very useful as an introduction.   This gives references to more technical papers describing the estimating processes of each of the agencies in detail.

Potential output is derived using two-factor constant-returns-to-scale Cobb Douglas production functions with some assumed rate of growth of total factor productivity.  If you are an international agency needing to make regular internationally comparable estimates of the potential output of scores of countries, this may be the best you can do, but this method of calculating potential output seems particularly inappropriate for Ireland, where the sudden arrival and departure of foreign firms and fluctuating rates of international migration can change the productive potential of the economy very quickly.   The agencies can presumably also use only very approximate rules of thumb when trying to calculate how tax revenues would increase to the achievement of this potential output.  The only expenditure that is held to be cyclically determined is unemployment compensation.

The inevitable imprecision of these calculations makes it unsurprising that agencies can differ quite markedly in the proportion of a given government deficit they attribute to non-structural causes.  For example, averaging estimates for Ireland for 2000-2009, the IMF had an average structural balance of -4.4% of GDP; the OECD had -2.2%.  In 2010, the OECD had a structural balance of 25.5% where the IMF had 9.9% (presumably reflecting different treatments of payment obligations under the banking bailout scheme.)   Unfortunately I do not know of a readily available internet source of EU Commission estimates.

Since Ireland is clearly in the “excessive deficit” zone, these differences are not currently of critical importance.  But eventually this position will change, and one can envisage very considerable argument about the proportion of any given deficit which is to be considered non-structural.  It would be advisable for the Irish government to develop its own methods of estimating structural deficits, and to be prepared to defend them under sceptical questioning if they show lower structural deficits than Commission or IMF figures.  Indeed it would be worth seeking the help of one or two economics of unimpeachable international reputation, and who have not previously taken public positions in rejecting EU stabilisation policies, to guide the process of making the estimates and certifying their credibility.

There is no reason why built-in stabilisers need be confined to payments to the unemployed.  A perfectly feasible Keynesian measure would be legislation that inversely relates VAT rates to the level of unemployment.  Discretionary stabilisers, such as a list of non-essential infrastructure maintenance projects that could be speedily put into operation would be another possibility, though more likely to be challenged by the EU monitors.

Although the Treaty regards national budget surpluses with favour, they have a potential deflationary impact on the Eurozone as a whole.  If Keynes had been involved in designing this treaty, he would probably have attempted to have supplemented the “excessive deficit procedure” with an “excessive surplus procedure”, to have forced countries with large budget surpluses to reduce these, even at the expense of greater domestic inflation.  He would of course have had as little success with the Germans as he did with the Americans when he made comparable proposals about persistent creditor countries at the Bretton Woods conference in 1944 that set up the postwar international monetary system.

The concept of a structural budget deficit has been in use for decades by the IMF, but it is not one that is in general discourse, even among economists.  It does not refer to the structure of an economy, which is normally taken to be a set of productive activities, many of which are locationally fixed, and includes both capital equipment, infrastructure and human capital which can change only slowly.  The EU funds designed to help areas of high unemployment to improve their productive capacity are accordingly known as structural funds.  This structural deficit is quite different—it involves a snapshot (if a one-year flow measure can be called a snapshot) of how the existing system of taxes and public expenditures implies for an economy operating at full capacity.

It is easy to get confused about this difference.  Finance Minister Michael Noonan interviewed on RTE’s This Week on May 20th appeared to be implying that needed structural reforms—he alluded to the retraining of unemployed construction workers—were part of the programme to reduce the structural deficit.  Of course, such reforms will lead to increases in both GDP and government revenues rises (and presumably reduce the structural as well as the general deficit)  but this is to use the word “structural” in its more usual meaning, rather than in the sense used in the treaty.

When the Maastricht Treaty was first agreed in 1993, there was much criticism that it required purely monetary convergence, and paid no attention to labor market convergence, either cyclical or structural.  At that time unemployment rates in different Eurozone countries diverged sharply.  Spain had an unemployment rate of over 20%, and Finland and Ireland rates of over 15%.  In contrast, it was only 4% in Austria.  There were concerns that whole countries might find themselves saddled with uncompetitive economies unable to devalue, and become permanently depressed regions within a larger federation, rather like the Italian Mezzogiorno or the US Rust Belt.

