The European Commission and European Council have blinked.1 Reprimanding France and Italy for their transgressions of the fiscal rules was too risky. With face-saving measures, France and Italy will now break the eurozone’s prized fiscal rules.2 While unseemly in the eurozone context, this is a good economic outcome. Forcing deeper austerity upon fragile economies is destructive. […]









The European Commission and European Council have blinked.1 Reprimanding France and Italy for their transgressions of the fiscal rules was too risky. With face-saving measures, France and Italy will now break the eurozone’s prized fiscal rules.2

While unseemly in the eurozone context, this is a good economic outcome. Forcing deeper austerity upon fragile economies is destructive. Yes, sure, the French and the Italians could have better managed the balance between taxes and spending. But fine-tuning those through a collective process is absurd.

Despite the small victory for economic good sense, it is too early to cheer. Indeed, the eventual agreement with France and Italy may well entail excessive austerity: we have no good way of knowing because the discussion has been focused on numerical targets rather than on economic considerations. Regrettably, the economic mythology of austerity lives on.

When Hans-Werner Sinn asserts that the reduced austerity is a license to run up fresh debts, he speaks for many who insistently disregard the empirical evidence. The evidence is overwhelmingly clear. Single-minded austerity caused growth to stall; as a consequence, the debt/GDP ratios increased rapidly, leading to the onset of a cycle of rising debt and deflation in the most distressed member states (Mazzolini and Mody, 2014). But no matter, the instinct remains that the rules must be respected.

The reason to be cautiously optimistic is that the French and Italian revolt may encourage new challenges from other countries. Such a momentum would politically discredit the rules, leaving them to atrophy. True, such optimism is premature. Germany and France did flout the rules in 2003, undermining their credibility. But instead of withering away, the rules reasserted their grip at precisely the wrong moment, when—amidst the crisis—the distressed economies needed the oxygen of fiscal stimulus.

German interests were central to the reassertion of the fiscal rules. Germany relishes its role as Europe’s hegemon but has no appetite to pay for that privilege. So the crisis forced to the surface the central dilemma in the construction of the eurozone:

The Commission and the Council have blinked. Reprimanding France and Italy was too risky

Germany is unwilling to pay for the “mistakes of others.”

But the option of restructuring sovereign debt has been ruled out.

Hence, everyone is agreed on the need for more austerity, even though unending austerity makes the debt repayment burden greater, not less.

To be clear: Germany’s unwillingness to pay was part of the contract at Maastricht in 1992 and remains so in the Lisbon Treaty. Those who now fret that Germany should do more must not forget that they signed on to the deal with open eyes; presumably the hope was that Germany would see good sense when it became necessary. But that hope did not incorporate the views of the German taxpayer or the ability of a new generation of German leaders to persuade the German taxpayer. With the passage of time, the German taxpayer is less likely to be compliant.

Germany relishes its role as Europe’s hegemon but has no appetite to pay for that privilege

For this reason, the resolute German opposition to such concepts as Eurobonds should not be a surprise to anyone. Indeed, if the European Stability Mechanism (ESM) had to be considered now—knowing that official loans to Greece will be largely forgiven—it is possible that the German authorities would be less forthcoming in their support and, more seriously, the European Court of Justice (ECJ) would find it illegal under the Lisbon Treaty. The ECJ judgment requires that the loans be paid back, otherwise they violate Article 125, the so-called no bailout clause.

1 Eurointelligence Professional Edition, October 23, 2014.

2 Analysts have described the changes in response to the Commission’s demand as “cosmetic.”

Article 125 did imply— and even encourage—the idea that private creditors would bear the costs of imprudent lending to eurozone sovereigns. But as soon as the crisis began, this option was ruled out on the grounds that the ensuing mayhem would have catastrophic costs. This folklore has persisted despite the historical evidence that, notwithstanding the temporary hiccups, the cleansing effect of debt restructuring benefits both debtors and creditors (Mody, 2013a). The damage inflicted by denying this evidence was manifest when Greek debt was eventually restructured. Sovereign debt attorney Lee Buchheit remarked: “I find it hard to imagine they will now man up to the proposition that they delayed – at appalling cost to Greece, its creditors and its official sector sponsors – an essential debt restructuring …”

Thus, the response to the crisis was a patchwork of financial safety nets (which arguably contravene the Treaty), the presumption of no debt restructuring (which the Treaty encourages), and an extraordinary political compromise on counter-productive austerity rules.

This outcome was extraordinary because the economics and politics of the eurozone’s fiscal rules were always known to be flawed and potentially corrosive

This outcome was extraordinary because the economics and politics of the eurozone’s fiscal rules were always known to be flawed and potentially corrosive.

