Will a ‘Yes’ Vote Cost €6 billion?

The cost of a ‘Yes’ vote as a result extra austerity that will be forced on us if the Treaty on Stability, Cooperation and Governance has been a main plank of the ‘No’ campaign.  Some of these claims are made on the basis of the application of the debt brake rule but they are little more than scaremongering.

The last week or so have seem the claims move to faux outrage to the impact of the structural deficit rule.  As per the Treaty, this will require Ireland to move to a structural deficit of no more than 0.5% of GDP over a timeframe to be agreed with the European Council.

The largest party of the ‘No’ campaign regularly claim:

“The Governments campaign is based on fear and evasion. They are asking us to sign up to new rules and regulations that will cost every single voter but refuse to tell us how much. They are asking us to write a blank cheque knowing that the cost will be at least €6 billion.

To ensure that this is quoted accurately you can see more here, here, here and here:

“The Government has a responsibility to explain to people the cost of a Yes vote. If the Treaty is passed we will have to reach a structural deficit of 0.5% after we exit the current Troika austerity programme in 2015.
“According to the Department of Finance’s own Spring Forecast published last week the structural deficit in 2015 will be 3.5%. The gap between this figure and the new 0.5% rule is equivalent to approximately €6 billion.

The figures come from the Stability Programme Update released a few weeks ago.  The projections of the structural budget balance are on the last page which has a table which shows that using the methodology applied by the European Commission it is projected that there will be a structural deficit of 3.5% of GDP in 2015.  Just a few pages earlier it can be seen that the projected nominal GDP for 2015 is €178,850 million.
It can be seen that the 3 percentage point gap is equivalent to €5,365.5 million.  There must be some imprudent application of the rounding rule being used to bring this to the €6 billion figure used above.

At this remove it is impossible to know what the structural deficit will be in 2015 (will we ever know?) and suggesting that there is a €5.4 billion gap to be filled may be an accurate representation of the situation.  This is not what is being claimed though and there is repeated reference to “€6 billion of cuts” but the claim that this is based on the upcoming referendum are very wide of the mark.  We cannot just vote away the necessity to reduce the budget deficit.

The structural deficit can be reduced through a combination of three factors:

• economic growth
• structural improvements in labour and capital
• fiscal consolidation

No allowance is being made for the first two to assist in reaching the target.  Of course, the important point is that this target is not new and will be unaffected by the outcome of the referendum.  As we have pointed out before there has been a EU regulation (equivalent to national law) that governments run a balanced budget since 1997 and that this was restated using the structural deficit in 2005.

In December 2005 the Department of Finance decided that Ireland would set itself a Medium Term Budget Objective (MTO) in terms of the structural deficit that would be “close to balance”, that is 0% of GDP.
The Stability Programme Update released with Budget 2010 in December 2009 contains the following useful section on page 32:

Review of Ireland’s medium-term budgetary framework and proposed reforms
In considering improvements, it is important to note the procedures already in place. Ireland’s budgetary process is already conditioned by various rules and requirements:

Under the Stability and Growth Pact,

• There are ceilings of 3 per cent of GDP for the general government deficit and 60 per cent of GDP for gross government debt.
• Medium-term budgetary objectives for the structural balance of the public finances.

Under the Excessive Deficit Procedure,

• The Irish authorities have made commitments aimed at reducing the general government deficit below 3 per cent of GDP by 2014 – with implicit strictures on taxation and expenditure.
• The EU’s fiscal surveillance process calls for improvements in national fiscal governance arrangements capable of improving the sustainability of public finances.
• There is an obligation to make annual improvements of 0.5 per cent of GDP towards structural balance after the excessive deficit has been corrected.

This was published two and a half years ago and clearly states that Ireland has the “obligation” to move to a “structural balance” after we exit the EDP (which was subsequently extended to 2015).  This is actually more stringent than the –0.5% of GDP limit placed on the structural deficit in the Fiscal Compact.

In the April 2011 Stability Programme Update (which is still seven months before the Fiscal Compact came into being) the Department of Finance announced a revised Medium Term Budget Objective on page 39:

In October 2007, the ECOFIN Council agreed that long-term fiscal  sustainability, notably the future impact of ageing, should be better taken into account when Member States are determining their medium-term budgetary objectives (MTOs). The subsequent EU Commission document “Modalities for the implementation of the new MTOs” set out the methodology for doing so. In the Irish case, the findings suggest an MTO of -½ per cent of GDP, which allows for 33 per cent of the likely cost of ageing to be covered.

In April 2011, without any recourse to a treaty, the Department of Finance announced that we were changing our MTO to –0.5% of GDP.  We were obliged to achieve what is set out in the Fiscal Compact long before this campaign begun.  How come it took until the announcement of a referendum to generate such interest in something the Department of Finance have been discussing and committing us to for six and a half years?

This was re-emphasised on page 31 in the most recent Stability Programme Update a few weeks ago:

As discussed in last year’s SPU, 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’). Ireland is making progress towards the achievement of its MTO, with further progress to be made in the post-2015 period on a phased basis, in accordance with a timeline to be agreed.

The “timeline to be agreed” will be in line with the Code of Conduct of the Stability and Growth Pact as revised by Council Regulation 1055/2005 and the application of this will not be changed by the referendum result.  The regulation states that:

The Council, when assessing the adjustment path toward the medium-term budgetary objective, shall examine if the Member State concerned pursues the annual improvement of its cyclically-adjusted balance, net of one-off and other temporary measures, required to meet its medium-term budgetary objective, with 0,5 % of GDP as a benchmark. The Council shall take into account whether a higher adjustment effort is made in economic good times, whereas the effort may be more limited in economic bad times.

This means we could have up to six years to move from a structural deficit of 3.5% of GDP to under the 0.5% of GDP limit.  As we are a high-debt country we will probably be asked to achieve that more quickly but even four years would give plenty of opportunity for economic growth and structural improvement to contribute to the effort.

The fiscal rules in the Treaty are not “new” and we cannot avoid them by voting ‘No’ in the referendum.  There maybe reasons for rejecting this Treaty but a claim that it will cost €6 billion in extra cuts and taxes has very little going for it.  In fact, you could say that compared to what were committed to in December 2009, the Treaty will actually save us something.

The impact of the Fiscal Compact on a ‘Good’ Country

Much of the early part of the referendum campaign has been focussed on the possible implications of the Treaty on Stability, Coordination and Governance in post-2015 Ireland when we are due to leave the Excessive Deficit Procedure.  In reality the Treaty will change very little as we are already bound by the rules in the Stability and Growth Pact, and even in the absence of rules the scope for discretionary fiscal policy in Ireland is going to be extremely limited for the medium term given the precarious state of the public finances.

It may be useful to consider the impact of the rules in the fiscal compact in a country that is currently in adherence of both the 3% of GDP deficit limit and the 60% of GDP debt limit from the Maastricht Treaty.  What will the impact of the rules be on such a country?  At present examples of such countries are scarce as 14 of the eurozone 17 are in an Excessive Deficit Procedure due to breaching the 3% of GDP deficit limit.  One example we can use is Finland.

According to the recent Maastricht Returns, Finland finished 2011 with a debt equal to 48.6% of its GDP and had a budget deficit equal to 0.5% of GDP.  Finnish GDP was around €191.5 billion in 2011.  According the Finland’s Apil 2012 Stability Programme Update, Finland had a structural budget balance of +0.9% in 2011 and an output gap of –3.5% of GDP.  Finland has a medium term budgetary objective (MTO) of +0.5% of GDP and was the only eurozone country to meet its MTO in 2011.

So let’s create a hypothetical country (but based loosely around the example of Finland).