This fear appears to have been premature.  The pre-crisis convergence of unemployment rates has been striking.  The standard deviation of national unemployment rates was 5.1% when the treaty came into force, 3.6% in 1999, the first year of the euro and only 2.1% in 2007.  Even in Spain, which appears to be the country in which unemployment has been most persistent, unemployment rates fell until in 2007 they were, at 8.3%, lower than in Germany (8.7%).  The effect of the crisis has, however, been sharp divergence among national rates. The standard deviation in 2011 was 5.4%;   Spanish unemployment was 21.7%.

None of this means, of course, that when stabilization has been achieved and a respectable rate of economic growth reestablished throughout the Eurozone, there will be no further need for reform.  The fear of permanently depressed countries has not gone away—(see, for example a recent article by Martin Wolf (Irish Times, May 21st).  This reinforces what this crisis has made sharply evident—the need for some central fiscal authority, (and also a properly empowered Central Bank).  But the 1993-2007 convergence in unemployment rates suggests that such central authorities ought to be able to adopt Keynesian policies as required.

19 replies on “Guest Post by Timothy King: Keynesian Policies Under the Fiscal Treaty”

The 3% headline deficit rule under Maastricht is re-affirmed. In theory the structural deficit allows for counter-cyclical measures. In practice much will depend on the estimation of this deficit and how it plays out over time politically and institutionally. OECD estimates refer to the CABB and not necessarily the structural deficit (the difference accounted for by one-off measures …). The only source of comparative international data that I am aware of are (i) IMF WEO online and (ii) European Commission periodic economic forecasts. Eurostat, at this time, does not estimate the structural deficit (as distinct from Cyclically adjusted deficit. The bottom line is that EU/DOF project a structural deficit of 3.5% in 2015 while the figure is 2.5% from the IMF. Lots done and lots more to be done under the heading of ‘fiscal adjustment’.

[Keynes] would of course have had as little success with the Germans as he did with the Americans when he made comparable proposals about persistent creditor countries at the Bretton Woods conference in 1944 that set up the postwar international monetary system.

The speculators solved that little problem in the 1970s by demolishing the defective fixed-FX-rate system. Best to prepare for the highly probable re-make, Eurodammerung. Funnily enough, my first contact with economists was during the 1972(?) crisis which marked the beginning of the end for Bretton Woods. Understandably, they were all at sea. Floating FX rates were not on the curriculum. History repeats itself; tragedy, farce, now what?

“… … a respectable rate of economic growth reestablished throughout the Eurozone …”

Is this for real? The Eurozone would need a productive economic expansion of goods and services (which MUST be sold outside the Eurozone for no-euro currencies) of something approaching 7% p/a for 10 years on the trot!

We cannot continue with the stupidity of increasing credit (ie. debt) and pretend that it is ‘growth’. It is nothing of the sort. At best its a ‘standstill’. At worst its an increase in our already unpayable debts. Your current debt is your future income. Is this so hard to grasp? Debt grows exponentially. Which means? Perhaps sixth form math is a sum too far.

That MW piece was interesting. For the first time there was a tiny well concealed acknowledgement that Permagrowth may be a problem. If all attempt simultaneous economic growth – its like gerbils in a treadmill. The mill moves, but the gerbil is stationary. What class of a dopey person believes that will not end in an another bigger and better financial disaster?

The Great mystery of our time (not) is that there is no excessive leverage procedure enforced by Goverments on Banks.
The core of the problem is quite clearly the money to credit ratio which distorts all activities , now to the point of absurdity.

The rise of “sovergin debt” (article 123) and credit bubbles are interlinked – to pay interest to private holders, credit bubbles are created – this enables the extraction of deposits from citizens without the danger of a uprising as the people somehow think real growth is occurring.

When they can no longer create a credit bubble via continued resourse extraction without money / real capital investment (technology / resourses)…… well thats when peoples deposits decline , creating the turmoil we see today.

Article 123 actually creates the conditions for Ponzi schemes.

“The Authorities” cannot be blind to the simple mathamatical function known as the exponential curve……. that would be simply incredulous.

