Failure to Regulate Regulation Could Prove Costly

My opinion piece in today’s Irish Times points out that the disbanding of the Better Regulation Unit in the Department of the Taoiseach risks reducing the capacity for effective oversight of regulatory institutions and strategies and for learning about and acting on regulatory successes and failures elsewhere in the OECD member states. A fuller policy brief on the topic, “W(h)ither Better Regulation?” is available here.

I hope there is no problem about my linking to the article I wrote.

Austerity games

Kevin and Philip have been keeping readers of this site up-to-date with economic analysis of Grexit, problems with EMU and other big picture items over the last few days.

If I may, I’d like to bring things back down to the level of Ireland and the upcoming referendum on the Fiscal Compact. To my mind, a few important concepts have gone out the window as the debate in Ireland about the referendum on the Fiscal Compact has descended into political games. Perhaps the first victim was cause-and-effect, with the mere correlation of banking debts and government deficits being translated by many into iron-cast causation.

A close second in the casualty list was the concept of opportunity cost: in other words, there’s not really much point focusing on how bad or economically illiterate the Fiscal Compact is in and of itself. We need to ask how attractive it is relative to the other options. As of now, the most important attribute of the Fiscal Compact is its ability to get Ireland the funding that it otherwise would not be able to get, to allow the country to gradually close the deficit. By 2020, that may be completely unimportant and we may want to ditch the Compact. But we are voting in 2012, not 2020.

With that in mind, I’ve developed “Austerity Games”, as a basic guide to voters on deficits, debt, fiscal policy and the EU’s Fiscal Compact (below, click to enlarge). Hopefully it’s useful to some readers.

choices for Irish voters
Austerity Games: choices for Irish voters

For a fuller exposition on why the IMF will not be a panacea, Karl Whelan has an excellent blog post here.

Irrational Greeks?

Lorenzo Bini Smaghi is fond of the word “irrational”. It appears several times in the article that Philip linked to yesterday. In particular, it seems that LBS thinks that Greek voters are irrational. Given that Greece is the birthplace not only of democracy, but of Euclid and the rest of them, it seems worthwhile querying the notion that Greek voters are irrational.

One evidence of their irrationality that is sometimes advanced is that while they have overwhelmingly rejected the current austerity measures in a democratic election, polls also show that they would like to remain in the euro.

What is irrational about this?

I guess the first best solution for Greeks is for Greece to stay in the euro, but for the current programme, based on multilateral austerity and internal devaluation, which has failed and indeed has no chance of succeeding, to be replaced with a programme which involves more debt forgiveness and more fiscal transfers from the centre. What is irrational from a Greek perspective about wanting this? That it probably isn’t going to happen is of course an important fact, but there is nothing irrational about wanting what is best for you.

Then there is the question of whether it is irrational to vote for Syriza. Let us assume that if Syriza forms a government with like-minded parties, and refuses to implement the current austerity programme, Greece is somehow ejected from the Eurozone. Knowing that this is a likely outcome, is it irrational for Greeks to vote for Syriza?

I’m not so sure.

If they vote for the two parties that have brought Greece to this sorry state of affairs — and why on earth would they? — then what is the likely outcome? The programme continues, and what Greece has lived through for the past few years continues for the next few years. This would offer zero hope for ordinary Greeks; no prospect of anything changing in the foreseeable future which might improve their lives. And in the end the strategy will probably fail, anyway.

If they vote for Syriza, perhaps Greece will leave the Eurozone. In that case, what happens? There is the certainty of a major economic crisis in the short run, but then what? Some commentators argue that the result will be hyperinflation. Given that the Greek primary deficit is very small, I am puzzled by the certainty with which this prediction is sometimes made. I suppose there is a certain probability of a very bad outcome like this occurring, but the probability is surely much less than one. On the other hand, there is also the possibility of default and devaluation leading to a recovery in two or three years. Again, the probability of this scenario occurring is less than one, but it is surely rather greater than zero.

And then there is the possibility that the Europeans will blink, and that the Greeks will get something like their preferred solution. I think this probability is vanishingly small myself, but perhaps I am wrong.