• Initial general government debt: 50% of GDP
• Medium term budgetary objective: –0.5% of GDP
• Output gap: –4% of GDP to +2% of GDP over the cycle
• Elasticity of budget balance to output gap: 0.5
• Average nominal GDP growth: 4% per annum

To simplify things we will assume that the country always hits the MTO and that the output gap improves from –4% of GDP by one percentage point a year up to +2% of GDP and declines in the same fashion to –4% of GDP and so on.  We will let nominal GDP growth average 4% per annum (say 2% inflation plus 2% real growth) and we will artificially assume that it follows a pattern of the output gap +5% so that it ranges from 1% to 7% over the cycle. 

As this country has a debt ratio below the 60% reference value we do not need to consider the impact of the ‘1/20th’ debt brake rule as it does not apply.  Thus we can focus on the structural deficit rule which was introduced in Council Regulation 1055/2005 in June 2005.

What happens to the debt and deficits in the hypothetical country described above if it adheres to the fiscal rules?  As the example is highly stylized it is relatively easy to see what will happen to the overall deficits.

Allowable Deficit = Structural Deficit + (Elasticity x Output Gap)

So when the output gap is -4% of GDP, –2% of GDP, 0% of GDP and 2% of GDP it can be seen that:

• At –4% Output Gap: Deficit = –0.5% + (0.5 x -4.0) = -2.5%
• At –2% Output Gap: Deficit = –0.5%  + (0.5 x 2.0) = -1.5%
• At 0% Output Gap:  Deficit = –0.5% + (0.5 x 0.0) = –0.5%
• At +2% Output Gap: Deficit = –0.5% + (0.5 x 2.0) = +0.5%

Over the course of the business cycle the overall deficit ranges between –2.5% of GDP at the trough to +0.5% at the peak.  The deficit keeps within the overall 3% of GDP limit and while it is counter-cyclical one question is whether it is counter-cyclical enough?

Here is what happens to the debt ratio over a 70 years period.

Again it can be seen that the pattern is cyclical, and if the economic cycle was included, it would be seen that it is counter-cyclical.  The debt ratio falls in good times, which here are when nominal growth is greater than 4% per annum, and rises when the nominal growth rate falls below this.  If inflation was 2% the inversion point would be real growth of 2% per annum.  Again there is the question of whether it is counter-cyclical enough. 

With the debt ratio there is the added question of whether it is “too low”.  The debt ratio starts off at 50% of GDP but as can be seen there is a downtrend as well as a cyclical trend.  With the assumptions here, there are overall deficits that average 1% of GDP and average nominal growth of 4% per annum so the debt will converge on a level equal to 25% of GDP.  That has happened at the end of the time period show above.  

This is well below the 60% threshold set in the Maastricht criteria and this value is never threatened.

For those concerned about debt repayments can note that the debt ratio falls in 41 of the years shown above, but that the amount of debt only falls in 6 of those (when there is a budget surplus).  There are 35 years where the debt ratio falls, while the level of debt doesn’t.

This is a highly stylized example and reality does not fit the straight line assumptions used here but it can be used as a gauge of what the rules are supposed to imply in theory.

Countries are not always going to exactly meet their MTO and some slippage in bad times is likely.  This would keep the debt ratio higher than is shown here.  If the average deficit was 1.6% of GDP over the cycle (rather than 1%) then the debt ratio here would converge on 40% of GDP.

For a good country it can be shown that deficits will vary with the cycle (but maybe not by enough) and that the debt will fall to sustainable levels (but maybe by too much).  Whatever about their application now (and it is actually the Excessive Deficit Procedure that is driving fiscal policy now) the rules themselves do seem like reasonable efforts at prudent fiscal management that offer some room for counter-cyclicality though this is based entirely on automatic stabilisers rather than discretionary measures.

Debt and Deficits in EU Fiscal Rules

The emphasis of the original Stability and Growth Pact was entirely on insuring that deficits did not exceed the 3% of GDP threshold, and it was taken that low deficits and nominal growth would do the work of bringing down the high debt ratios.

The focus on deficits has been evident since the original entry criteria laid out in the Maastricht Treaty.  The 1992 Maastricht Treaty provided the reference values for the annual deficit (3% of GDP) and the stock of debt (60% of GDP).  However, greater emphasis was placed on the deficit rule. 

To gain entry to the euro is was necessary that a country’s deficit was “close to the reference value”, but for the level of debt all that was necessary was that the debt ratio was “sufficiently diminishing and approaching the reference value at a satisfactory pace”. 

No numerical benchmark was provided to define satisfactory pace.  Even though they had debt ratios in excess of 100% of GDP both Belgium and Italy were cleared for entry into the euro in 1999 as the rate of reduction in the debt ratio was deemed ‘satisfactory’. Greece was admitted in 2001 with a debt ratio that was also above 100% of GDP, but it was actually increasing rather than falling.

The performance of annual deficits relative to the Maastricht criteria was much better and all the original 11 members had deficits of less than 3% of GDP in 1999.  The ‘close to’ requirement under the deficit rule was much less accommodating than the ‘sufficiently diminishing’ flexibility allowed under the debt rule.  Of course, in 2001 Greece was allowed into the single currency with a deficit of 4.5% of GDP and it had been 1980 since it last had a deficit below the 3% of GDP reference value.

As the launch of the euro approached in the mid-nineties the EU put together the framework that would oversee fiscal outcomes in the EU.  This saw the introduction of the Stability and Growth Pact.  This took the reference values from the Maastricht Treaty and incorporation them into two EU Council Regulations; the ‘preventative’ arm and the ‘corrective’ arm.

It was in the preventative arm that countries agreed to “the objective of sound budgetary positions close to balance or in surplus”.  It is 15 years since Ireland first committed to a balanced-budget rule.

The corrective arm of the Stability and Growth Pact set out what was to happen if a country exceeded the reference values, but the emphasis was entirely on the annual deficit.  If a country’s annual deficit exceeded the 3% of GDP threshold, that country would be put in an Excessive Deficit Procedure (EDP) and be required to try and bring its deficit until the 3% of GDP benchmark.  If the country failed to introduce measures to try and curb the deficit it would face fines of up to 0.1% of GDP.

Although a reference value was set for the level of debt there were no fines or sanctions for countries that exceeded the 60% of GDP threshold.  The emphasis of the corrective arm was entirely on the annual deficit.  The view was that if deficits were sufficiently curtailed that low deficits in conjunction with economic growth would bring the ratio down.

The Maastricht criteria was internally consistent with a world in which nominal GDP growth was 5%.  In such a world average deficits of 3% of GDP would see the debt-t0-GDP ratio converge on 60% regardless of the initial starting position.  The view was that the emphasis on deficits was sufficient as the debt ratio would improve with reductions in deficits.

The reality did not fit with the view.  From 2000 to 2008, Italy had an average nominal growth rate of 3.2%, while at the same time it ran average deficits of 2.9% of GDP.  In such an environment the debt ratio will not change by much and Italy’s 2008 debt ratio of 106% was not much different from the debt level it carried into the euro in 1999.

Under the rules of the Stability and Growth Pact there was little that could be done against such a continued exceeding of the reference value for government debt as the corrective arm was framed entirely in terms of the annual deficit.  Italy needed nominal growth to close to 5% to bring the debt ratio down but this did not materialise.

Greece actually exceeded the assumed nominal growth rate and between 2000 and 2008, nominal GDP growth in Greece averaged around 7% per annum.  The problem was that Greece has average deficits of just over 6% of GDP.  Although Greece had the nominal growth to allow the debt ratio to fall, this space was filled by additional borrowing required because of the large deficits.