Gavin Barrett has a forensic dissection of the implications of the TSCG for “austerity” in today’s IT. There are none. This, however, poses the question is to what the fuss is all about.

http://www.irishtimes.com/newspaper/opinion/2012/0529/1224316859011.html

The real point of the treaty is in the following extract;

“Most of what the fiscal treaty involves ultimately simply reiterates existing legally binding debt and deficit rules in treaty form and tightens up (and switches to national level) their enforcement. If that seems a very minor legal matter to have a referendum or even a treaty about, that is because it is”.

The key is in the phrase “switches to national level”; coupled with the sanction of the ECJ for any failure to do so and the introduction of reverse QMV in relation to excessive deficits (which should prevent a repeat of what happened in 2004/5).

That is the real meat of the treaty and it is much more than simply a political statement for Merkel to wave.

Incidentally, the recommendation of Keynes is in the maco-imbalances regulation in a very timid way and in a version which leaves Germany off the hook. What a surprise!

However the arguments for a yes vote are dressed up, the emperor has no clothes on. I’m assuming non-structural portion of our deficit spending is due to that portion of our deficit that relates to the repayment of our bailouts/bank debt.

“agencies can differ quite markedly in the proportion of a given government deficit they attribute to non-structural causes.” “In 2010, the OECD had a structural balance of 25.5% where the IMF had 9.9% (presumably reflecting different treatments of payment obligations under the banking bailout scheme.) ”

Let’s do a spring clean and also throw out all that propaganda from the Referendum Commission about the Referendum being about “The Treaty is about strengthening the rules designed to make governments keep a balance between their income and their spending. ”

Let’s look at non structural causes of our deficit. Let’s look at bank debt.

Why would you do that?

As a passenger on the Titanic some used the Archimedes Principle to calculate the ship would sink in approx 2 hours. As a method to deal with the fact the Titanic has collided with an iceberg and is holed beneath the waterline with 5 ‘watertight’ holds breached, its not very useful to look at the amount of water and not see the the real damage caused by gaping holes letting in water. Our bank debt is sinking us.

Its not so much that we are spending more than we are taking in; we realise this must be dealt with. Its that a major part of our spend is odious bank debt we are not liable for. Money for schools is being sent to bondholders and ELA/PN’s while our Govt stands idly by.

Let’s look at the iceberg, the bank debt, and more from Philip piercing the shibboleths surrounding bank debt is required.

The Government has put its head in the sand on this matter. Its failed to plug the holes in our economy due to the lack of writedown of bank debt.

In epic MISTAKE at the level of both timing and content, Govt is forcing the Referendum down the throats of the electorate on the mere pretext we may ‘apply’ for a further bailout if this bailout fails. Its failed on every level to negotiate a rebalance of our economy through debt writedown of banking debt; its asking endorsement through a Y vote for more penal peonage with more odious conditionality attached.

In Ireland’s case between 20-40% of our debt/GDP is related to banking debt. Take that away and our economy has a chance of stabilising. Ignore this and we’re sunk.

Voting Yes will make it more difficult to renegotiate the non structural parts of our deficit due to our banking debt. So, vote No.

Demand writedown of our bank debt.

“..agencies can differ quite markedly in the proportion of a given government deficit they attribute to non-structural causes.” Its sadly the case academia in the economics fear in Ireland, has failed to do the sums here and analyse the data around our debt repayment obligations, to show the exact percentage of the non structural aspect of our debt profile related to banking debt alone.

Bank debt is our sinkhole bringing this economy under water.

The Yes campaign have made political capital out of this by confusing structural and non structural aspects of our debt profile. Through propaganda they’ve swept bank debt under the carpet and made it as if bank debt has no consequence and can be managed by growth and austerity.

The timing and content of the current Referendum campaign must in terms of political ineptitude be up there with the ill judged guarantee. It ranks up there with Ceaucescu’s mess which similarly did not go well. Unless the issue of non structural bank debt is dealt with, we should be prepared to leave the euro; unless vassal, debt peonage to pay back odious debt to French/German banks is to your liking.

This is a sane and helpful post.
The discussion of the measurement of the ‘structural’ deficit is mercifully simplified. The reader is spared trying to come to grips with notions like the Hodrick Prescott Filter, of which I have a vague memory from an economics course in UCD which I took years before anyone took the idea of cyclically-adjusted budget balances seriously!

