Europe's New Fiscal Compact Treaty Does Not Outlaw Keynesianism and Is a Stepping Stone to More Progress
Op-ed in VoxEU
In record time since the idea was first mulled over at the EU Council on December 9, 2011, Europe has compiled a new fiscal compact treaty.1 Angela Merkel called it a "masterpiece" on the night of its final approval on January 30. It is perhaps unsurprising, though, that not everyone agrees. Many policymakers and economists—particularly those in English-speaking or peripheral European countries—have quickly dismissed the new fiscal compact treaty as an economic disaster for Europe that, true to caricatures of German policies, forever outlaws Keynesian countercyclical policies.
However, for at least two reasons, it is wrong to simply condemn the new treaty as the completely wrong answer.
First of all, when one actually reads the provisions of the new treaty, it becomes clear that they do not in fact contain any budgetary constraints enshrining "pro-cyclical fiscal policies" or even outlaw Keynesianism. Commentary like the recent archetypical editorial in the New York Times (2012) asserting that the treaty "will legally restrict [European governments] from fighting recessions with robust fiscal stimulus" is simply wrong. Actually, Article 3 states that euro area members "may temporarily deviate from the medium-term objective [a structural budget deficit of 0.5 percent of GDP] or the adjustment path towards it only in exceptional circumstances." The rules thus concern the "structural budget deficit," not deficits driven by cyclical economic trends. This provision is thus not comparable to, for instance, the balanced-budget requirements in many US state constitutions, which have in recent years forced them to enact severe budget cuts, despite a weak US economy.
A structural budget deficit is defined in the treaty as the "annual cyclically-adjusted general government budget balance net of one-off and temporary measures." Contrary to the New York Times' assertion, euro area governments can therefore implement a "robust fiscal stimulus" if it so needs.
Moreover, "exceptional circumstances" can include an "unusual event outside the control of the [euro area government] concerned which has a major impact on the financial position of the general government." Such circumstances could also include "periods of severe economic downturn," causing a "temporary deviation" in the budget that "does not endanger fiscal sustainability in the medium term." Accordingly, the treaty permits a euro area member hit by an earthquake, natural disaster, or a severe economic blow to undertake temporary fiscal stimulus.
The treaty notes further that under the revised Stability and Growth Pact [pdf], a "severe economic downturn" occurs "if the excess over the reference value [the 0.5 percent of GDP in structural deficit] results from a negative annual GDP volume growth rate or from an accumulated loss of output during a protracted period of very low annual GDP volume growth potential relative to its potential." In other words, if a euro area has a large output gap, it can implement a fiscal stimulus to reduce it.
Of equal importance is the prescription in the revised Stability and Growth Pact that:
… structural reforms will be taken into account when defining the adjustment path to the medium-term objective [0.5 percent of GDP in structural budget deficit] for countries that have not yet reached this objective and in allowing a temporary deviation from this objective for countries that have already reached it. Only major reforms that have direct long-term positive budgetary effects, including by raising potential growth, and therefore a verifiable positive impact on the long-term sustainability of public finances will be taken into account. For instance, major health, pension, and labor market reforms may be considered.
As such, countries that initiate major structural reforms will therefore not be rigidly bound the new fiscal rules. This could be of particularly importance in 2012—for instance the new Spanish government, which in a year of potential recession has both an extremely ambitious fiscal target of reducing its deficit to 4.4 percent and a highly ambitious structural reform agenda in especially the banking sector and labor markets ahead of it. While the Spanish government may of course of its own volition for domestic policy credibility reasons choose to do whatever it must to reach its 4.4 percent deficit target during 2012, provided that it pushes forward on its structural agenda, there is ample scope in the new European fiscal rules to cut Madrid some fiscal slack. In short, for convincing structural reformers, diktats from Brussels need not be a millstone weighing down growth opportunities. For a continent that is still in need of ambitious overhauls of many of its social, economic, and governance institutions, this is tangible progress.
Contrary to the—in principle at least, had it ever been implemented—mechanical application of the old Stability and Growth Pact when euro area members exceeded a 3 percent budget deficit, Europe's new fiscal rules will in all probability not be disastrously procyclical. Instead, allowing for inevitable data uncertainties surrounding the empirical estimation of structural balances, the new fiscal rules' focus on the structural budget deficits has the potential to preempt the emergence of highly procyclical government revenues in the euro area. Consequently, the sudden emergence of large structural deficits, as a result of sudden revenue drops, as seen in Spain and Ireland during the crisis, should be a thing of the past.
Thus whatever one thinks about the appropriateness of current fiscal policies in the euro area, they are driven by a host of political and market factors, and it is indisputable that the new treaty will permit robust future fiscal stimuli. What it will hopefully achieve, however, is a requirement that euro area members consolidate government sectors and reduce structural deficits in good times.
The second reason why it is wrong to simply summarily dismiss the new fiscal compact treaty as "the wrong answer for Europe" is that it is a fallacy to believe that the new treaty is the only response, or the last institutional innovation in Europe to combat the crisis. Some criticize the fiscal treaty for failing to address the biggest current obstacle to a lasting stabilization of euro area crisis—the construction of a large and credible financial firewall to prevent contagion from the periphery to the core of Europe. Yet such a judgment is simplistic and fails to take into consideration the constant quid pro quo nature of the different parts of European crisis policymaking.
The key decisions in the euro crisis follow a pattern of happening only at the last minute, after the various actors have wrung the best deal possible from daunting circumstances. The ECB, for example, backed a full-scale banking bailout (through their three-year Long-Term Refinancing Operations) in December only after reform-friendly governments were in place in Spain and Italy and after it was clear that the euro area would accept the new fiscal compact. At the same time, the euro area governments offered €150 billion to the International Monetary Fund (IMF)—rather than the European Stability Mechanism (ESM) and its predecessor the European Financial Stability Facility (EFSF)—to placate German domestic political concerns2 and also to get other G-20 countries hurt by the crisis to contribute their share. The G-20 turned around and told the euro area (particularly Germany) that they might contribute more—but only after Europe comes up with more money itself.
The new fiscal compact treaty fits in the same pattern. Europe's paymaster Angela Merkel has evidently demanded its creation ahead of any decision on a potential increase in the size of the ESM, currently scheduled for the next EU Council in early March. The German government will not contemplate increasing its financial contribution to the European firewall until a new set of fiscal rules has been agreed.
While many may lament this chronology of European policymaking, the new fiscal compact will help change the political narrative of bailouts from "pouring ever more German taxpayers' money into Greece" to "Germany providing support for Europe's new Stability Union." Needless to say, the latter is far more politically palatable and will help secure the Bundestag's overwhelming approval of higher German contributions to the ESM later in the spring. This is good news for Europe, and the new fiscal compact is the critical "down payment" making it possible.
New York Times. 2012. Making it worse in Europe. NYTimes.com, January 31, 2012.
1. The full name is the "Treaty on Stability, Coordination and Governance in the Economic and Monetary Union" [pdf].
2. In Germany, the new money to the IMF comes from the Bundesbank rather than the German government, making it important that the independent Bundesbank will not lend directly to the ESM/EFSF (as it regards it as monetary financing), but can accept lending to the IMF.