Wolfgang Münchau asks whether the only way to save the eurozone is to destroy the EU here.
My guess is that if Europeans had to choose between the EU and the euro, most would opt for the former.
Today’s Euro summit document commits all members to a fiscal rule in which “the annual structural deficit does not exceed 0.5% of nominal GDP.” It also commits to “The specification of the debt criterion in terms of a numerical benchmark for debt reduction (1/20 rule) for Member States with a government debt in excess of 60%.”
I’m on the record as being in favour of numerical benchmarks for debt reduction. Indeed, I argued for a more stringent one than the one-twentieth rule that has been proposed by the Commission and has been adopted today.
However, I wonder whether those proposing the limit of 0.5% of nominal GDP on the structural deficit have thought about what this implies for debt ratios. I take this proposal to mean that the average deficit, going through the cycle, should not be more than 0.5% of GDP.
Now suppose a country consistently ran a deficit of exactly 0.5% of GDP. What would happen to its debt-GDP ratio?
Here’s a little note describing the dynamics of the debt-GDP ratio in a simple world with a constant deficit ratio, d, and a constant growth rate of nominal GDP, g. It shows that the debt to GDP ratio converges over time to (1+g)*d/g. (One could add random fluctuations in the growth rate or the deficit ratio and then the debt ratio would cycle around this long-run average value. Also, the timing assumption could be changed so that the current-period debt is determined by last period’s deficit, in which case the (1+g) would dissappear, but that wouldn’t make much difference to the calculation.)
Let’s assume a modest long-term growth outlook for the Euro area of 3 percent nominal GDP growth, i.e. 2 percent inflation and 1 percent growth in real GDP. In this case, the long-run implication of a 0.5 percent of GDP deficit ratio is a debt-GDP ratio of 1.03*0.005/0.03 = 0.172.
Since 0.5 percent of GDP is to be a maximum for the average deficit, this is a fiscal rule that would see long-run debt-GDP ratios below 17 percent of GDP in all Eurozone member states.
This is, of course, a long way from where we are now in most member states. Many countries currently have excessive debt ratios and there is a need to get debt and deficit ratios down over the medium term. It would take a very long time for countries like Ireland to end up with this very low debt ratio, so these limits may work fine as a medium term rule for high debt countries.
However, taken on its own merits, this rule doesn’t seem to make much sense as a long-run legally binding rule. As an alternative, an average deficit of 1.5 percent of GDP could combine with a nominal growth rate of 3 percent to produce a stable and manageable average debt-GDP ratio of 51.5 percent. This would seem like a more sensible benchmark.
Of course, if a government followed such a policy, normal cyclical fluctuations would likely take the economy above a 3 percent deficit fairly often without in any way jeopardising long-run fiscal stability. So the elevation of a three percent deficit limit to sacred cow status (“As soon as a Member State is recognised to be in breach of the 3% ceiling by the Commission, there will be automatic consequences unless a qualified majority of euro area Member States is opposed”) has little grounding in the actual economics of fiscal stability.
There is little doubt that Europe needs to act to reduce debt levels over the medium term and better institutional fiscal frameworks are required. However, these rules, however much they may appeal to the Swabian housewife instinct, are overly restrictive and have little connection to fiscal arithmetic. They are all the more likely to be flouted in future because of their poor design.
Here‘s the statement by the Euro Area Heads of State.
In honor of the summit, I thought I’d post a link to Colm’s last piece in the Sunday Independent, which hasn’t yet had a thread of its own.
Summiteers, please remember: just because a particular “solution” seems politically necessary, that doesn’t mean that it makes any economic sense at all. If you really want to save the euro (as opposed to enabling it to hobble along for a few more weeks, months or years), then shouldn’t reforming the mandate of the ECB be at the top of your agenda?
And do please think about what constitutionalizing the equation
“Europe = austerity + unemployment”
will mean politically for the European project going forward.