As Eichengreen (2003) bluntly pointed out, there never was an economic basis for the fiscal rules. Jean Tirole, the most recent recipient of the Economics Nobel Prize, wrote a similarly scathing critique in 2012.

There is limited contemporary commentary on the political evolution of the rules. Of German origin, they were defined by the Delors Committee’s Report in 1989 and reaffirmed in the deliberations leading to the Maastricht Treaty in 1992. Interestingly, however, Charles Grant, Delors’ biographer, recounts that Delors himself was unhappy with the rules. In the months before Maastricht (Grant, 1994, pp. 183-184):

“The Germans continued to argue for sanctions against countries with ‘excessive deficits.’ Only the strange alliance of Delors and [Norman] Lamont [the British Finance Minister] argued against centralization of fiscal policy. Delors claimed that EC sanctions would breach subsidiarity and be unnecessary. …Lamont argued that markets would discipline profligate governments by demanding higher rates of interest.”

The fiscal rules persisted along with the equally stupid idea—one that has never been invoked—that countries in economic distress need to be helped along with sanctions

But that fight went nowhere. In October 1991, two months before the summit at Maastricht to sign the Treaty, Delors and Lamont “conceded defeat.” Delors had come so close to the monetary union that he had so desperately wanted; he was willing to make an essential compromise.

From then on, the history is well known. Romano Prodi, as president of the European Commission, pronounced the rules (recast in 1997 as the Stability and Growth Pact) to be “stupid.” But they persisted along with the equally stupid idea—one that has never been invoked—that countries in economic distress need to be helped along with sanctions.

Hence, after the onset of the crisis, the search for a more “scientific” approach offered a ray of hope. The intention was to downplay the requirement that budget deficits could not exceed 3 percent of GDP and target instead the “structural deficit.”3 The structural deficit is more apt because it sees through to the more permanent underlying deficit by filtering out the deficit due to the temporary decline in revenues and increase in social support during a recession.

3 In an important sense, the 3 percent rule has never gone. The so-called excessive deficit procedure (EDP) continues to specify a date by which the 3 percent needs to be reached. So, while there may be agreement on and adherence to a structural adjustment path (with automatic stabilizers allowed to operate), if the country under scrutiny does not observe the EDP date for the 3 percent target, there is a problem.

But this “scientific” approach was always fraught with difficulty. The simple truth is that measuring the depth of a recession—and isolating it from a more durable decline in an economy’s potential output—is an art, not a science. Plausible approaches come up with completely different estimates. For example, Robert Gordon of Northwestern University has proposed “a surprisingly simple” new method of estimating potential output, which leads him to conclude that the estimates of the Congressional Budget Office are “too optimistic.” For this reason, I wrote a year ago (Mody, 2013b, p. 18):

“[…] the shift from the SGP’s three percent of GDP budget deficit target to the ‘structurally’-balanced budget deficit is technically appropriate. But that requires assessment of a country’s potential output, a nebulous concept especially during periods of economic stress. The risks are high that the assessment to be conducted by a committee of member-country representatives will be politicised. The actions that follow from the assessment also remain subject to discretion.”

Since then, things have played out much as predicted. The various groups and committees set up to assess a country’s fiscal position have taken the traditional refuge in process, while the real debate has occurred in the political arena. Hence, Italian Prime Minister Mateo Renzi’s call for greater flexibility in the application of rules met with the anticipated retort from the German Chancellor Angela Merkel. She told the German Bundestag that the rules permitted sufficient flexibility: “The German government agrees that the Stability and Growth Pact offers excellent conditions for that, with clear guard rails and limits on the one hand and a lot of instruments allowing flexibility on the other.” To good effect, she added, “We must use both just as they have been used in the past.” In other words, she said, “What exactly is the problem?” Even ECB President Draghi, whose speeches have been viewed as calling for more fiscal stimulus, has been cautious:

“[…] we are operating within a set of fiscal rules – the Stability and Growth Pact – which acts as an anchor for confidence and that would be self-defeating to break.”

The call for exempting “investment” from the fiscal rules has resurfaced. That once again makes economic sense, but it is easy to see why the idea goes nowhere

Predictably also, the call for exempting “investment” from the fiscal rules has resurfaced. That once again makes economic sense, but it is easy to see why the idea goes nowhere. Over a decade ago, one commentator noted that investment is a “wonderfully elastic concept” (Righter, 2002). Even serious scholars, however, have been seduced by the possibility. Blanchard and Giavazzi (2004) offered a proposal for encouraging investment within the SGP framework but note, without irony (p. 9): “Such rules would need to deal with the incentive to re-deﬁne current spending as public investment, and this may not be easy.”