So, Greek voters can do what Europe’s elites are now urging them to do, and vote for the two establishment parties. In this case, they know with certainty that nothing will get better, and indeed that things will continue to get worse. Or, they can roll the dice. I don’t think it’s irrational for them to roll the dice. And thankfully, they seem to be gambling on Syriza, not Golden Dawn.

Of course, with a certain probability, which may be less than one, but is certainly much bigger than zero, a Greek Eurozone exit will lead to financial chaos elsewhere, and possibly even the collapse of the single currency. But that will primarily be our problem, not a problem for Greek voters.

So I am unconvinced by the argument that Greek voters are irrational, even if one only considers the economics of the situation they find themselves in. And this argument is strengthened when you consider non-economic factors. Everywhere in Europe you hear ordinary people saying that they feel powerless, that voting changes nothing, that they feel disenfranchised. In Greece, voters may be about to really change things, regaining some control over an agenda which has up till now been dictated by people like Lorenzo Bini Smaghi. I guess that many voters will derive utility from this.

Knowing all of this, leaders in other European countries should surely be trying to offer Greek voters something that the status quo excludes: hope. Instead, they are offering warnings about dire consequences, and statements to the effect that the rest of us can handle a Greek exit. You do have to ask: who is it that is being irrational here?

Aghion on Hollande

Philippe Aghion has had a very influential academic career at Harvard; recently, he has been advising Francois Hollande and he explains the new presidents’s supply-side economic strategy in this FT article.

By the way,  the article also explains in passing:

Mr Hollande’s third main idea is that what is true for each individual country within the European Union is also true for the EU as a whole. In other words, the EU must pursue both budgetary discipline and a complementary growth package.

This applies even more to the eurozone. Foreign observers have been worrying about Mr Hollande’s use of the word “renegotiating” in relation to the European fiscal pact. However, to a large extent, the issue is semantic. His use of the word “renegotiate” refers more to the notion of combining the existing budgetary agreements with a growth package than to truly renegotiating the budgetary part of the project.

Pat Swords v The World

The UN-ECE Compliance Committee of the Aarhus Convention has now ruled in the case Pat Swords v European Union. The ruling has implications far beyond this case.

To recap, Pat is no friend of renewable energy. He complained about the government’s renewable energy policy to every authority in Ireland and was either ignored or told to go away. So he complained to every European authority with the same result. And so he complained to the United Nations Economic Commission for Europe under the Aarhus Convention on Access to Information, Public Participation in Decision Making and Access of Justice in Environmental Matters.

In February 2011, the Committee admitted Pat’s complaint. This is significant. Ireland did not ratify the Aarhus Convention. The EU did, however. Because Brussels handed down its renewable energy policy, Dublin is bound by Aarhus.

This sets a precedent. Any Irish policy that is somehow proscribed, inspired, or constrained by EU policy, is now subject to Aarhus.

The Committee has now issued its draft ruling. It is long and complex. It is silent on the policy itself. On procedural issues, two points stand:

  • Ireland made a mess of its public consultation on the National Renewable Energy Action Plan.
  • The European Commission failed in its duty to supervise Ireland.


  • Anything in the NREAP can now be challenged.
  • Consultation on the NREAP was not pretty, but it was not particularly ugly by Irish standards either. Other government plans can now be challenged too.
  • And the EU has been told to intrude more.

ECB on the Fiscal Compact

  • 10/05/2012 – Publication: Article, Monthly Bulletin, May 2012, pp 79-94, A fiscal compact for a stronger Economic and Monetary Union, 222 kb, en

See also:

  • 10/05/2012 – Publication: Article, Monthly Bulletin, May 2012, pp 95-112, Comparing the recent financial crisis in the United States and the euro area with the experience of Japan in the 1990s, 715 kb, en

Nama Scheme Increases Recorded Property Sales Prices by Approximately 7.5%

In announcing its 80/20 negative equity insurance scheme, Nama management could have, but did not, provide estimates of the implicit cost of the insurance component of the package product. The cost is hidden in the package sales prices, which Nama management describe as “fair value prices” for the property.  With a bit of work, it is possible to reverse-engineer the insurance-component cost from the scanty information provided by Nama. 
Continue reading “Nama Scheme Increases Recorded Property Sales Prices by Approximately 7.5%”

A Guest Post By Gavin Barrett

The Zero Impact Treaty?

