The FT also has an editorial here

LBS writes about contagion here

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.

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.

So

• 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.

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

This breakdown of the package price into its two components is important for getting the true sales price of the property-only component of the package, and for inferring the profit/loss (net of the cost of providing the insurance) that Nama incurs on each package sale. With reasonable assumptions I get that the insurance component is 7.5% of the package value and the property itself is 92.5%.

The required inputs (in order to use the Black-Scholes options pricing model) are the time to maturity (5 years), risk free rate of interest, implicit rental yield (equivalent cash value of residing in the property), and property price volatility. For convenience the package price is fixed at 100 and therefore the insurance floor price at 80, so that the results are in percentage of total value.

I used 4% per annum as the appropriate risk-free rate of interest. To calibrate the implicit rental yield I used a quote from Ronan Lyon’s blog on Irish property,

“Figures on rents are even harder to get than figures in household income and I’ve only been able to get numbers back to 1996. Nonetheless, over the period 1996-2002, the average yield was about three quarters of a percentage point above the average mortgage interest rate, which was 6%. By coincidence, 6% is the ballpark long-run rate of interest that I think will prevail in Ireland over the coming generation. Thus, we can use that 6.75% yield – and figures on rents up to this year – to calculate an alternative equilibrium house price from 1996 on.”

Hence I use an implicit rental yield of 4.75% which is three-quarters of a percentage point above the calibrated risk-free rate of 4% that I use.

The sample quarterly volatility of log-changes to the Permanent TSB house price index is 0.045153 which implies annualized volatility of .063855.  Index volatilities are lower than the volatilities of individual components of the index (single properties) and the Nama insurance option is written against the single-property-specific price.  Hence this volatility estimate is biased downward. On the other hand, the sample period includes a property bubble which might bias the volatility estimate upward.  Treating these two biases as roughly offsetting, I use .063855 as the annualized volatility of log property price changes. 

The excel spreadsheet performing these calculations can be downloaded from the following url:
http://dl.dropbox.com/u/36105182/namaoption.xlsx

European Stability Mechanism Bill 2012

Explanatory Memo - European Stability Mechanism Bill 2012

Publication of European Stability Mechanism Bill 2012

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 4^th 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 IrishEconomy.ie - 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 IrishEconomy.ie, 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.

• The Return of the Surprise in Central Banking
• The Experience of Financial Integration – Ireland, Britain and Europe

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.

 
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.

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.

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 https://www.openconf.org/infiniti2012/openconf.php. 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.

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.

Dublin is lobbying Paris against pushing for changes to the core treaty text or anything that could be considered “constitutional” in character and require a second Irish referendum for ratification.

Source: here.

“The stability and growth pact is not stupid,” Mr Rehn will say, according to a draft of his address seen by the FT. “Yes, the EU fiscal framework is rules-based … but at the same time, the pact entails considerable scope for judgement when it comes to its application.”

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.

By the way, an interesting summary of this blog’s readership is provided:

Compared with all internet users, Irisheconomy.ie appeals more to users who have postgraduate educations; its visitors also tend to consist of less affluent, childless men between the ages of 35 and 65 who browse from home.

The Irish Presidential Election 2011 Web Archive collection consists of  70 archived websites relating to the Presidential Election of 2011. Selected websites can be broken down as follows:

• The seven candidate websites
• Political Party websites
• Official Government websites
• Informal and formal policital commentary websites
• News media websites

A one off snapshort of 70 websites was taken in the two weeks prior to the election date of 27th Oct 2011, with a further 10 sites (such as that of the newly elected president)  being archived after the election as well.

I thought I might dig into this a little. The chart below shows monthly data from 2007 on industrial production for the ‘modern’ sectors of chemicals, pharmaceuticals, recording media, and medical devices, and individually the key exporting pharmaceutical and chemical sectors. Seasonally adjusted and indexed to 2005, then, we have the following:

Which shows that, for these key sectors on a seasonally adjusted basis there has been a marked drop since the end of last year. Before we all go shorting Ireland just yet though, to put these figures in a bit more context, here’s the same series averaged annually, with the last period averaged quarterly for 2012.

There’s still a decline, but it’s not quite the patent cliff Frank Barry has been highlighting recently. Definitely a series to watch however. Here’s the turnover statistics for the two chemical sectors, they don’t produce one for the modern sector:

We can clearly see more of a drop , but it’s a bit too soon to tell where this series is headed. Again, one to watch.

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.