Thursday, March 15, 2012

Evening Echo 15/03/12

Here is the text I submitted for an article that was published in tonight’s Evening Echo.

Voting ‘no’ to Treaty will not stop this austerity

After a few weeks of uncertainty we now know that there will be a referendum on the EU’s Fiscal Stability Treaty.  We still don’t know what the proposed change to the Constitution actually is but we do know what the referendum isn’t.  It is not a vote on the rules in the ‘Fiscal Compact’ element of the Treaty. 

Ireland has already signed up to these rules, and some more besides, as part of the revised Stability and Growth Pact agreed last year.  The ‘balanced-budget rule’ in the Fiscal Compact has actually being part of the fiscal rulebook since 2005.

The main addition is that the Treaty requires the rules in it, including an automatic correction mechanism of excessive deficits, to be introduced in national law “through binding, permanent and preferably constitutional provisions”. 

The Maastricht Treaty of the early 1990s laid out the criteria for fiscal convergence in the common currency area.  These were that countries could not run an annual deficit of more than 3% of GDP and could not have a government debt of greater than 60% of GDP.  In theory, these rules may seem sensible but in practice they were anything but.

Conventional economic wisdom is that governments should attempt to run a counter-cyclical budgetary policy.  This requires a reduction of government expenditure and an increase in taxes during the good times to allow the opposite to occur during a downturn. 

Some of this will happen naturally as tax revenues rise and social welfare expenditure falls during an expansion.  A problem can arise when governments use the fiscal space afforded by an upturn for discretionary expenditure increases and tax cuts.

It is these structural or political influences on the budget balance that the fiscal rules are trying to address rather than the naturally occurring cyclical elements.  The rules are trying to move fiscal policy away from a setting where it is based on a philosophy of “when you have it, you spend it” as declared by Charlie McCreevey in 2002.

Many governments used the existing 3% of GDP deficit benchmark as a target rather than a limit.  Thus when economic improvements allowed they loosened fiscal policy.  When the downturn hit in 2008 deficits across the eurozone surged past the 3% limit. 

At present, 14 of the 17 eurozone countries are in an Excessive Deficit Procedure which means they must reduce deficit back in an agreed timeframe.  Ireland has one of the largest deficits and we are aiming to be under the limit by 2015.

The problem with this is that the fiscal stance of the eurozone is pro-cyclical.  Governments increased discretionary expenditure in the relatively good times. Now European economies are in a downturn but fiscal policy is exacerbating this through expenditure cuts and tax increases.  This is not the basis for sound macroeconomic management.

There are alternative views on this.  One is that fiscal policy is wrong now because reducing deficits in a downturn is not sensible.  A second is that fiscal policy was wrong in the past because it did not allow for sufficiently large surpluses to create the room to run the deficits that the downturn now necessitates.  Both arguments have merit.

The rules in the Fiscal Compact would have had little impact in pre-crisis Ireland as we easily satisfied them every year up to 2007.  This is also true for Spain, and in the five years to 2007, Portugal had a better record of adhering to rules than Germany.  Only Italy and Greece were in almost permanent breach.  The rules in the Fiscal Compact would not have prevented the current crisis nor are they a complete solution to the current crisis.

However, it is important to remember that there are more changes than the deficit and debt rules enshrined in the Fiscal Compact.  The Fiscal Compact takes some of the rules from the revised Stability and Growth Pact and seeks to make them binding and permanent so that adherence to them is automatic rather than by choice. 

There are other elements to the Stability and Growth Pact not included in the Fiscal Compact that might have had an impact in Ireland if they were in place for the past decade.

The first is a government expenditure rule which limits the increase in expenditure to a long-term average growth rate in the economy.  In the years leading up to the crisis Irish government expenditure increased at an alarming rate but they were financed through the huge tax revenues that the property bubble was generating.  At the time of the above quote from Charlie McCreevey government expenditure was increasing at a staggering 20% per year.

As we now know the tax revenues were transitory and have disappeared while the expenditure increases were permanent.  Scaling back on these expenditure increases, or finding sustainable tax revenue to fund them, is proving incredibly difficult.  The expenditure rule would have curtailed the increases in government expenditure and more of the windfall taxes from the property bubble would have been saved.

The second mechanism is the Macroeconomic Imbalance Procedure.  This is an attempt to broaden the surveillance of an economy out from the government deficit and debt measures which were the focus of the original Stability and Growth Pact. 

This procedure is based on a scorecard of ten macroeconomic indicators.  If it had been used at the time, Ireland’s scorecard would have shown continued imbalances in relation to house prices and private sector credit.  It is possible we would have been forced to introduce policies to try and curb these imbalances rather than wilfully declaring that “the fundamentals are sound”.

We cannot be sure what the exact impact of the expenditure rule and the imbalance procedure actually would have been.  They are very unlikely to have fully prevented the crisis  but they might have left us in a stronger fiscal position at the end of the boom and may have curbed some of the excessive bank lending that took place during it.

In the lead-up to the referendum there will be increased scrutiny on the budgetary rules in the Fiscal Stability Treaty.  It is important to note that these rules are already in place and rejecting the Treaty cannot alter that.  There are some changes in the Treaty that deal with the enforcement of the rules and the imposition of fines and penalties.

If the Treaty is rejected we will be forced to adhere to the budgetary rules anyway but will be denied access the new European Stability Mechanism (ESM) bailout fund.  This will have no impact on the current EU/IMF programme we are in and, if necessary, this programme can be extended.  However if Ireland needs to enter a new programme of assistance at some time in the future we will not be granted assistance via EU loans and may be left in a vulnerable funding position. 

There is little that is new in the Treaty, and some of the rules governing fiscal policy in the EU have been left out altogether.  It is hard to know why this Treaty is necessary, apart from appeasing voters in France and particularly Germany. 

We cannot avoid the fiscal rules in the Treaty.  We cannot avoid the measures necessary to bring our deficit under control.  The Treaty may be part of a long-term move for a more fiscally-integrated Europe.  This would be a real change and one we should be part of.  All in all there is little to be gained from rejecting the Treaty. 

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