Some Observations About the Debt and Deficit Rules in the Fiscal Treaty

Some readers will have come across an article I wrote which was published in the Irish Times on Friday 4th May. If not they will locate it here. This is just a short expansion on some of the ideas about the law expressed in that article. In essence, the point being made here is that the impact of this Treaty seems to be in the enhanced guarantee of adherence to its debt and deficit rules provided by (a) their ‘elevation’ to Treaty status (b) their domestication into national legal systems and (c) the Treaty’s extra enforcement provisions. Very far from costing us billions of extra euro or ushering in twenty years of austerity, the rules themselves however do not appear to involve any change at all from the standards we are already complying with – a point which is frequently missed by expert analyses. It is proposed to turn to each rule in question

1)      Debt Brake 

As I note in my Irish Times article, whatever the economic impact of such a debt brake – and this is something which has (quite reasonably) formed the subject of discussions on – this rule involves nothing new, since precisely such a debt brake is already found in Article 2(1a) of Council Regulation (EC) No. 1467/97   as amended by Article 1 of ‘Six Pack’ Council Regulation (EU) No. 1177/2011.   Readers will find that here (see p. 3 thereof). 

Its impact will not therefore be felt by anyone in the form of increased austerity. 

2)      Deficit Target 

Here unfortunately, in order to understand the legal position, it is necessary to quote the deficit target rule at length. Under Article 3 of the Fiscal Treaty,

 “(a) the budgetary position of the general government shall be balanced or in surplus.

   (b) the rule under point (a) shall be deemed to be respected if the annual structural balance of the general government is at its country-specific medium-term objective as defined in the revised Stability and Growth Pact with a lower limit of a structural deficit of 0.5 % of the gross domestic product at market prices. The Contracting Parties shall ensure rapid convergence towards their respective medium-term objective. The time frame for such convergence will be proposed by the Commission taking into consideration country-specific sustainability risks. Progress towards and respect of the medium-term objective shall be evaluated on the basis of an overall assessment with the structural balance as a reference, including an analysis of expenditure net of discretionary revenue measures, in line with the provisions of the revised Stability and Growth Pact.  

   (c) The Contracting Parties may temporarily deviate from their medium-term objective or the adjustment path towards it only in exceptional circumstances as defined in paragraph 3.”   

Article 3(3) provides some definitions which are necessary for the purposes of understanding the foregoing rule:  

“…”annual structural balance of the general government” refers to the annual cyclically-adjusted balance net of one-off and temporary measures. “Exceptional circumstances” refer to the case of an unusual event outside the control of the Contracting Party concerned which has a major impact on the financial position of the general government or to periods of severe economic downturn as defined in the revised Stability and Growth Pact, provided that the temporary deviation of the Contracting Party concerned does not endanger fiscal sustainability in the medium term.”  

What can be said about this new deficit rule?  The first observation is that there is already a rule in place – Article 2a of Council Regulation (EC) No. 1467/97   as inserted by Article 1(5) of Regulation 1175/2011 –  which stipulates that  

 “the country-specific medium-term budgetary objectives shall be specified within a defined range between -1 % of GDP and balance or surplus, in cyclically adjusted terms, net of one-off and temporary measures.”

Readers will find that here (see p. 5 thereof). So even if the Fiscal Treaty involved a straightforward obligation to hit a 0.5% structural deficit target, the most we could ever have been talking about would have been a shift in targets from a -1% cyclically adjusted deficit, to a -0.5% cyclically adjusted deficit.