@ DOCM

re Barrett “Most of what the fiscal treaty involves ultimately simply reiterates existing legally binding debt and deficit rules in treaty form and tightens up (and switches to national level) their enforcement. If that seems a very minor legal matter to have a referendum or even a treaty about, that is because it is”.”

Our AG doesn’t regard the provisions of FC as a minor legal matter, that’s why we’re having a referendum 🙂

If Barrett doesn’t see the benighted nature of the stranglehold of FC on this economy, perhaps he’s a stakeholder doing quite well out of it. How long that will continue is a matter for him to judge.

This FC was written by the bankers, for the bankers, of the bankers. The bankers want their money back and don’t trust the politicians. They don’t like ELA/PN’s because its conceivable some politicians et al, not our benighted lot, sickened by the malign austerity unfolding before them, may decide; hey, not going to pay the PN’s.

The bankers may be confronted by politicians deciding they made a mistake and now wishing to default.

So, the unelected directors of the ESM want the means to contractually bind supplicant members to ensure they have no getaway means of exit through default.

That’s why they are introducing the punitive and penal conditions of a new debt arbitrage, a Faustian Pact between the European Court of Justice and the bankers, a threat of sanction and other unspecified measures against EMU members in breach of ESM rules.

The FC/ESM is the European equivalent of the Irish banking guarantee, you know where that’s left us.

“When the Maastricht Treaty was first agreed in 1993, there was much criticism that it required purely monetary convergence, and paid no attention to labor market convergence, either cyclical or structural. At that time unemployment rates in different Eurozone countries diverged sharply. Spain had an unemployment rate of over 20%, and Finland and Ireland rates of over 15%. In contrast, it was only 4% in Austria. There were concerns that whole countries might find themselves saddled with uncompetitive economies unable to devalue, and become permanently depressed regions within a larger federation, rather like the Italian Mezzogiorno or the US Rust Belt.

This fear appears to have been premature.”

I and many others would put it to Timothy that the predicted scenario he refers to was not expected to be te immediate effect. The first effect was to be cheap credit booms from monetary ‘convergence’, followed by …….

There was wide disagreement about the length of the temporary booms (I went for 5 years, it was just a guess), but the sceptics’ predictions cannot be sensibly dismissed – they were basically correct.

@docm

There are two items, one is the Treaty, the other is the constitutional amendment. I find Gavin’s concentration on the first, interesting.

Please pardon my ignorance here, and no disrespect intended:

Who exactly is Timothy King?

I ask only because it is notable that none of the host of economists and establishment figures telling us that the Fiscal Compact allows for Keynesian type policies seem themselves to be Keynesians.

Would it be be fair to say that the vast majority of those saying that the Fiscal Compact allows for Keynesian policies are not generally in favour of Keynesian policies and that most have a neoliberal outlook, economically at least?

Can anyone name me an active economist traditionally considered a Keynesian, hard or otherwise, who thinks that the Fiscal Compact is a good idea?

Professor Lane? Mr King? Would a statement of where you stand on the political spectrum be in order?

Great post and badly wanted.

Fear tactics aside, this government have been keen to obscure the bigger picture by making questionably assertive statements to support biased, isolated arguments. This is par for the course.

For instance, the government might refer to the money multiplier with regard investment but never when referring to the cutting of capital spending programs – some estimate a €6bn cut necessary in 2015 to meet the Fiscal Compact 0.5% target – all things constant this would mean €15bn damage to GDP if you used a conservative multiplier of 0.4

Driving the “yes” vote is a populist idea that government spending is unproductive, that people are more prudent with money than the government. This ignores the governments role with regard market failure.

The general rhetoric in Europe has changed – words like “solidarity” and “common” have gone out the window. In isolation, quick fixes like the Fiscal Treaty are only incremental and seemingly “harmless” but they steer us toward a federation which is startling when you consider the lack of cohesion and transparency around EU strategy – lack of respect for democratic rights. Should that kind of machine even be allowed to move forward?

