Treaty and future of eurozone

I wrote the following background piece in response to a request last week.  It’s similar to John’s Compact Logic.  My respondent wrote back:  “So a Yes will facilitate EU growth policies, the exact opposite of the No position?”. I was also asked about the consequences of a Greek exit:

Adopting the euro as our currency was supposed to give us much greater stability than the fixed exchange rate regimes that preceded it.  But if Greece leaves the euro, financial markets will no longer accept at face value a statement by a struggling country such as Ireland that it intends to remain within the single currency.  We are likely to see a repeat of the Irish currency crisis of the early 1990s when markets lost their faith in the fixed exchange rate arrangement of the time and Irish short-term interest rates quadrupled over the space of a few months.

Ironically, the currency turmoil of that time was triggered by the outcome of a European treaty referendum but, for once, not one of ours.  Everything had been proceeding smoothly towards the eventual introduction of the euro.  Financial markets believed that Central Banks would intervene to any extent necessary to defend existing exchange rates and a speculative attack on a currency could not possibly be successful.  All changed when Denmark voted no to the euro in June 1992.  It was possible that France would do likewise in September. Suddenly the single currency was no longer inevitable.  Sterling succumbed to  speculative attack and devalued, and attention shifted to Ireland.  Over a billion pounds flowed out of Irish financial markets over the course of a few days and short term interest rates soared to almost 60 percent.

The Irish government tried to hold off the speculators.  Currency control were reintroduced.  The Central Bank raised its lending to the money markets more than twenty-fold to prevent mortgage and commercial interest rates rising by more than 4 to 5 percent.  But this could not be sustained over the longer term as all the country’s foreign exchange reserves would be lost.  Ireland succumbed to devaluation in January 1993.

The same turmoil, with a run on the banks and a massive risk premium on foreign lending to Ireland, would undoubtedly follow a Greek departure from the euro.  The difference in the present case is that where then we had only our own Central Bank, we now have the European Central Bank with its vastly greater firepower.

The fact that numerous other countries would be calling on the firepower of the ECB at the same time, and possibly indefinitely into the future, is why the eurozone powers seem lately to have drawn back from the precipice of countenancing a Greek exit.

The ECB has recently shown itself ready to provide enough liquidity to stave off catastrophe.   At the behest of the Americans, the IMF and now the French, the German government now seems to agree that austerity alone on the fiscal side will fail, just as it did in the Great Depression of the 1930s. But can the Germans be expected to run deficits to stimulate the European economy, or countenance eurobonds – which would put their own credit rating at risk –  before the rest of the eurozone has promised to limit its borrowing?  As a German politician said this week, “you don’t lend your credit card to someone who doesn’t know how to control their spending”.

Compact Logic

After wavering for some time, Deputy Shane Ross has now publicly taken a No position on the Treaty. (See Sunday Independent article here.)   His position is that he is withholding judgement until he sees later growth-focused elements, and takes it that there would be another opportunity to vote on the complete package later. 

While this is a coherent position, I think it is worthwhile to stand back and recall the genesis of the fiscal compact.   The euro zone crisis was spinning out of control late last year, with runs on the sovereign bonds of Italy and Spain.  (The crisis has flared up again recently with the renewed uncertainties in Greece.)   It became ever clearer that the euro zone might not survive unless stronger mutual insurance mechanisms were developed.   Understandably enough, the euro zone countries most at risk of having to make positive net transfers under such mechanisms wanted some degree of assurance that all euro zone countries would follow reasonably disciplined policies, both to limit the expected value of the contingent liability and to minimise inevitable moral hazard.   Politicians in stronger countries also needed a degree of political cover in order to convince their electorates to take on large risks.  

For the most part, it was evident that stronger commitments to mutual discipline would have to lead that strengthening of the mutual insurance mechanisms, but the logic was clear.   In the event, the actual fiscal compact did not go much beyond what countries had already signed up to under the revised Stability and Growth Pact, but it did attempt to strengthen domestic ownership by introducing domestic enforcement mechanisms for the already existing structural balance rule.   Recent events in Spain have brought the possibility of more centralised bank resolution, deposit insurance and supervision onto the agenda as part of this process. 