The Fiscal Treaty does not however involve a straightforward obligation to hit a 0.5% structural deficit target.  Instead, the Article 3 Fiscal Treaty requirement involves an obligation to hit a tailor-made target for each country – and even that is shot through with exceptions and ‘wiggle room’ for those charged with enforcing it either at Irish or European levels: 

(i)                  the real requirement is merely that  the annual structural balance of the general government be at its country-specific medium-term objective as defined in the revised Stability and Growth Pact (with a lower limit of a structural deficit of 0.5 % of the gross domestic product at market prices); 

(ii)                even that is putting things too strongly, since Article 3(1) immediately stipulates that “the Contracting Parties shall ensure rapid convergence towards their respective medium-term objective.” – implying in reality that they do not actually have to hit their medium term objective, merely converge rapidly with it;  

(iii)               even ‘rapidly’ is a relative term:  according to Article 3(1), the “time frame for such convergence will be proposed by the Commission taking into consideration country-specific sustainability risks”; 

(iv)              moreover “progress towards and respect of the medium-term objective shall be evaluated on the basis of an overall assessment with the structural balance as a reference, including an analysis of expenditure net of discretionary revenue measures, in line with the provisions of the revised Stability and Growth Pact”; 

(v)                it should not be forgotten also that under Article 3(1)(c), the Contracting Parties may temporarily deviate from their medium-term objective or the adjustment path towards it in the exceptional circumstances as defined in paragraph 3 – which are broadly enough defined to include, within certain limits, ‘an unusual event outside the control of the Contracting Party concerned which has a major impact on the financial position of the general government’ and ‘periods of severe economic downturn’; 

That is not all. All of the foregoing are merely the general rules: more specific ‘soft law’ rules apply to Ireland. According to Ireland – Stability Programme Update (April 2012) at p. 31

… Ireland’s ‘medium-term budgetary objective’ (MTO) currently stands at -0.5% of GDP. This objective was set well in advance of the Inter-Governmental Treaty on Stability, Coordination and Governance in the Economic and Monetary Union (the ‘Stability Treaty’)…”

In other words, as with the debt brake, the Fiscal Treaty involves the introduction of a structural deficit target which we are already aiming for. As with the Treaty’s debt rule therefore, regardless of the economic impact of aiming for such a target – and again, this has formed a very legitimate source of discussion on, the fact that the target is the same before and after the coming into force of the Fiscal Treaty should mean that the economic impact of the introduction of the Fiscal Treaty’s new deficit target should be precisely zero.

A few final rather random but still significant observations may be made on the debt and deficit rules

As regards the debt rule: 

·         even the veritable non-event of the new rule’s coming into force is postponed for several years –  Article 2(1a) plus Clause 13 of the Preamble to the 2011 Regulation provides for a transitional period before the debt reduction rule applies with full force, a rule which does not appear to be interfered with by the Fiscal Treaty (see Clause 20 of its Preamble)); 

·         some degree of confusion has arisen because of the somewhat ambiguous wording of Article 4 as to whether the ‘one twentieth per year’ benchmark reduction it refers to relates to one twentieth of the entire debt-to-GDP ration or merely to (a less onerous) one twentieth of the excess over 60% reference value. The words ‘as provided for in Article 2 of Council Regulation (EC) No. 1467/97 of 7 July 1997’, however indicate that what was intended was the lesser amount i.e., one twentieth of the excess over 60% reference value. There appears to be no change there from the existing legal position.

As regards the deficit rule:

·         despite the misleading wording of Article 3(1)(a)of the Fiscal Treaty, the Treaty does not really oblige the budgetary position of a Contracting State’s general government to be ‘balanced or in surplus’ (since moments later Article 3(1)(b) refers to a lower limit of a structural deficit of 0.5 % of the gross domestic product at market prices) – a lower limit which could not exist were there really an obligation to have a budgetary position balanced; 

·         structural deficits are easier targets to be aiming at for an economy in a downturn than ordinary deficits; 

·         as regards the meaning of ‘rapid convergence’, in Ireland’s case, the Commission has already set us an ‘excessive deficit procedure’ general government balance target of 2.9% by 2013. It seems unlikely to adopt a different approach in the context of structural deficits. (see p. 45 of  Ireland – Stability Programme Update (April 2012)). 

There is of course far more to be said about the law and the Fiscal Treaty, but not in a blog of this size. The IIEA were kind enough to invite me to contribute a few thoughts to their website on e.g., the implications of putting this material in the Constitution. Interested readers may want to visit that site which they will find linked here.

