"Governments are claiming that it is not their fault, that their economies are the victims of an unfavourable business cycle"
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Europe's problem is not stability pact
By Daniel Gros
Published: October 23 2002 21:38 | Last Updated: October 23 2002 21:38
Tough economic times expose weakness in economic policy-making. This is illustrated by the collapse of support for the stability pact, the European Union's rules on public deficits. Everybody, including the president of the Commission, the guardian of the treaty, is chafing at the limits it imposes and seems to be clamouring for it to be made more flexible.
The pact was invented in 1996 to make fiscal policy sustainable. It was clearly needed, given years of rising public debt as a proportion of gross domestic product. There is little disagreement over the need to stabilise debt/GDP ratios at reasonable levels. This is why the 3 per cent ceiling on deficits makes sense and why it is not really disputed at the political level - except when it hurts.
Why is Germany breaching the 3 per cent limit and why are the other large countries close to doing so? Governments are claiming that it is not their fault, that their economies are the victims of an unfavourable business cycle. This might be an optimistic view. Our recent research has shown that the potential growth rate of the eurozone is declining, due primarily to the fact that productivity growth has slowed to a snail's pace in Europe (while it has accelerated in the US). Productivity is a slow-moving variable and the exact numbers are available only after several years. There can nevertheless be little doubt that productivity growth is now significantly lower than it was 10 years ago, when the Maastricht treaty was signed. During the 15 years to 1990, labour productivity growth had been increasing at 2.3 per cent a year. It is now running at 1.3 to 1.4 per cent. Moreover, there is no reason to hope for a quick rebound (as happened in the US over the 1990s).
Most policymakers would not admit that potential growth may have declined. They maintain that all we need do is to wait for growth to return to its full potential, which they estimate to be over more than 2.5 per cent. In fact 1.2 to 1.8 per cent might be a more realistic target, especially for the larger eurozone economies.
The decline in potential growth has two immediate implications for how fiscal policy is judged. First, current estimates of structural balances are too low. Since public spending accounts for about 50 per cent of GDP, each percentage point of lower potential growth implies an overestimate of structural balances by 0.5 per cent of GDP. If potential growth is in reality only 1.5 per cent, the 2001 deficit would be almost totally structural, not cyclical.
For example, Germany's deficit will probably be about 3.5 per cent for 2002. Growth in Germany might turn out to be only 0.5 to 0.8 per cent this year. If potential growth in Germany is only 1.5 to 1.8 per cent, as suggested by the recent productivity data, this would imply that its structural deficit for 2002 is close to 3 per cent of GDP.
Second, lower potential growth will affect debt sustainability. If potential growth is as low as 1.5 per cent while inflation averages 1.5 per cent, the maximum allowable deficit to keep public debt at 60 per cent of GDP is only 1.8 per cent of GDP, not the 3 per cent stipulated by EU rules. If Germany continued with a structural deficit of close to 3 per cent, its debt/GDP ratio would soon start to rise and would stop only at 100 per cent.
Policy-makers should face up to the problem of slower productivity growth and stop blaming the global business cycle. Apart from Portugal, it is the large countries - Germany, France and Italy - that have strained budgets. The reason for this is quite clear. The eight virtuous members have cut expenditure on average by about 1.5 per cent of GDP over the past three years, whereas the three large members and Portugal were not able to manage even one third of this. In the smaller countries, the body politic has been quicker to appreciate the merits of the pact.
What is the most likely outcome at this point? France's long-standing opposition to the pact's tight rules is well known. The Commission appears to have abandoned its role as guardian of the treaty. What about Germany, the country that invented the pact? After the elections, one might have hoped that it would revert to being the custodian of financial stability. But apparently Berlin now believes that German interests are better served by political haggling than defending clear rules.
Germany and Europe will pay dearly for sacrificing sensible long-term policies to myopic political convenience. The only hope is that the small countries will bring their larger partners back to reality. |