These observations are not an argument against “flexibility” in rules or greater incentives for investment. They are argument for the political improbability of centrally applying rules to a collection of sovereign nations with widely differing economic capabilities and trajectories. Inevitably, exceptions will be needed, but they will create a sense (often incorrectly) that some nations are cheating and free-riding. The political debate will continue to be poisoned.

For this reason, the hope that France and Italy are in the vanguard of rendering these rules obsolete should be a matter of cheer. Delors was right: centralization of fiscal rules makes neither economic nor political sense. Persisting with centralized fiscal rules despite their evident costs—because all other options have been ruled out—is a grievous error.

Once centralized surveillance and enforcement of fiscal rules is consigned to the dustbin of history, there is only one way ahead: more-orderly recourse to debt restructuring combined with the forceful exercise of ECB powers to prevent financial contagion (see Mody, 2013b). Although applying this principle to the problems inherited from this crisis will require considerable improvisation, it is the only logically-consistent and politically feasible system for the future. All other approaches will continue to run into political and economic cul-de-sacs.

4 The current Bundesbank President, Jens Weidmann has recently reiterated this proposal.

Central to the new architecture must be system of more automated debt-restructuring. The idea was first proposed in 2011 by then Bundesbank President Axel Weber and his colleagues. Whenever a country applied to the European Stability Mechanism for financial assistance, private creditors would be required to automatically extend the maturities of all bonds issued by that country.4 This, in principle, is the right idea because it removes the discretion in sovereign debt restructuring. That discretion is always used to postpone needed restructuring because, despite all evidence to the contrary, the fear of wild contagion is invoked. Although an important step in the right direction, the trigger for maturity extension proposed by Weber et al. is not the right one. Since an ESM program is intended to kick in as “a last resort” (when the eurozone’s financial stability is threatened), the distress by then would be acute; and because the timing of the program remains uncertain, the trigger would be difficult to price. Hence, I recently outlined a proposal for automated restructuring using risk spreads as triggers.

Being wedded to an ingrained way of doing business, Berlin, Brussels, and Frankfurt may prefer to find accommodation with Paris, Rome, and others that come after them

The symbiosis between automated debt restructuring and ECB’s lender-of-last resort functions is clear: with the burden of insolvent sovereigns on the ECB eliminated, the concerns of the German Court will be reduced (Mody, 2014). And a politically legitimate and transparent commitment to an ECB safety net should then be possible.

Those who are persuaded by this agenda—which entails discarding fiscal policy centralization, making debt restructuring integral to the policy framework, and creating a politically legitimate financial safety net—may yet argue that the task is too hard to achieve. Being wedded to an ingrained way of doing business, Berlin, Brussels, and Frankfurt may prefer to find accommodation with Paris, Rome, and others that come after them. A new normal in the rules may allow some modest, hard-fought exceptions. That will be an unfortunate response. A continued reliance on centralized fiscal policy will be like searching for lost car keys under the lamppost because it is easiest to look where the light is.

Without implicating them, I am grateful to Ajai Chopra and Guntram Wolff for their comments and suggestions.

References

Blanchard, Olivier J. and Francesco Giavazzi, 2004, “Improving the SGP through a proper accounting of public investment,” CPER Discussion Paper No. 4220.

Eichengreen, Barry, 2003, “What to do with the Stability Pact?” Intereconomics 38(1): 7-10.

Gordon, Robert J. 2014, “A New Method of Estimating Potential Real GDP Growth: Implications for the Labor Market and the Debt/GDP Ratio,” NBER Working Paper No. 20423, August.

Grant, Charles, 1994, “Delors: Inside the House that Jacques Built,” London: Nicholas Brealey Publishing.

Mazzolini, Giulio and Ashoka Mody, 2014, “Austerity Tales: Netherlands and Italy”

Mody, Ashoka, 2013a, “Sovereign Debt and its Restructuring Framework in the Eurozone”

Mody, Ashoka, 2013b , “A Schuman Compact for the Euro Area”

Mody, Ashoka, 2014, “Did the German Court Do Europe a Favour?”

Righter, Rosemary, 2002, “Romano was right, but it is the currency, stupid,” The Times (London), October 24, p. 24.

Tirole, Jean, 2012, “The euro crisis: some reflexions on institutional reform,” Banque de France,” Financial Stability Review, 16 (April).

Weber, Axel A., Jens Ulbrich, Karsten Wendorff, 2011, “Safeguarding financial market stability, strengthening investor responsibility, protecting taxpayers: a proposal to reinforce the European Stability Mechanism through supplementary bond issuance terms.” Published in Frankfurter Allgemeine Zeitung, 3 March 2011.