A comment on the European Commission’s Box 1.5
This post was written by John McHale
The Commission has provided a useful contribution to the size of fiscal multiplier debate. The disagreements between different analyses are not really surprising given the limited number of observations everyone has to work with. A particularly useful addition is the addition of controls for sovereign default premia. The literature on sovereign default has emphasized the output costs associated with default (see here), even if the channels of causality are murky. This is likely to lead to a significant “fear of default” effect on growth, underling the importance of lowering default risk in the broad crisis-resolution effort.
But in one important respect the Commission lets itself off the hook too easily. Rightly recognising the importance of lowering sovereign bond yields (and with it the perceived probability of a default on private bond holders), it emphasises the importance of lowering debt to GDP ratios.
When discussing the negative short-term output costs of consolidation it is important not to lose sight of what the counterfactual would be. For the most vulnerable countries, exposure to financial market pressures means there is no alternative than to pursue consolidation measures. The alternative of rising risk premia and higher borrowing costs would be worse for these countries, and consolidations are needed to restore fiscal positions and put debt projections back on a sustainable path.
However, for countries without their own central bank to act as lender of last resort (LOLR) in extremis, and with high debt/deficit levels and weak/uncertain growth prospects, creditworthiness will be fragile for the foreseeable future. Central to creditworthiness will be design of euro zone LOLR arrangements. Modest reductions in official debt will not change this underlying fact – though would certainly help. I think Ireland stands a reasonable chance of avoiding a formal second bailout programme. But we should not forget that if it does avoid such a programme, it will be significantly because of the available of a quality LOLR backup, possibly through the OMT programme.
The fiscal adjustment conditions underlying this back up should be: (i) reasonable (i.e. do not push the capacity of a government to deliver fiscal adjustment beyond breaking point; (ii) reliable (i.e. investors should be confident that the support will be there without a forced private-sector default); (iii) flexible (i.e. the conditions should not be designed so that the country is forced to pursue ever larger fiscal adjustments if growth disappoints; and (iv) the link between bank losses and sovereign debt should be broken (taking away a lingering source of uncertainty about the country’s true fiscal position.
The Commission clearly believes that it is critical for credibility that governments meet the nominal budget deficit to GDP targets set down in their programmes. But what it is really important is that it is credible that the government will meet its conditions – which could be made growth contingent.
It has to be recognised that such arrangements do require that the stronger euro zone countries take on substantial risk. We have to accept that the quid pro quo for this will be stronger collective rules and surveillance. It is a two-way process.
For the Irish case, there is a common interest in supporting a “well-performing adjustment programme” to demonstrate that this approach can work. Part of this could be relieving the burden of official debt, with a restructuring of the PN/ELA arrangements holding the most promise. But the design of ongoing LOLR arrangements is also critical. The good thing about a mutual advantage argument is that it does not depend on allocating blame for past “sins”. There is plenty of blame to go around. But as Derek Scally argues today, arguments based on blame are unlikely to get us very far.