Is Ireland’s Fiscal Adjustment Failing?

Paul Krugman has an interesting column in Sunday’s New York Times; it is also appears in the Business section of today’s Irish Times.   There is much that I agree with in the article regarding the boarder European crisis resolution response.   But I think his comments on Ireland’s adjustment policies are off the mark.   Paul complains about Ireland being used as a misleading data point in the international debate.   I think Paul is himself guilty on this score. 

Here’s what he says about Ireland:

What’s wrong with the prescription of spending cuts as the remedy for Europe’s ills?

One answer is that the confidence fairy doesn’t exist – that is, claims that slashing government spending would somehow encourage consumers and businesses to spend more have been overwhelmingly refuted by the experience of the past two years. So spending cuts in a depressed economy just make the depression deeper. Moreover, there seems to be little if any gain in return for the pain.

Consider the case of Ireland, which has been a good soldier in this crisis, imposing ever-harsher austerity in an attempt to win back the favour of the bond markets. According to the prevailing orthodoxy, this should work. In fact, the will to believe is so strong that members of Europe’s policy elite keep proclaiming that Irish austerity has indeed worked; that the Irish economy has begun to recover.

But it hasn’t. And although you’d never know it from much of the press coverage, Irish borrowing costs remain much higher than those of Spain or Italy, let alone Germany.

A number of responses:

1.   As far as I can see, those involved in the design of Ireland’s adjustment programme do not believe in the “confidence fairy”.   It has been explicitly recognised that fiscal adjustment slows the economy.   The programme has been designed in order to balance the need put Ireland on a fiscal path consistent with debt sustainability and regaining the country’s creditworthiness, while securing needed official lender support, and minimising the adverse effects on the real economy through a official-lender supported phased adjustment approach.

2.  Ireland’s growth performance has been disappointing.   But the causes of the poor performance go well beyond the effects of fiscal austerity.   The weight of impaired balance sheets in a post-bubble and a weak international environment are also major drags on growth.   Of course, Paul is far too good an economist not to realise this.  

3.  It would be true that Ireland’s adjustment effort is failing if the fiscal measures were directly self defeating in terms of improving the underlying fiscal situation.   There are a number of relevant measures: Are the fiscal adjustments leading to an improvement in the underlying primary deficit?   Are these adjustments improving the underlying path of the debt to GDP ratio and putting Ireland on a path to debt to GDP ratio stabilisation?   And are these adjustments helping to restore Ireland’s creditworthiness? 

On the underlying primary deficit, the number has come down from 9.7 percent in 2009 to 6.0 percent in 2011, with a projected further fall to 4.2 percent in 2012. 

On the debt to GDP ratio, the calculation is more complex because we have to see how adjustments affect the path of the ratio.   For plausible multipliers, it is certainly possible that the debt to GDP ratio rises in the year of adjustment due to a strong adverse effect on the denominator.    For example, using an automatic stabiliser coefficient 0.4 – a key parameter in determining the possibility of self-defeating adjustment – simulations show the debt to GDP ratio would rise this year as a result of a (permanent) additional €1 billion of adjustment with a deficit multiplier of 1.  However, this ignores the positive effect on the future debt ratio of lowering the nominal primary deficit this year, which will lower the nominal debt and thus interest payments in the future.   Simulations show that the multiplier would have to be as large as 3.8 – completely implausible for a small open economy – for the debt to GDP ratio to be actually higher in 2015, all else equal. 

On creditworthiness, the impressive recent work of Delong and Summers introduces the possibly adverse effect of “hysteresis” on creditworthiness.   (The effect here refers to the fiscal shadow cast by lower output today due to persistent effects on output.)    This is harder to get an empirical handle on due to the difficultly in observing these effects.   However, notwithstanding the fact that Ireland’s bond yields are above those in the Germany or even Spain, the improvement in Ireland’s market creditworthiness has been dramatic since last summer as Ireland’s adjustment programme has gained credibility.   (The evolution of Ireland’s 2-year bond is shown here; the 9-year yield here.)  This has occurred despite increasing evidence of the damage done to the economy by the bubble, despite the euro zone crisis remaining in flux and despite the clamour to abandon the adjustment programme and default. 