So why didn’t the Excessive Deficit Procedure (EDP) as outlined in the 1997 Stability and Growth Pact and require Greece to bring the deficit below the 3% of GDP reference value and create the fiscal space for the debt ratio to fall?  Greece was put into an EDP in 2004 but was allowed to exit the EDP in 2007 when the Council ruled that the Greek deficit would fall below the 3% of GDP reference value.  This was not true as Greece was hiding the true extent of the deficits.  The excessive deficit was not corrected and the 2007 deficit was actually more the twice the allowable level at 6.5% of GDP.

As part of the ‘six pack’ agreed last year a numerical reduction was agreed to provide a benchmark for the required falls in the debt ratio.  As John McHale has shown that ‘1/20th’ rule is actually the equivalent of the 3% deficit rule in a situation where nominal growth is 5%.  The debt brake rule takes the expectation of the Maastricht Treaty and formalises it.  Here is a graph that illustrates this point.



This shows what happens to the debt ratio in a country that rules deficits of 3% of GDP and experiences different nominal growth rates.  The starting point is a country with a debt ratio equal to 100% of GDP.

With 3% nominal growth, the debt ratio will not change as the growth in the numerator (debt) is the same as the growth in the denominator (GDP).  With deficits of 3% of GDP it takes nominal growth of greater than 3% to bring the ratio down.  With 4% growth the ratio falls, albeit very slowly and with 5% growth the ratio can be seen to converge on the 60% of GDP reference value.  If growth is 6% the ratio will decline more rapidly and converge on 50% of GDP.  At higher growth rates the rate of decline increases and the level the debt converges on gets lower (provided the country continues to run deficits of 3% of GDP).

The graph also includes the debt reduction requirement of the 1/20th rule.  This sets a numerical benchmark for the reduction in the debt ratio, and in the strictest sense is independent of the debt ratio.  The line for the 1/20th rule can hardly be seen.  This is because it is almost completely covered by the line represented 3% deficits and 5% nominal GDP growth (the assumptions of the Maastricht Treaty).  What is being required in the debt brake of 2011 is no more than was expected under the Maastricht criteria in 1992.

The rules are virtually equivalent in the case of 5% nominal GDP growth.  With 6% growth the debt-brake will be non-binding as the requirements of the 3% deficit rule will exceed it. At growth rates lower than 5% the debt brake will be binding and will force reductions in the debt ratio that are larger than those that can be achieved by running 3% deficits.

Of course, it is important to note that 3% of GDP is the limit for deficits and not the target.  Since 1997, EU countries have committed to running budgets “close to balance or in surplus”.  In 2005, the balanced-budget rule was restated in terms of the structural deficit and a limit of –0.5% of GDP was placed in the structural balance via country’s Medium Term Budgetary Objective.  This will be more restrictive than the debt brake rule. 

Here is a graph that shows the changes in the debt ratio with 4% nominal growth under the 3% of GDP deficit limit, the ‘1/20th’ debt brake and the 0.5% of GDP structural deficit limit.  For the latter I have assumed that the cyclical element of the budget balance as a percent of GDP follows the pattern –2%, –1%, 0%, +1%, 2%, +1%, 0%, –1% and so on, and allowed a structural deficit of 1.0% of GDP once the debt ratio falls below the 60% threshold.



It can be seen that the structural deficit rule is far more restrictive and, in the example here with 4% nominal growth, will force the debt ratio to converge on a level equal to 25% of GDP.  This is well below the 60% of GDP reference value but that appears to be the intention.

Complying with the Debt Reduction Rule

The issue of whether the Fiscal Compact will mean additional austerity in the post-2015 period has generated some heat in the referendum debate.  John has usefully provided some light to this issue in a previous post.  This post adds little to the conclusions there on the “1/20th” rule but relays a similar point in a slightly different way.  Based on IMF projections Ireland will satisfy the debt reduction rule in 2015.

The debt reduction benchmark is calculated as an average over a three-year period.  One of two averages can be used to satisfy the rule.  There is a backward-looking average covering the years t-1, t-2 and t-3 with a benchmark calculated for year t, and there is also a partially-forward-looking average for the years t-1, t and t+1 with a benchmark calculated for year t+2.

The formula for the benchmark is in the Code of Conduct for the Stability and Growth Pact and for the retrospective average it can be seen on page 8 to be:



where bb is the benchmark or target debt ratio and b is the debt-to-GDP ratio in other years.  Although there is a bit to the formula all that is needed is the debt ratios for three years in order to calculate the benchmark for the next year. 

If the debt ratio for the current year is expected to be below the benchmark level given by the formula then the conditions of the debt reduction rule are satisfied.

To simulate the impact of the rule on Ireland we can use the IMF’s forecasts of the general government gross debt from the recent update of the World Economic Outlook as these extend out to 2017.  We will use these to gauge Ireland’s performance to the rule beginning in 2012.



The debt ratio column are actual data up to 2010 and are the IMF’s projections from 2011 to 2017.  The benchmark column are the targets for each year and is calculated by putting the debt ratios for the preceding three years into the formula shown above.   Compliance is true if the debt ratio for any year is less than the benchmark calculated for that year.  Under current assumptions and IMF projections Ireland will satisfy the retrospective version of the debt reduction rule in 2017.

One of the assumptions the IMF makes is that we undertake the €8.6 billion of fiscal adjustment planned for 2013-15.  Projections after that are based on a “no policy change” scenario.  Under IMF projections we will satisfy the debt brake rule in 2017 with no additional fiscal effort above what has already been provided for up to 2015 with neutral budgets after that.

The debt reduction rule can be satisfied while running deficits and does not require any debt repayments.  The IMF project that there will be an overall budget deficit of 1.9% of GDP in 2017. 

The gross debt continues to rise and in the years from 2014 to 2017 (the years used in the 2017 comparison) the gross debt increases from €201.0 billion in 2014 to €213.5 billion in 2017. 

If the alternative forward-looking version of the rule was applied it would actually show that we would be in compliance with the rule from 2015, as the benchmark calculation is based on the debt ratios in the same three years, 2014, 2015 and 2016 and again compared to the ratio in 2017.  Using the forward looking version of the rule in 2015 will also give a benchmark of 109.6% of GDP for 2017 which is, of course, above the projected debt ratio for 2017.

Although this is only a simulation it does show that we would not need additional fiscal adjustment to satisfy the debt brake rule.  In fact, using IMF projections it can be shown that we will be able to satisfy the rule before we even leave the Excessive Deficit Procedure (EDP).  The debt brake rule doesn’t actually become effective until three years after a country leaves the EDP.  We have until 2018 to become compliant with the debt reduction rule but we may actually be compliant by as early as 2015.

One reason for this is that the “1/20th” rule is actually relatively benign and according to Karl Whelan in section 2.1 of this paper the “rate of progress that is deemed satisfactory is still very slow.”  We have plenty to be worrying about but satisfying the conditions of the debt brake is not one of them.  In fact, it is likely that we will want to reduce the debt ratio at a rate faster than that required by the rule.

Additional Fiscal Effort: Scaremongering?

We pretty much know what is in store for us when it comes to fiscal adjustment over the next three years.  Here is a table take from last week’s Stability Programme Update.



We are looking at a further €8.6 billion of “consolidation” over the next three budgets.  The table shows the proposed spilt between expenditure cuts (€5.55 billion) and tax increases (€3.05 billion).  As we are in an Excessive Deficit Procedure there is nothing in the Treaty on Stability, Coordination and Governance that will change the targets.

The period after this has received some attention and there have been a number of claims that either or both of the 0.5% of GDP structural deficit limit and the “1/20th” debt reduction target will require further €X billions of fiscal adjustment in the post-2015 period.  Over the past few days I have heard a number of these claims in various debates.  Here are a few unearthed from a very quick search.