The current state of the Eurozone is proof that Europe is not yet ready for “one size fits all” policy-making. It has damaged diplomacy via beggar thy neighbour and finger pointing. Enforcing deficit caps suffers similar pitfalls to the Euro. Irish society is in a very different place to the “core” member states. Our population is growing and we have a lot of first generation Irish to integrate. Investment in education, culture and community should yield return. It’s a shame this argument has not found a voice in the debate.

Fiscal transfer union is surely the convincing remedy that’s needed (as argued above with the “excessive surplus procedure” but the EU seems to have different gears for different policies….and are not keen on transparent joined-up thinking, much like our government.

@ Shay

Too many inconvenient questions. You wouldn’t last 2 mins in the Dail.

There has been very little balance in the debate. It’s been the establishment vs the looney left – order vs anarchy apparently. As unconvincingly as the establishment have performed, they are just lucky that the “no” side didn’t find the more credible people to run the campaign. Not too long ago the church might have held sway in the debate. I had hoped some economists might come in this time and show that economics is about the value of things rather than the price…but alas.

@Peter

It’s been the establishment vs the looney left – order vs anarchy apparently. As unconvincingly as the establishment have performed, they are just lucky that the “no” side didn’t find the more credible people to run the campaign.

I am not sure that the largest anti-treaty party, Sinn Fein, even wants to block the Fiscal Compact being approved. It would after all not take much of a publicity campaign to show how deeply embedded the banking sector are in Fine Gael (Bruton, Sutherland, Dukes) or how those most in favour of the Fiscal Compact were also the most wild enthused about the orgy of credit, market led policy making and light touch regulation that left us so vulnerable to the European component of the global financial crisis. The same economists, the same business ‘leaders’, the same media outlets and the same political parties.

From the point of view of the anti-treaty left (and the young) the mess of having to repudiate the Fiscal Compact later may be outweighed by the electoral benefit of having the Labour party self immolate in the furnace of European neoliberalism – as a show of solidarity for the people who stoked the fire.

Dear Shay

I am a former University Lecturer in Economics at Cambridge University and subsequently an economist with the World Bank. In retirement, I live in Killiney, Co Dublin. I hold strong views on many policy issues, including one that Ireland would strongly benefit from voting Yes, but I would not consider myself consistently at any niche in the political spectrum of any country.

Timothy

Timothy who?

Is he one of the 44?

@All Economists

Final call: anyone care to argue in favour of the social scientific economic validity of the key constraints [0.5; 60.00; 1/2] within Angela’s Fiscal Corset – based on reasonable empircal evidence and any reasonably plausible theory even remotely linked to economics – 6-pack journal standard OK – no need for all the fuss on 5* standard?

@Timothy King

Hi Timothy. A little challenge to keep you fresh in your well-earned sojourn in lovely Killiney: care to argue in favour of the social scientific economic validity of the key constraints [0.5; 60.00; 1/2] within Angela’s Fiscal Corset – based on reasonable empircal evidence and any reasonably plausible theory even remotely linked to economics – 6-pack journal standard OK – no need for all the fuss on 5* standard?

Thank you Mr King. I feel slightly less ignorant now.

I hope that you are enjoying your retirement, but no so much that you give up making contributions to the public sphere.

FYI

Banking crisis
Can Spain make a solo comeback?
29 May 2012El País Madrid

Assurances from the head of government cannot amount to much: victim of a severe banking crisis, Madrid will soon be forced to seek help in the EU. Like Ireland, it will then be placed on a drip-feed – and under guardianship. [……..]
What would happen if the Spanish government were finally forced to dip into the rescue fund? Harvard professor Kenneth Rogoff answers: “If the eurozone and the ECB fail to take unequivocal and speedy steps, there’ll be bank runs throughout the periphery and devastating capital flight. To avoid this, banks must be provided with liquidity.

“The eurozone should move several rungs up the ladder of fiscal union with Eurobonds. We will see exceptional measures, which until very recently were unthinkable – but that has happened every time Europe has been on the verge of an accident.”

http://www.presseurop.eu/en/content/article/2077841-can-spain-make-solo-comeback

Vote NO for a change in direction – Rapidly. Incrementalism is Death.

As Timothy King puts it – a properly functioning European Central Bank ..

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