I have told myself to stay out of the Target 2 debate, partly because this pretty much sums it up and I’ll just end up repeating myself and partly because the brave Olaf Storbeck has taken this on himself so many times.
However, this article by Tornell and Westermann is worth bringing up because the appearance of two people who are not Hans Werner Sinn making Sinn-like claims might suggest there is a point here. In fact, this piece has even less to add (and more to subtract, if believed) to the stock of useful knowledge than Sinn’s various pieces. (Unfortunately, its points were repeated on the usually-excellent FT Alphaville.)
Tornell-Westermann (TW) repeat the fallacy that the Bundesbank has loaned money to the so-called GIPS central banks. Their new twist on this story is that “In order to fund these loans, the Bundesbank sold its holdings of German assets.”
They back this up with a table showing information from the Bundesbank balance sheet. A line labelled “Private securities owned by central bank” shows a large decline in recent years.
What does this line correspond to? Well, TW’s line for “Private securities owned by central bank” equals €224 billion in 2009 and €277 billion in 2008.
Let’s go consult the Bundesbank’s own description of its balance sheet for these years (page 148 of this file). It tells us that “Lending to euro-area credit institutions related to monetary policy operations denominated in euro” equalled €223.61 billion in 2009 and €277.425 billion in 2008. I’m going to guess that the resemblance between these figures and those reported by TW is not coincidental and that TW’s figures correspond to the same entries.
Is “Private securities owned by central bank” – as best I can see a terminology invented by TW – a more accurate description than the terminology used by the Bundesbank, which effectively means “loans”?
Well, no. These entries correspond to loans. They are securitised loans, specifically repurchase agreements, so the Bundesbank holds a security as collateral for the (usually short) maturity period of this loan. But the value of the loans are less the value of the corresponding securities (i.e. a haircut is applied to the collateral) so the asset on the Bundesbank’s balance sheet is the value of the loan, not the value of the asset. Also, the asset remains on the balance sheet of the borrowing bank because the bank regains the asset on repayment of the loan and thus the transaction does not correspond to the accounting requirements for “derecognition” of assets.
So, this item – lending by the Bundesbank to German banks – has declined in recent years, from €277.425 billion in 2008 to €37.6 billion in August 2011 (the latest figures I could find – page 111). The reasons for this are not too surprising. There has been enormous capital flight from the periphery into German banks which, as a consequence, have had far less need than previously to borrow funds from the Bundesbank for liquidity purposes.
Note also that Eurosystem policy in recent years has been to supply banks with a full allotment of funds requested in refinancing operations, so the Bundesbank has not made any conscious decision to reduce the amount of lending it has done.
If “the Bundesbank has done less lending because German banks have asked for a smaller amount of loans” sounds different from “the Bundesbank has had to sell off securities to fund loans to peripheral central banks” that’s because it is. The first statement is true and the second isn’t.
The rest of Tornell and Westermann’s article is not much better.
· The presentation of the Bundesbank’s “Other claims within the Eurosystem (net)” (i.e. the Target 2 credit) as some kind of enforced loan to the rest of the system rather than the accounting entry that reflects a transfer from the rest of the system to Germany mirrors Professor Sinn’s ability to make something that is good for Germany appear to be Germans getting ripped off.
· The idea that the Bundesbank is about to “run out of money” – “the Bundesbank will soon exhaust the stock of securities that it can sell to fund further loans to the Eurosystem” – is completely without basis in reality. Still, the stuff about the Bundesbank’s gold holdings and the German public not wanting to sell it will appeal to paranoid goldbugs everywhere.
· The material about Target claims being collateralised by, for example, Greek bonds sounds scary but, in reality, is just false.
· The less said about TARGET being “overwhelmed” because “the ECB has a relatively small capital base” the better.
The crazy thing is that the Euro area is undergoing a real crisis and there is a huge need for an informed public debate on potential solutions. We don’t need academics making up fake crises and stirring intra-European resentments based on a misunderstanding of central bank arcania.