(1) “The Austerity Treaty would turn this recession into an economic depression. It would bring at least €5.7 billion additional cuts and taxes from 2015, on top of the €8.6 billion austerity up til then.”
(2) “This treaty will mean an extra €6 billion in tax increases and spending cuts post 2015. This will further depress consumer demand, pushing the domestic economy further into recession.”
(3) “On May 31, we are being asked to support an austerity treaty that will result in €6bn of extra spending cuts and tax increases being imposed on people post 2015. This is on top of the €8bn the Government intends to cut in the coming four years. If you are against austerity, you must vote against the austerity treaty.”
(4) “Debt should be 60 per cent of GDP. If debt is greater than 60 per cent, it will be reduced by 1/20 per year over the next 20 years. This would start in 2018, when the bailout terms expire, and could require up to €5 billion a year in savings to 2038.”
(5) “Ireland's debt to GDP ratio is likely to be around 120% in 2015 when we exit the bailout. Reducing the debt to GDP ratio by one twentieth of the excess per year will therefore mean reducing it by 3% of GDP per year. Without significant economic growth, that means paying back €4.5 billion per year in principal”

I’m not sure where the figures have come from but a figure of around €6 billion is attributed to the structural deficit rule and one of around €5 billion is attributed to the debt reduction requirement.

Over on irisheconomy.ie, Prof. John McHale has an excellent post on some budgetary arithmetic for fiscal rules that teases out some of the implications for Ireland after we leave the Excessive Deficit Procedure in 2015.  The conclusion is that there will actually be very little additional effort required to meet the requirements of the fiscal rules post-2015.

1. The Debt Reduction Rule

This is the straightforward one and it is one we have looked at before.  For a start it is important to note that Ireland will not be subject to the debt reduction rule until three years after we leave the excessive deficit procedure.  The rule will begin to apply from 2018.

Here is a table that shows the IMF projections for Ireland for 2017 and shows the overall budget balances that would be allowed if nominal growth was 3.5% per annum.



The starting nominal GDP from 2017 is the IMF projection.  The figures for 2018 to 2021 are based on a nominal growth rate of 3.5% per annum.  This is lower than the 4.5% per annum that the IMF are projecting for 2015, 2016 and 2017.

The 2017 gross debt is also the IMF projection which gives the starting debt ratio of 109.2% of GDP.  The debt ratio from 2018 onwards are those that would be required to satisfy the “1/20th” debt reduction benchmark.

The change in gross debt is the annual change in debt that is allowed.  It can be seen that this is always positive.  The level of debt can increase in each year.  There is no requirement to repay debt and definitely no requirement for annual payments of €5 billion per annum. 

The final column is the key one.  This gives the allowable budget balance to satisfy the debt brake rule.  The €8.6 billion of adjustments is designed to bring the deficit below 3% of GDP by 2015.  The IMF projections for 2016 and 2017 are based on a “no-policy change” scenario.  By 2017 they project that the deficit will be down to 1.9% of GDP. 

Continuing the IMF scenario into 2018 it is likely that the deficit would be around 1.4% of GDP in 2018.  This is only 0.3% of GDP (€0.6 billion) away from the deficit required to satisfy the debt brake rule.  As the debt reduction requirement is calculated over a three-year average it is likely that the expected outcomes for 2019 and 2020 would allow us to satisfy the debt reduction requirement.

Using the IMF’s projections and assuming 3.5% nominal GDP growth from 2018, Ireland can satisfy the debt reduction rule with no additional fiscal effort.  There is no guarantee that this scenario will come to pass but it is difficult to see how the kind of assumptions that would give arise to annual repayments of around €5 billion per annum could come to pass.  It is far more likely that we will be allowed to borrow small amounts rather than have to make the repayments suggested.

2. The Balanced-Budget Rule

The balanced-budget rule is a little more involved.  This is the rule that requires a cyclically-adjusted or structural budget balance of no more than –0.5% of GDP.  Last week’s Stability Programme Update says that using the European Commission methodology it is forecast that Ireland will have a structural deficit of 3.5% of GDP in 2015.

There is no transition period when a country leaves an EDP so the balanced budget rule becomes applicable in 2016.  What matters here is the pace of reduction and as we pointed out previously the requirement is an improvement of 0.5% of GDP towards the budget objective.  What will happen in Ireland post-2015?  Will be have to undertake €6 billion of additional fiscal adjustment to satisfy the balanced-budget rule?



The starting point here is the structural deficit of 3.5% of GDP given in the SPU.  Next it is assumed that nominal GDP will go by 3.5% per annum (this is lower than the IMF projections of 4.5% per annum).
The coefficient of elasticity is the impact of the growth rate on the structural balance.  There is no way of knowing what this is but we will follow the figure of 0.2 used by Prof. McHale.  Using this figure a nominal growth rate of 3.5% is expected to improve the structural balance by 0.7 percentage points of GDP per annum under the assumption of “no policy change”, i.e. no additional adjustment.  This is in excess of the 0.5% of GDP improvement required under the Stability and Growth Pact.

By 2019 it can be seen that the structural deficit would be down to –0.7% of GDP.  Using the projections here this is achieved with no additional fiscal effort and is in line with Council Regulation 1055/2005 which says that countries should aim “to gradually reach the medium-term budgetary objective”.

There is no guarantee that this is what will happen.  The IMF’s debt projections for 2017 and the DoF’s structural deficit projection for 2015 are only estimates.  They are very unlikely to be wholly accurate.  The assumed 3.5% nominal growth rate in the subsequent four year period is only a conjecture.  For what it’s worth Ireland’s nominal GDP growth rate from 1971 to 2010 averaged 11.5% per annum.  However, the scenarios do show what could happen and, in my opinion, are based are fairly prudent assumptions.

It is possible that Ireland could satisfy the conditions of the debt-reduction rule and the balanced-budget rule without any additional fiscal adjustment after 2015.  There are plenty of accusations of scaremongering in relation to official funding floating around.  Are claims of €5 billion and €6 billion of additional fiscal adjustment after 2015 more of the same?

Of course, it should also be pointed out the the result of the referendum will not change the necessity to satisfy the fiscal rules.  These rules are all elsewhere in EU regulations and the Fiscal Compact element of the Treaty just restates them.  We have already committed to adhere to them.  In fact, even if the referendum is defeated we could still introduce a Fiscal Responsibility Bill that incorporates these fiscal rules.  The referendum is to allow us to ratify (become a signatory of) the Treaty.

Hitting the structural deficit target

Article 3 of the Treaty on Stability, Cooperation and Governance states countries are to aim for a structural budget deficit of no more than 0.5% of GDP. 

The original balanced budget rule was introduced as part of the Stability and Growth Pact in 1997 when member countries committed “themselves to respect the medium-term budgetary objective of positions close to balance or in surplus”.  This was revised in 2005 and the rule was restated in terms of the structural balance rather than the overall balance.

At present this is not an issue for Ireland.  As our overall deficit is above 3% of GDP we are in an Excessive Deficit Procedure (EDP).  We will remain in the EDP as long as the deficit is above 3% of GDP.  This year it is forecast that the deficit will be around 8.3% of GDP and it is estimated that it will be 2015 before we leave the EDP.  On leaving the EDP we will then become subject to the balanced budget rule.

Ireland first set a Medium-Term Budgetary Objective (MTO) in terms of the cyclically-adjusted or structural budget balance in December 2005 when we set as “close to balance” (discussed here).  The current MTBO is a structural deficit of –0.5% as stated on page 31 in last week’s Stability Programme Update.

As discussed in last year’s SPU, 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’). Ireland is making progress towards the achievement of its MTO, with further progress to be made in the post-2015 period on a phased basis, in accordance with a timeline to be agreed.

Up until 2015, or whenever it is achieved, the fiscal target will be to bring the overall deficit below the 3% of GDP limit.  In the post-2015 period we will be subject to the balanced budget rule and must move towards meeting the MTO (which is subject to revision).

