Author: John McHale

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.

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.

I hope Karl does not mind a link to his post back here on the mother ship.   Karl’s post does a very nice job explaining that the Treaty does not imply additional austerity beyond what Ireland is committed to under the revised Stability and Growth Pact.  This fact does not seem to be getting through.    

The basic conclusion (emphasis in original):

. . . Yes campaigners have failed to highlight that the treaty does not, in fact, imply additional austerity in the coming years relative to what would occur if there was a No vote, even if the EU did decide to fund Ireland via EFSF or some other vehicle. The fiscal parameters laid down in the treaty are all part of the existing EU fiscal framework that Ireland is already operating within and would continue to operate within after a No vote.

Many thanks to Seamus for providing an excellent analysis of the debt rule.   At the risk of overkill, I think it is useful to offer one further angle.  

One aspect of the debt (i.e. 1/20^th) rule that may not be fully appreciated it that it is – like the 3 percent deficit rule – a trigger for the Excessive Deficit Procedure (EDP).   In the past, the trigger for the EDP was a deficit greater than 3 percent of GDP.   With the revised Stability and Growth Pact, the EDP can be triggered either by an excessive deficit or an insufficient rate of reduction in the debt to GDP ratio.   This fact is important for reasons that link to the discussion about the uncertainty surrounding growth prospects across recent threads.  

To see this, it is useful to recast both the deficit and debt-reduction rules in a way that makes them more easily comparable.   (I will make some approximations to make the maths a bit more digestible, but they don’t change the basic message.)

The equation for the change in the debt to GDP ratio can be approximated by,

Δd = (i – g)d_-1 – ps,

where d is the debt to GDP ratio (in percent of GDP), i is the average nominal interest rate on outstanding debt, g is the nominal growth rate, d_-1 is last year’s debt to GDP ratio (in percent of GDP), ps is the primary surplus (in percent of GDP), and Δ represents the change in a variable (measured in percentage points of GDP). 

Noting that the overall deficit as a percent of GDP (denoted def) can be written as id_-1 – ps, we can rewrite the equation as

Δd = def – gd_-1.

The 3 percent deficit rule says that the deficit must be below 3 percent of GDP.   Using the last equation, we can rewrite the deficit rule as a debt reduction rule,

Δd < 3 – gd_-1.

Ignoring the averaging procedure that Seamus details in his post below to keep things simple, we can write the debt reduction rule as,

Δd < (1/20)(60 – d_-1) = 3 – 0.05d_-1.

Both rules take a surprisingly similar form.   Given the existence of deficit rule, the debt-reduction rule only binds on fiscal policy (in the sense of triggering an EDP) if the nominal growth rate is less the 5 percent per year.   (Note this is consistent with Seamus’s calculations given that the deficit is projected to fall below 3 pecent of GDP in 2015.)

(As an aside, some commentators have noted the superiority of debt-reduction rules over deficit rules.   I agree with this as a general principle.   But it is not necessarily the case when it comes to comparing the particular rules we have above.  The deficit rule has the advantage of being “growth contingent”: the implied required rate of debt reduction falls as the growth rate falls.   The debt-reduction rule is insensitive to the rate of economic growth.   I see the growth contingency as an attractive feature of the deficit rule.) 

While noting yet again that the debt rule is already in place under the revised SGP and so not new to the fiscal compact, critics of the rule have a point when they draw attention to possible drastic implications of the rule in a very low-growth scenario.  (In our previous posts, both Seamus and I took existing projections from the IMF and Government (SPU).  These projections are based on a return to reasonable growth rates.   But there is downside risk to these relatively benign growth scenarios.) 

This is where the fact that the debt-reduction rule is a trigger for the EDP becomes so important.   If the rule actually forced debt reductions according to the third equation above, the results could be catastrophic.    To take an extreme case, if nominal growth was zero percent and the debt to GDP ratio was 120 percent, then the rule would require that the debt to GDP ratio is lowered at the rate of 3 percentage points per year.  

This would be crazy in the context of zero growth; it would require a overall surplus of 3 percent of GDP and a primary surplus of about 9 percent of GDP.   But it is not what would happen.   If the rule is not met the country would enter the EDP.   Under the EDP, a deficit reduction path would be worked out that would balance the need to move towards compliance with the need to phase the adjustment over time.    The fact that what the debt-reduction rule does is trigger the EDP is a critical fact in understanding the implications of the rules.

Note: The post has been corrected for an error in the original version. 

I would usually include this as a comment on my previous post.  Philip has urged us to put more substantive comments as new posts on the grounds that many readers do not read the comments – I hope that is not true.  

Commenters have rightly pointed to the substantial uncertainty surrounding the growth projections in the SPU.   Kevin’s post also puts a question mark over near-term projections.   This uncertainty is a major theme of the IFAC’s recent Fiscal Assessment Report (available here).    Although it is benchmarked on the projections in Budget 2012 rather than recently released SPU, one of the things we do in the report is examine the budgetary implications out to 2015 of alternative nominal growth assumptions.    The Figures on page 34 provide a sensitivity analysis based on a relatively simple simulation model that allows for two-way causality between the deficit and the state of the economy.   Figure 3.3.c shows the implied additional discretionary adjustments that would be required to meet the EDP target of a deficit below 3 percent of GDP in 2015 based on alternative nominal growth assumptions. 

On the question of the need for a less contractionary fiscal stance for the euro zone as a whole that Kevin emphasises, Simon Wren-Lewis had a typically thoughtful piece a couple of weeks back on the constraints on fiscal policy within the monetary union (see here).   Unfortunately, I am sceptical that much will be forthcoming in this direction.   While I am under no illusions about the massive – some might say impossible – political challenge, I think the best route to ease the contractionary forces within the euro zone still remain with the ECB.   A credible commitment to a higher euro zone inflation target (say 4 percent) – or, even better, and price-level target based on underlying 4 percent inflation – offers a real opportunity.  

While there are downsides, this revised target could accomplish a number of things: (i) with a clear mandate to achieve this single target, it is compatible with a reasonable definition of price stability; (ii) it would allow for lower real interest rates, thereby boosting interest-sensitive spending; (iii) given inevitable nominal rigidities, it would allow for a more feasible route to real exchange rate depreciations in the periphery relative to the core; (iv) it should lead to a nominal depreciation of the euro, allowing further  trade-weighted real depreciation for the periphery; (v) it would help ease real debt burdens; and (vi) it would help ease the overall euro zone budget constraint through higher seigniorage revenues.  

I am probably more sympathetic than many readers to the concerns of stronger euro zone countries over the large contingent liabilities and moral hazard problems that come with substantially beefed up mutual fiscal support mechanisms.   But, while recognising the value that countries place on price stability, the extent of the euro-zone crisis means that a higher inflation target appears to score well on any reasonable cost-benefit analysis.   Some (sensible) radicalism is badly needed.