The success of Ireland’s adjustment programme is too important for it to be used as misleading fodder in a debate over appropriate fiscal policies for creditworthy countries.

Nama giving away “free” insurance, thereby distorting both its published accounts and Irish property market prices

I have written about this before, twice, but now some more details have emerged and the Nama scheme has gone live.  Nama has announced that it will providing “free” insurance against price falls for selected properties, in order to help sell its Irish residential property portfolio.

From the information provided, it seems Nama will hide the insurance premium in the recorded property sales price, thereby simultaneously distorting Nama’s published accounts, CSO property sales price statistics, and the soon-to-be-released property price sales registry.

Wonkish paragraph: Hiding the insurance premium in this way also has a knock-on effect on the “moneyness” of the embedded option.  Since the actual sales price includes a hidden insurance premium, and the eventual valuation of the property (used to determine the insurance pay-out) does not include any insurance premium, the insurance scheme is immediately “in the red” as soon as the property is sold. Nama has to hope for price increases, not just the absence of decreases, in order to claw back the embedded insurance premium which is hidden in the distorted sales price. This knock-on effect can be quite substantial.

Fiscal Rules and Required Post-2015 Austerity Measures

Thanks to Jagdip Singh for pointing to Michael Taft’s response to an earlier post of mine on the implications of fiscal rules – including the structural balance rule – on the need for additional austerity post 2015.  

It is worth reiterating two critical points before responding to Michael’s critique.   First, the Fiscal Compact does not imply additional constraints beyond what we are already signed up to under the revised Stability and Growth Pact.   Ireland already has a medium-term budgetary objective of a structural balance of 0.5 percent of GDP.   I believe the No campaign is being disingenuous on this point.  Second, the main driver of austerity measures in Ireland is not the fiscal rules: it is that Ireland has a large deficit, substantial debt that needs to be rolled over in the coming years, and is not creditworthy.   The only reason Ireland does not have substantially greater front-loaded austerity is that we have been able to obtain official-funding support at low interest rates.   However, this support is conditional on pursuing a phased deficit-reduction programme. 

Michael’s main objection to my post relates to the definition of the structural balance.   He claims that the only way to reduce the structural balance is through additional discretionary measures.  However, what he does not note is that his assumed baseline of “no policy change” involves expenditure rising at a rate equal to the underlying nominal potential GDP of the economy.   Assuming total tax revenue rises at the same rate as potential GDP growth, expenditure rising at this rate would keep primary structural deficit constant as a share of potential GDP.   Using the European Commission’s coefficient of 0.4, in the absence of expenditure growth, the nominal structural deficit would fall by 0.4 times the change in nominal potential GDP due to the rise in tax revenues at constant tax rates as the economy expands.   In my calculation, I allowed for expenditure increases equal to half the projected rise in tax revenues, so that the nominal structural deficit falls by 0.2 times the increase in nominal potential GDP.   I think most people view austerity measures as involving higher tax rates (or new taxes) combined with cuts in expenditure.   What my calculation shows is the even with nominal expenditure rising (though at a slower rate than nominal potential GDP), the structural deficit target could be met by around 2019.   As Seamus Coffey emphasises, the annual rate of improvement would be approximately 0.7 percentage points of GDP per year, which is above the SGP’s requirement of 0.5 percentage points. 

In sum, if your definition of austerity involves government expenditure – public-sector pay rates, social welfare rates, etc. – growing at a rate less than nominal potential GDP, then you should agree with Michael that hitting the structural deficit target will involve additional austerity measures.   However, if your definition is what I see as the more natural one of additional cuts and tax rises, then, even with relatively conservative assumptions about growth, moving back to structural balance would not require additional austerity.

10th INFINITI Conference on International Finance

The site is live here, the programme looks excellent, and the guest speakers are world class. From the site:

2012 is a special year for us. It will be the 10th year of running the INFINITI Conference on International Finance, in conjunction this year with the Journal of Banking and Finance. Over the last ten years, we have been privileged to have had keynote speakers such as Ike Mathur, Raman Uppal, William L Megginson, Edward Kane, Andrei Shleifer, Robert Engle, Maureen O’Hara, and Elroy Dimson. We have also been fortunate to have been joined by many other leading academics, students and practitioners who have openly shared and discussed each others’ latest research.