Firstly, it is very impossible to know what the structural balance actually will be in 2015.  Tables A5 and A6 on page 53 of the SPU provide some estimates from the Department of Finance.  Using the European Commissions methodology they estimate a structural balance of –3.5% of GDP and using the approach of the IMF the figure is –2.5% of GDP.  Taking the midpoint (though the EC’s approach will take precedence for the EU’s fiscal rules) it seems we are set to have a structural deficit of around 3% of GDP in 2015.  At this remove these estimates can only be considered to be tentative.

So if the structural deficit is 3.0% of GDP how quickly does it have to be reduced to the 0.5% of GDP limit?  The SPU says it will be done “on a phased basis, in accordance with a timeline to be agreed.”  This is true and it is likely to be much more moderate than the current timeline to bring the overall deficit under the 3% of GDP limit.

The answer was actually provided in June 2005 in Council Regulation 1055/2005 which forms part of the Stability and Growth Pact.

The Council, when assessing the adjustment path toward the medium-term budgetary objective, shall examine if the Member State concerned pursues the annual improvement of its cyclically-adjusted balance, net of one-off and other temporary measures, required to meet its medium-term budgetary objective, with 0,5 % of GDP as a benchmark. The Council shall take into account whether a higher adjustment effort is made in economic good times, whereas the effort may be more limited in economic bad times.

This is confirmed in the revised Code of Conduct for the Stability and Growth Pact which was published in January of this year.  A slightly abridged version of the section on reaching the MTO is below the fold and, as can be seen, it is not lacking in get-out clauses.

2) The adjustment path toward the medium term budgetary objective and deviations from it

Fiscal behaviour over the cycle and adjustment path toward the MTO

Member States should achieve a more symmetrical approach to fiscal policy over the cycle through enhanced budgetary discipline in periods of economic recovery, with the objective to avoid pro-cyclical policies and to gradually reach their medium-term budgetary objective, thus creating the necessary room to accommodate economic downturns and reduce government debt at a satisfactory pace, thereby contributing to the long-term sustainability of public finances.

Sufficient progress towards the MTO shall be evaluated on the basis of an overall assessment with the structural balance as the reference, including an analysis of expenditure net of discretionary revenue measures.

Member States that have not yet reached their MTO should take steps to achieve it over the cycle. Their adjustment effort should be higher in good times; it could be more limited in bad times. In order to reach their MTO, Member States of the euro area or of ERM-II should pursue an annual adjustment in cyclically adjusted terms, net of one-off and other temporary measures, of 0.5 of a percentage point of GDP as a benchmark.

For Member States that have not yet reached their MTO and are faced with a debt level exceeding 60% of GDP or with pronounced risks in terms of overall debt sustainability, a faster adjustment path towards the medium-term budgetary objectives should be expected, i.e. above 0.5 of a percentage point of GDP as a benchmark in cyclically adjusted terms, net of one-off and other temporary measures.

Based on the principles mentioned above and on the explanations provided by Member States, the Commission and the Council, in their assessments of the Stability or Convergence Programmes, should examine whether a higher adjustment effort is made in economic good times.

In case of an unusual event outside the control of the Member State concerned and which has a major impact on the financial position of the general government or in periods of severe economic downturn for the euro area or the Union as a whole, Member States may be allowed to temporarily depart from the adjustment path towards the medium-term objective implied by the benchmarks for the structural balance and expenditure, on condition that this does not endanger fiscal sustainability in the medium-term.

What’s on the table?

Today Irish Times carries an opinion piece from Prof. Terence McDonough of NUIG on the Treaty on Stability, Cooperation and Governance.  It is headed ‘Treaty not a safe option but a perilous experiment’.

I agree with some the article says in relation to the funding options available to Ireland in the event of a ‘No’ vote.  Towards the end of the article there is a summary of “what’s on the table” in four points.  There are a number of parts in this list that I disagree with.

1. Structural deficits for Ireland should be about half of 1 per cent of GDP, with a 3 per cent top limit on the headline deficit even in the worst years. This requirement seriously compromises government ability to end recessions.

The implementation of the 0.5 per cent structural deficit rule in the new treaty is considerably more stringent than any of the existing “six-pack” regulations, which are themselves unwise. Eventually, a shortage of government bonds will emerge, forcing conservative investors such as pension funds into less safe investments, risking the reappearance of dangerous asset bubbles.

The 0.5% of GDP target for the structural deficit is not ‘new’ and is not more stringent than the existing ‘six pack’.  The balanced-budget rule in terms of the structural deficit has been in place since June 2005 as we discussed here.  In fact the current rule is actually less stringent than that proposed in 2005. 

In the March 2005 document approved by the Commission as the template to revise the Stability and Growth Pact, the rule required high-debt countries to have  structural balances that were “in balance or surplus”.  This is slightly relaxed in the 2012 Fiscal Compact with high debt countries allowed a structural deficit of up to 0.5% of GDP.

The balanced-budget rule is restrictive and will bring government debt levels down to low levels as previously discussed but it is not so because of the Fiscal Compact.

2. Debt should be 60 per cent of GDP. If debt is greater than 60 per cent, it will be reduced by 1/20 per year over the next 20 years. This would start in 2018, when the bailout terms expire, and could require up to €5 billion a year in savings to 2038.

This is utterly wrong.  The debt brake rule, which on this occasion is part of the “six pack” and was introduced as part of Council Regulation 1177/2011 last November.  The regulation makes no reference to 20 years.  What it does specify is that if a country’s debt ratio exceeds the 60% of GDP threshold, then the country must close one-twentieth of the gap between the current level and the 60% threshold (and doing so on average over a three-year period is sufficient).

Consider a country with a debt equal to 100% of GDP.  This is 40 percentage points above the threshold.  In order to satisfy the rule one-twentieth of this gap must be reduced.  One-twentieth of 40 is 2, thus the following year the indicative target for the debt ratio is 98% of GDP.

This can be easily achieved with growth and inflation.  With 2% growth and 2% inflation this country could satisfy the conditions of the debt brake with a deficit of close to 1.9% of GDP.  In the second year GDP would be around 104 and the nominal debt 101.9 giving a debt ratio of 101.9/104 = .98.

Here are some indicative nominal debt levels at different nominal growth rates for a country that starts with a debt ratio of 120% of GDP.

In the extreme case of no nominal growth for 20 years the debt must be reduced from 120 to 81.5 over the 20 years with very moderate debt reductions in the second 10 years.  With just 2% nominal growth (the ECB’s inflation target plus zero real growth) the debt stays relatively constant and is up slightly to 121.1 after 20 years.  In this scenario the debt must fall marginally for the first 10 years and then can increase gradually after that.

In a more typical scenario of 4% nominal growth (say 2% inflation and 2% real growth)  then the actual debt must never be reduced.  Deficits are around 2% of GDP are allowed right from the start and over the 20 year period shown above the nominal debt can increase from 120 to 178.6.  The level of debt increase allowed is even greater with 6% nominal growth.

Today’s article says that the debt brake rule “could require up to €5 billion a year in savings to 2038”.  I am not sure what this means.  By using the word savings I assume this is money put on deposit or, in this case, money used to pay down debt.  There is no plausible scenario in which Ireland will have to reduce the debt by €5 billion per annum. 

Even with zero nominal growth such repayments would not be required.  Any nominal growth close to 2% will mean the debt level has just to be maintained and if nominal growth is above 2% the amount of debt can actually be increased.  From 1971 to 2010 average annual nominal GDP growth in Ireland was 11.5%.

3. Even after we reach this target, Ireland will be forced to run primary surpluses, that is excluding interest payments on the national debt, for many years, taking steam out of the economy.