An often heard complaint in the debate that the commitment to develop these mutual insurance (and related growth) measures are too vague – hence Deputy Ross’s position.    But it is interesting that where the linkage is made explicit – i.e. access to a scaled up ESM – it is considered a “blackmail” clause.  

Not surprisingly, the Treaty debate has ranged widely – the impacts of austerity measures, the implications for post-2015 fiscal adjustment of the existing SGP rules, the nature of additional commitments made under the Treaty, access to alternative sources funding if the Treaty is rejected, etc.   An unintended positive spinoff is that voters are now much better informed on fiscal issues – even if sick to the teeth from hearing about them.   But in the few days remaining before the vote, and with the euro zone again in turmoil, it is important to bring focus back to the core purpose of the compact. 

DeLong and Summers and Self-Financing Fiscal Expansion (very wonkish)

Advance warning: This post will only be of interest to those who have read the DeLong and Summers paper.

As has been referenced on this blog a number of times, the recent paper by Brad DeLong and Larry Summers has had a significant impact on the debate over optimal fiscal adjustment in a depressed economy.    Although the authors themselves note that the balance of arguments may be quite different in a non-creditworthy economy, the paper is still important to our debate (see also here and here).   

The key innovation in the paper is to incorporate the fiscal implications of potential “hysteresis effects.”  Put simply, these effects refer to long-lasting effects on future output – and thus on the future fiscal position – of fiscal adjustment measures today that reduce today’s output.   For example, the loss of a job due to weaker growth this year could have long-lasting fiscal implications if it makes it harder for the person losing their job to gain employment in the future. 

A striking conclusion in the paper is that, under what appear to be a relatively undemanding set of conditions, an expansion of government spending (or alternatively not engaging in some planned expenditure cut) could be self-financing from a long-term fiscal perspective.    Put another way, fiscal expansion could bring about improvement rather than disimprovement in a country’s underlying creditworthiness.  Thus, fiscal adjustment could be self-defeating from a creditworthiness perspective.   Given the influence of their argument, it is important to look closely at the assumptions that underlie this result. 

Continue reading “DeLong and Summers and Self-Financing Fiscal Expansion (very wonkish)”

What is not in the Fiscal Compact?

At 1,395 words, Title III of the Treaty on Stability, Coordination and Governance is a very short document by official standards.  The Fiscal Compact contains just six articles and 11 paragraphs.  Understanding what is in the Fiscal Compact should not be difficult but there continues to be significant misrepresentations of the what the provisions actually mean.

As a response to the causes and consequences of the current crisis the Fiscal Compact is wholly inadequate.   From an Irish perspective it is true that “had the the Fiscal Compact been in place since 1999 it could not and would not have prevented the crisis in Ireland”.  It is possible that, in the run-up to the crisis, a greater adherence to the rules across Europe would have created some additional fiscal space to deal with the downturn but this leniency did not cause the crisis.

As regards the ongoing policy response to the crisis, the Fiscal Compact will make little difference.  At present 23 out of the EU27 (and 13 of the EZ17) are in the Excessive Deficit Procedure so even if the Fiscal Compact is torn up it would not lead to a significant change in policy.

However, when assessing whether the crisis could have been prevented it is important to realise that the Fiscal Compact only covers some aspects of the EU framework on economic policy. For example, the Compact does not mention the 3% of GDP overall deficit limit that was introduced in the Protocol on the EDP in the Maastricht Treaty.

The Compact also excludes some elements of the ‘Six Pack’ introduced last year.  From an Irish perspective, two additions worth considering are:

Continue reading “What is not in the Fiscal Compact?”

Mortgage Arrears Crisis deepens

To the surprise of exactly no-one the residential mortgage arrears problem has continued to worsen. The Central Bank’s Q1:2012 figures show that 116,288 accounts were either in arrears of over 90 days or had been restructured in some shape or fashion.

10.2% of private residential mortgage accounts were in arrears.

There are others, but right now two important (and updated) questions arise:

  1. at what point will this growth in arrears begin to slow appreciably? As Jagdip and Carson in the comments point out, the rate has fallen off but clearly arrears levels are increasing at an alarming rate.
  2. what projected effect will the proposed personal insolvency legislation have on these arrears going (ahem) forward?