Our keynote speakers for 2012 are Carmen Reinhart and Iftekhar Hasan.

We hope that you will be able to join us this year, and to that end are pleased to announce that the Call for Papers has been sent out and the online paper submission facility is now open. Please see the full call here.

We would also like to draw your attention to a call for papers for a special issue of RIBAF.

2012 will be a great year, and we hope to see you here at Trinity College Dublin for yet another fantastic INFINITI Conference on 11-12 June.

A DRAFT of the conference paper sessions is available at Note however that this is not finalised, and that it omits as yet the details of a number of special sessions on the future of the euro, financial regulation etc.

An Impossible Trinity?

There is an important debate taking place across the European economics blogosphere on the policy mix required to resolve the euro zone crisis.   Simon Wren-Lewis provides a good overview here, with many useful links.   The election outcomes in France and Greece will provide further impetus to this debate, though the likely direct results – e.g. a scaled-up European Investment Bank – are probably going to be of just marginal significance, even if they make good headlines. 

The core problem is the difficulty of reconciling there fundamental goals of key actors: saving the euro; avoiding a large-scale transfer union that would involve significant transfers from core to the periphery; and sticking with current definitions of euro zone price stability.   

The vulnerability of the euro has been demonstrated by the susceptibility to self-fulfilling runs on sovereigns (and banks) when they do not have their own central banks to act as lenders of last resort to the government in extremis. 

As a partial replacement, the euro zone has developed lender of last resort mechanisms (e.g. the ESM and the ECB’s bond-buying programme).   But these mechanisms entail risk of significant transfers from the strong to the weak within the euro zone.   The stronger countries have shown a (limited) willingness to run the risk of such transfers, but have required greater assurance that countries will pursue reasonably disciplined policies.  The Fiscal Compact must be seen in this light.  (See Jacob Funk Kirkegaard here.) 

Unfortunately, the massive growth challenge faced by the periphery casts grave doubt over whether this approach can work.  As noted in an earlier post, a higher euro zone inflation target could significantly ease the growth challenge.  But Germany in particular will be reluctant to allow this given their commitment to the overwhelming importance of price stability. 

In the post linked to above, Simon Wren-Lewis provides a possible mix of policies that he thinks could be acceptable and would make a significant difference: (i) the ECB accepts a symmetric inflation target around 2 percent; (ii) the need for inflation above 2 percent in stronger countries such as Germany is explicitly recognised; (iii) the ECB stands ready to cap individual-country bond yields, potentially giving easing the market constraint on their fiscal policies; and (iv) if monetary policy is not sufficient to achieve the 2 percent inflation target, the aggregate fiscal policy stance of the euro zone is used to ensure the target is met. 

On the last point, the message from Marco Buti and Lucio Pench in this Vox piece is important.   (Marco Buti has been an important intellectual force behind the development of the Stability and Growth Pact.)   They note that the EDP is sufficiently flexible to allow the aggregate fiscal stance in the euro zone to be taken into account.  

Concerning the response to shocks, it needs stressing that the Stability and Growth Pact explicitly allows for the playing of automatic stabilisers around the adjustment path, that is, the adjustment is formulated in structural terms. Acknowledging the problems inherent in the measurement of structural balances, the framework calls for an ‘in-depth analysis’ of the reasons behind a country’ s failure to meet the budgetary targets, including revisions in potential growth and endogenous changes in revenue elasticities. To these elements of flexibility, the recent reform has added the possibility of extending deadlines for the correction of the excessive deficits irrespective of a country’s individual predicament, if the situation of the Eurozone or the EU as a whole calls for a relaxation of fiscal policy.

Saving the euro, avoiding large-scale transfers and sticking with the current definition of price stability may be an “impossible trinity”.   The effort to find economically workable and politically saleable combinations of policies shows the European blogosphere at its best.