Ireland will have to run primary surpluses for the foreseeable future but this will probably not be the case if we can reach the target of the 60% of GDP threshold.  If we ever get the debt back to 60% of GDP then we will only be required to run primary surpluses if the interest rate exceeds the nominal growth rate.  This might not happen and small primary surpluses might be required to keep the debt ratio at 60% but there nothing to suggest that “Ireland will be forced to run primary surpluses”.

If will take decades for the debt to approach the 60% threshold and, of course, this limit does not come from the Stability Treaty.  It was first introduced as part of the Maastricht Treaty in 1992.

4. If these conditions are violated, control over fiscal policy is ceded to Europe and the European Court of Justice.

This is just plain wrong.

The Structural Deficit Rule

Here is an extract from a Department of Finance document:

“The underlying (structural) budget balance […]  respects the terms of the Stability and Growth Pact, and is consistent with a medium-term objective of keeping the budget close to balance”

This document set Ireland’s medium term budget objective as a structural budget balance of 0% of GDP, i.e. balanced.  This document was the December 2005 Stability Programme Update published with Budget 2006.  The quote is from page 5.

It is nearly six and a half years since Ireland first announced the target of a budget with a structural balance of 0% of GDP.  In fact, most EU countries set similar targets in 2005.  This table is taken from page 47.



The range of medium-term budget objectives is from a low of –1.0% to GDP for four countries to balanced or “close to balance” for Ireland and eight other countries, up to a high of +2.0% of GDP for Sweden.  These are all in line with the provisions in the Fiscal Compact component of the Treaty on Stability, Cooperation and Governance agreed in January of this year.

As part of the 2005 revision of the Stability and Growth Pact, Council Regulation 1055/2005 was introduced in June 2005 which augmented the original Stability and Growth Pact with the following:

“Taking these factors into account, for Member States that have adopted the euro and for ERM2 Member States 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.”

The original SGP from 1997 merely said that countries were “to adhere to the medium term
objective of budgetary positions of close to balance or in surplus” (Council Regulation 1466/97).  The structural deficit variation of the rule was introduced in 2005.

There is nothing new in the ‘balanced-budget rule’ in the Fiscal Compact.  Of course, just because something is already in place does not mean it is correct.  But if it is wrong why has it taken seven years for those who object to the balanced budget rule to voice their concerns?  A short chronology of the changes to the Stability and Growth pact is provided here.

Access to Official Funding

The issue of whether Ireland will have access to official funding after the current €67.5 billion of loans from the EU/IMF have been drawn down continues to get a lot of attention.  We first looked at this when the referendum was first announced and the conclusion remains the same.  The evidence suggests that Ireland will have continued access to EU funding until we have regained market access regardless of the outcome of the forthcoming referendum as long as we meet the terms of the programme.

The debate is centred around the so-called ‘blackmail’ clause that is included in both the Treaty on Stability, Coordination and Governance (The Fiscal Stability Treaty) and the European Stability Mechanism Treaty.   We don’t need to repeat both so here is the one from the ESM Treaty:

“It is acknowledged and agreed that the granting of financial assistance in the framework of new programmes under the ESM will be conditional, as of 1 March 2013, on the ratification of the TSCG [Treaty of Stability, Cooperation and Governance] by the ESM Member concerned and, upon expiration of the transposition period referred to in Article 3(2) TSCG on compliance with the requirements of that article.”

The process that saw this clause inserted into the Treaty at the start of February, even though the Treaty was originally agreed last July, has generated plenty of heat.  However, it seems reasonable if someone who is lending money wants to apply conditions to those who are trying to get access to that money.

One potentially crucial word is that it only applies to ‘new’ programmes from the 1st of March 2013.  Ireland is already in a programme and there already have been substantial changes to it. 

Initially €17.5 billion of the €67.5 billion to be provided by the EU/IMF was set aside for the banks.  After last March’s stress tests the drawdown for the banks was around €7.5 billion and the remaining €10 billion was shifted to provide additional funding for the day-to-day running of the State.  Could there be a further increase?

As the previous post pointed out this was actually agreed last July when the EU leaders announced that:

“We are determined to continue to provide support to countries under programmes until they have regained market access, provided they successfully implement those programmes. We welcome Ireland and Portugal's resolve to strictly implement their programmes and reiterate our strong commitment to the success of these programmes.”

This may not be the most tenable basis on which to believe that Ireland will have access to EU funds after the full amount of current loans have been drawn down but it is what the EU agreed.  It was reiterated as recently as the EU summit of the 30th of January when the statement of the EU leaders said that:

We welcome the latest positive reviews of the Irish and Portuguese programmes which concluded that quantitative performance criteria and structural benchmarks have been met. We will continue to provide support to countries under a programme until they have regained market access, provided they successfully implement their programmes.

That seems pretty unequivocal to me and this statement was released after the Stability Treaty was agreed and the so-called ‘blackmail’ clause had been introduced.   It has not been contradicted in any subsequent EU statements, and the applicability of the ‘blackmail’  clause to ‘new’ programmes does leave scope for the current Irish programme to be extended.

Poul Thomsen, an IMF Deputy Director in the European Department is of the view that the programme can be extended.  In a recent IMF seminar on Greece, Ireland and Portugal he said:

“The key here is, of course, that Europe has underscored, European leaders have emphasized that Europe stands ready to support these countries for as long as it will take to bring them back to market, provided, of course, that there’s steady progress under these programs. That is clearly unprecedented.”

Although only an observer, last week the ratings agency Standard and Poors released a short statement when the maintained their BBB+ investment grade rating of Irish government bonds.  In it they said:

However, we currently expect that the rating would remain investment grade following such an outcome. This is based on our expectation that even if the electorate were to reject the constitutional amendment in the May 31 referendum, political negotiations with Ireland's European partners could lead to official funding continuing beyond the current program that ends in 2013. If we were to conclude that Ireland would be effectively excluded from future official funding before regaining reliable access to market funding, we could lower the rating to speculative grade.

It is possible to find quotes in the S&P statement that are almost in contradiction to this.  The reason of course is that there are no absolutes in relation to this issue as the decisions are political. 

It is interesting to hear the couched words by many of those discussing this issue.  A rejection of the Treaty will have clear implications if Ireland requires assistance at some future date but from what I can see there is little to prevent Ireland’s current programme with the EU being extended in 2014. 

Quote-unquote

Today’s meeting of the Oireachtas EU Affairs sub-committee on the Stability Treaty had Sinn Fein leader Gerry Adams in front of it to present the views of his party.  I’m sure the session covered lots of interesting facets of the debate but an exchange Mr. Adams had with Fine Gael deputy Paschal Donohue has been picked up by most of the coverage of the session. See here, here and here.

The exchange focused on a leaflet Sinn Fein has produced on the Stability Treaty referendum.  The full leaflet can be seen here and this is the part that was in question today.



The comments focused on the sources of the quotes used from some “experts”.  Karl Whelan (an expert without the quotation marks) had already flagged this as early as last Thursday.  Here is a video showing today’s discussion courtesy of journal.ie.

It is an entertaining exchange but it doesn't add a huge amount to the debate on the actual issues relating to the Treaty. The Sinn Fein leaflet quotes me as saying:

“Had the Fiscal Compact being in place since 1999 it would not and could not have prevented the crisis in Ireland”

This quote is 100% accurate and, of course, is true.  It is taken from my opening presentation to the Joint Oireachtas EU Affairs Committee meeting from the 22nd of February (transcript) and is also referred to in my written submission to the Committee.  Here is some of the text from the transcript surrounding the quote.

However it must be acknowledged that it is not just the treaty that will impact on countries. An important change during the past couple of months has been the adoption of the six pack, which has not received sufficient attention. Had the fiscal compact been in place since 1999, it could not and would not have prevented the crisis in Ireland because we would have satisfied the structural deficit and debt break rule during the last five or six years prior to the crisis. As such, it would not have helped us in terms of avoiding the crisis.

Some elements of the six pack are important and may have to some extent alleviated the crisis in which we now find ourselves.

I repeated the view in bold as quoted in the leaflet towards the end of my remarks.

The fiscal compact would not have prevented the Irish crisis. While there are issues about the flexibility it offers, the so-called six pack and the further measures in place would have, if applied retrospectively, had an impact.

These measures are the government expenditure rule and the Macroeconomic Imbalance Procedure both of which now form part of the toolkit to be used when fiscal and economic performance in EU members is being assessed but are not included in the Stability Treaty.
In his questioning of Gerry Adams, Paschal Donohoe quoted me as saying:

“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.  We cannot avoid the fiscal rules in the Treaty.  All in all there is little to be gained from rejecting the Treaty.”  

Again this quote is 100% accurate.  This is extracted from the final paragraphs of a recent article I wrote for The Evening Echo.

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.  

The parts in bold were used by Paschal Donohue today.   All in all, it is a little ado about nothing. 
There are many strands to the EU response to the current crisis.  They won’t all be right but they should not be considered in isolation.  Focusing on short, and sometimes abridged, quotes can provide some entertaining parlour games but does not get us any nearer a full understanding of the issues involved.

The Expenditure Rule

The upcoming referendum on the Fiscal Stability Treaty (FST) has brought the fiscal rules contained in the treaty to the forefront of our attention.  However, as has been said a number of times when it comes to the numerical rules in the Treaty there is nothing new.

The ‘balanced-budget rule’ has been in place since 2005 and actually in the guise it was originally proposed was even more stringent than the current version.

The range for the country-specific MTOs for euro area and ERM II Member States would thus be, in cyclically adjusted terms, net of one-off and temporary measures, between -1% of GDP for low debt/high potential growth countries and balance or surplus for high debt/low potential growth countries.

High debt countries are actually allowed a structural deficit of 0.5% of GDP under the Treaty.  The ‘debt brake rule’ is from the revised Stability and Growth Pact (SGP))agreed last year.

What is perhaps of interest is the fiscal rules in the revised SGP that did not make it into the FST and it is not clear why some elements of the SGP were omitted.  The focus of the Fiscal Compact is on debt and deficits but the focus on the SGP is much broader.  The revised SGP includes a government expenditure rule and a Macroeconomic Imbalance Procedure.

The rules in the Fiscal Compact would not have had any impact in Ireland were they in place from 2000 to 2007.  Ireland ran overall budget surpluses, the EC estimated at the time that Ireland was running structural surpluses and the debt ratio fell to 25% of GDP by 2007. 

The fiscal rules in the Treaty would not have limited fiscal policy in Ireland in the run up to the crisis in any way.  Under the terms of the Treaty Ireland would have been fiscally sound.  However, this would not be the case if the full gamut of features of the SGP are considered.

When the Six Pack was agreed last October by the EU Council it was stated that:

the reform introduces an expenditure benchmark, which implies that annual expenditure growth should not exceed a reference medium-term rate of GDP growth.

When the new workings of the Stability and Growth Pact were announced in January it clarified what this meant:

The reference-medium-term rate of potential GDP growth is based on regularly updated forward-looking projections and backward-looking estimates, taking into account the relevant calculation method provided by the EPC. The reference-medium-term rate of potential GDP growth will be the average of the estimates of the previous 5 years, the estimate for the current year and the projections for the following 4 years.

The government expenditure aggregate to be assessed should exclude:

• interest expenditure,
• expenditure on EU programmes fully matched by EU funds revenue, and
• non-discretionary changes in unemployment benefit expenditure.

Due to the potentially very high variability of investment expenditure, especially in the case of small Member States, the government expenditure aggregate should be adjusted by averaging investment expenditure over 4 years.

It is unlikely that this rule will be assessed retrospectively but we can provide a crude analysis using some existing data.  Here is a summary of the findings.  Click to enlarge.

 
The adjusted government expenditure is found by starting with total general government expenditure in the eurostat government finance statistics subtracting interest expenditure, investment expenditure and EU receipts (taken from Table 10 here) and adding in the four-year moving average of investment expenditure.  No adjustment is made for non-discretionary changes in unemployment benefit expenditure. 

The potential growth rates are taken from the archive of estimates provided on the CIRCA website of the European Commission: Economic and Financial Affairs.  The estimates for each year are the Autumn estimates provided by the Commission in that year except for 2001 and 2002 both of which are based on the Spring 2002 estimates.

The results are clear.  In each year from 2001 to 2007 the increase in government expenditure was above that which would have been allowed under the proposed expenditure rule.  Over the seven years adjusted government expenditure increased by 130%, with an increase less than half of that allowed under the rule.

The 2001 Budget led to the first official rebuke of a eurozone country’s budget by the Commission and the Council of Ministers declared:

… the Council finds that the planned contribution of fiscal policy to the macroeconomic policy mix in Ireland is inappropriate. The Council recalls that it has repeatedly urged the Irish authorities, most recently in its 2000 broad guidelines of the economic policies, to ensure economic stability by means of fiscal policy. The Council regrets that this advice was not reflected in the budget for 2001, despite developments in the course of 2000 indicating an increasing extent of overheating. The Council considers that Irish fiscal policy in 2001 is not consistent with the broad guidelines of the economic policies as regards budgetary policy. The Council has therefore decided, together with this Opinion, to make a recommendation under Article 99(4) of the Treaty establishing the European Community with a view to ending this inconsistency.

Charlie McCreevey did not change the budget and although the rate of expenditure increase was tempered, for each year after 2001 expenditure increased by more than would be allowed by the rule.  Of course, even if the rule were in place there is no guarantee that it would have been respected.  There is always a get-out clause and for the expenditure rule the SGP further states:

A Member State that has overachieved the MTO could temporarily let annual expenditure growth exceed a reference medium-term rate of potential GDP growth as long as, taking into account the possibility of significant revenue windfalls, the MTO is respected throughout the programme period.

Though I’m not sure that breaking the rule for at least seven years would be considered temporary.

The End of Public Debt

The previous post looked at some possible implications of the forthcoming EU fiscal rules on budget balances.  In theory, counter-cyclical deficits are allowed but it remains to be seen how this will work in practice.  Following on from Prof. Karl Whelan (here and here) it is also useful to examine the impact of the rules on the overall level of public debt. 

Again the focus will be on the ‘balanced budget rule’ (structural deficit < 0.5% of GDP) rather than the ‘debt brake rule’ (reduction of 1/20th in the debt to GDP ratio of the excess over the 60% threshold).  The debt brake rule has got a lot of attention but it is the balanced budget rule that will have the biggest impact.

Here are actual and forecast general government debts in the eurozone from 2001 to 2013.  Click to enlarge.



Data to 2010 are from Eurostat and forecasts to 2013 are from the European Commission. Yellow indicates that a country is in excess of the 60% of GDP limit and red indicated that the country also fails to meet the numerical debt reduction target of the debt brake rule.  From the perspective of the proposed rules this is not a pretty table.  A table of the government deficits for each year can be seen here.

Under the proposed rules, when a country gets below the 60% of GDP limit it is allowed to run a structural deficit of 1% of GDP.  If we assume that the output gap averages zero over the economic cycle, this means that a country is expected to run average overall deficits of 1% over the cycle.  As Prof. Whelan has shown in a situation with 4% nominal GDP growth this means that the general government debt will converge on a level equal to 25% of GDP.

This is well below the 60% of GDP benchmark level but it is important to remember that this 60% benchmark is not a target to be aimed for, but is a level that the debt “does not exceed”, in the words of the Fiscal Stability Treaty.

Thus the 60% of GDP is an upper limit.  In order to stay within this limit it would be necessary that countries be below the 60% of GDP level to absorb the debt effects of a downturn and remain below the 60% of GDP limit. 

So how far below the 60% of GDP level is required to satisfy this?

We can use some examples from the above table.  Consider the case of Spain which in 2007 had a budget surplus of 2% of GDP and a debt of 36% of GDP.  On the basis of the original 3% deficit and 60% debt rules Spain was in a very healthy position in the run up to the crisis.  Just three years later Spain had breached the 60% threshold and the general government debt ratio is forecast to have more than doubled to 78% of GDP by 2013.

This might suggest that a debt of 36% of GDP does not offer a sufficient buffer to allow a country to stay below the 60% of GDP benchmark in response to a downturn.  However, Spain may not be an appropriate example as the relative health in the public finances was not reflected in the overall economy. 
This can be seen if one examines Spain’s Macroeconomic Imbalance Scorecard for the past ten years.  This is not an economy that was “in balance”.  For example in 2005, Spain exceeded the balance threshold for seven of the ten measures in the scorecard. Click to enlarge.


A better example might be the Netherlands which in 2007 ran a small budget surplus of 0.2% of GDP and had a general government debt of 45% of GDP.  The Macroeconomic Imbalance Scorecard for Holland shows an economy in reasonable shape.  The only significant imbalance is private sector debt and that is mainly a result of the structure of mortgages and pension savings for Dutch households (net debt is much lower than the gross figures given here).  Again click to enlarge.



The Netherlands looked to be in a reasonably strong position in 2007 but breached the 3% of GDP limit in 2009 and exceeded the 60% of GDP debt limit in 2009.  The debt is expected to stabilise quickly and is forecast to be 66% of GDP in 2013.  The point is though, that running budget surpluses and having a debt ratio of 45% of GDP is not enough to keep a country below the 60% of GDP threshold in response to a downturn.

And the downturn in the Netherlands was relatively mild compared to what we have experienced here.   Between 2007 and 2009, real GDP fell 1.8%.  By 2011 real GDP is expected to be 1.1% up on its 2007 level.  In nominal terms GDP was down 0.1% between 2007 and 2009 and up more than 6% from 2007 to 2011.  When compared to the Irish performance over the same period this is a mere speed-bump.
The implication drawn by those who devised the fiscal rules is clear.  Small budget surpluses and a debt of 45% of GDP are not sufficient buffers to ensure that a country in a relatively good economic position will stay within the 3% of GDP deficit and 60% of GDP debt limits.  Bigger surpluses and smaller debt are required.

The proposed budget rules seem designed to force balances to levels that will see public debt levels approach 25% of GDP (assuming 4% nominal GDP growth).  In general, this seems a remarkably low level of public debt to target given that countries rarely have to repay debt but can merely service the interest into perpetuity.

[It is perhaps a little ironic that Ireland had a debt ratio of 25% of GDP in 2007 and now has one which ended 2011 at 108% of GDP and is rapidly hurtling towards 120% of GDP. Maybe the target should be lower than 25%.]

It would be useful if economics had empirical evidence to support the 25% of GDP level as an appropriate target, or the 60% of GDP level as an appropriate limit, or (in the case of Greece in particular) the 120% of GDP level as an appropriate danger threshold.  No such benchmarks exist.  It has been suggested that a government debt above 85% of GDP harms growth but we do not know what is the wrong (or right) level of debt.

The proposed rules in the Fiscal Stability Treaty, and more particularly in the revised Stability and Growth Pact, are designed to bring public finances in the EU to an extreme level of fitness rather than a level that might be considered “normal”. 

In particular, it is the structural deficit rule that has the biggest impact.  Targeting deficits that are created by political decisions is a useful move, but setting a limit on these of 1% of GDP on these may not be.  As Prof. Whelan said in a presentation to the ICTU “there is no need for a balanced budget [ ] as long as GDP is growing”.

Of course, the above is a very mechanical interpretation of how the rules will be applied in practice.  When the rules come into force there will be country-specific Medium Term Budgetary Objectives (MTO) that each country will have to target.  Although some guidelines have been provided on the formula to be used to create the MTOs we are still awaiting the specifics.

In order to operationalize this formula, explicit parameters will be made public through a Commission services paper, endorsed by the EFC.

This may outline how the flexibility built into the rules will be incorporated and whether it is likely that average deficits of more than 1% of GDP and debts of more than 25% of GDP will be allowed.

Killing Keynes

There have been some suggestions recently that the revised fiscal rules which all 27 EU members have already agreed to as part of the revised Stability and Growth Pact and which 25 of the 27 are proceeding to “transpose the ‘balanced budget rule’ into their national legal systems, through binding, permanent and preferably constitutional provisions” via the  Treaty on Stability, Coordination and Governance is the death of Keynesian-style fiscal policies in the EU.  That is not the case.

Keynesianism, as it is typically described now, is a counter-cyclical policy that allows governments to run deficits in bad times is respond to downturns with “sufficiently large” surpluses run in the good times to fund these deficits.  Virtually all countries are very good at achieving the former, but very few accommodate the latter.  Rather than outlawing counter-cyclical policy the fiscal rules are actually an attempt to formalise it as is said in the SGP.

Member States should achieve a more symmetrical approach to fiscal policy over the cycle through enhanced budgetary discipline in periods of economic recovery, with the objective to avoid pro-cyclical policies and to gradually reach their medium-term budgetary objective, thus creating the necessary room to accommodate economic downturns and reduce government debt at a satisfactory pace, thereby contributing to the long-term sustainability of public finances.

Of course, this is not to suggest that Lord Keynes himself would be a devout advocate of this approach to fiscal policy.  Keynes did favour a counter-cyclical pattern of expenditure but his emphasis was on the confidence effects that increased government capital expenditure can offer in a downturn, rather than current expenditure which has become the emphasis of government expenditure.
In one of his more whimsical moments in the GT Keynes wrote:

"If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez faire to dig the notes up again . . . there need be no more unemployment. . . . It would indeed be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing."

Although the government is essentially giving away the money it is doing so in a manner to stimulate private-sector investment in order to obtain the money.  Anyway, away from Keynes and back to Keynesians.  Here is a table which shows how the proposed ‘balanced budget rule’ incorporating a 0.5% of GDP limit on the structural deficit is counter-cyclical.

The first column is the output gap: the difference between the forecast actual GDP and the estimated potential GDP.  We will not go into the difficulties of determining this here.  The next column is the sensitivity of the budget balance to the output gap.  The figure used here is 0.5 which is not too different from the EU15 figure of 0.49 used by the European Commission.  The figure for Ireland is 0.40.  All the current sensitivity estimates can be seen here.

Multiplying the first number by the second gives the cyclical-component of the budget balance, i.e. the impact of the economic cycle of the budget.  For example, if the economy is growing above its potential rate and has an output gap of 2% of GDP this is forecast to lead to an improvement in the budget balance of 1% of GDP.
If a country has a debt of greater than 60% of GDP the allowed structural balance is 0.5% of GDP.  Adding the two together gives the overall balance the country should be aiming for at different stages of the economic cycle.

If should be clear that the allowed overall balances are counter-cyclical. When the economy is growing above its potential it is required to run overall surpluses, and in a downturn it is allowed to run deficits.  In the case of a very large output gap of –4% of GDP it can be seen that the rule allows a deficit of 2.5% of GDP. 
Counter-cyclical government spending has not been outlawed.  The intention is to try and ensure “sufficiently large” surpluses in the good times.  There is no guarantee of that but this is not the attempt to kill Keynes, or more specifically Keynesianism, that some have been claiming. 

For those who are making this claim it would be useful if they could provide references to their calls for fiscal restraint and a reigning in of government expenditure during the good times.