Stability Pact's ghost will return to haunt EU
By Anatole Kaletsky
CONSIDERING all the fuss back in 1996 when the eurozone’s Growth and Stability Pact was shoehorned into the Maastricht treaty by the German Government, the Pact’s final burial last week excited amazingly little comment.
Last Tuesday the European Court of Justice (ECJ) condemned EU finance ministers for “suspending” the Pact’s recommendations on deficit reduction, but upheld the rights of large national governments to ignore these recommendations and all the disciplinary procedures that were so painstakingly attached to them in 1996 by the German Government and the Bundesbank. This decision did not even merit a front-page story in the Financial Times.
Yet the result of the ECJ judgment is that the Pact now has no greater legal authority than a newspaper editorial. European governments are free to ignore the Pact’s 3 per cent deficit limit and the sanctions regime that Germany had demanded as the price for sharing a currency with Italy and other notorious fiscal profligates.
As if to confirm the Germans’ worst misgivings, the Italian Government removed its austerity-oriented Finance Minister shortly before the ECJ judgment and adopted a new deficit-reduction plan, which would, according to a respected group of independent Italian public finance monitors, increase the Italian deficit to almost 5 per cent of GDP in 2005, from 3 per cent this year. As a result, Italy became the first eurozone member to have its credit rating downgraded by Standard & Poor’ s.
Does all this mean that the euro project is now in serious danger? Or will Europe create a new fiscal framework much stronger than the collapsed Stability Pact? Will European governments now have more freedom to use Keynesian policies to stimulate their economies? Or will the collapse of the Pact provoke even more deflationary disciplinarian reactions from the European Central Bank (ECB)? The answer to all these questions is Yes. While the demise of the Pact has had no immediate market impact and is not going to make any difference to economic conditions in Europe over the next few months, the medium and long-term consequences will be far-reaching and complex.
The ECB is bound to become even more cautious about easing monetary policy in the face of mass unemployment and inadequate economic growth. While there has been some better news on European growth recently, the improvements in demand have been almost entirely due to exports. But exports are likely to weaken as the rising euro takes its toll and the US economy decelerates from its recent stratospheric ascent into a period of steady growth.
As a result, the eurozone seems set to remain an island of mass unemployment in a booming global economy in the next year or two. Other things being equal, therefore, the ECB should be moving towards a policy of lower interest rates. Because of the ECJ’s ruling, this is now even less likely than it was a few weeks ago. In addition to its concerns about inflation, which remains stubbornly above the 2 per cent official ceiling, the ECB will now have a new excuse for inaction — uncertainty about the fiscal prospects while a new stability pact is under negotiation, a process that may take years rather than months.
In theory the paralysis in monetary policy could now be offset by fiscal reflation. Released from their legal strait-jackets, the German and French Governments could now announce radical Keynesian programmes of tax reduction and counter-cyclical spending to reduce unemployment and stimulate domestic demand. In practice, however, nothing of this kind is going to happen. In fact, even without the Stability Pact, fiscal policies are set to become more restrictive generally, with the possible exception of Italy and a few smaller countries.
This may sound like good news for deficit bean-counters but will be bad news for economic growth.
Part of the reason for the fiscal tightening is a creditable concern about long-term fiscal sustainability in countries such as Germany where government pension and health obligations are growing exponentially as the population ages, while tax revenues stagnate. In the long run, however, such demographic imbalances can be resolved only by restructuring pension and health systems, or by eliminating mass unemployment and accelerating economic growth.
The less benign reason for fiscal tightening is that, while the Stability Pact may now be officially dead and buried, its ghost will continue to haunt Europe for years to come. In the eight years since the Pact was created, all the eurozone members put in place procedures to achieve compliance with its targets, in word if not deed. In every country, finance ministers have put these targets at the centre of their economic strategies and have staked their personal credibility on their achievement. As a result, short-term budgetary fixes, one-off asset sales and temporary tax changes designed to boost revenues for a year or two have proliferated all over Europe.
These reforms have paid lip service to the Pact’s guidelines but have often damaged economic growth. They have also harmed long-term budget consolidation by deluding politicians in Italy, France and Germany that they were solving their fiscal problems. In fact the euro-related budgetary gimmicks were distracting attention from the deep social reforms and the accelerated economic growth with which countries such as Britain, Ireland, Denmark and Sweden have achieved lasting results.
Sadly, it seems highly unlikely that finance ministers will now start to focus again on their national responsibilities and long-term fiscal objectives. The collapse of the Pact is not going to end the European Commission’s pretensions to “co-ordinate” fiscal policy, at least among the members of the eurozone. Far from returning tax and spending policy to the national political arena, finance ministers will now be pressed to agree on a much more intrusive form of fiscal oversight.
Under a revised Stability Pact, national tax and spending plans will be subject to permanent EU surveillance, probably with binding sanctions, whether a country is breaching its 3 per cent deficit limit or not. In the longer term, therefore, the collapse of the Pact is likely to increase the centralisation of Europe’s fiscal policies.
This will intensify, rather than ease, the conflict between the EU and member states, and will aggravate the culture of irresponsibility and blame-shifting that has reduced the political legitimacy of economic policy in all euro-zone countries and made controversial economic decisions extremely difficult to implement.
The long-term future of the euro project now looks more perilous than it did a few weeks ago because the most fundamental objection to a pan-European single currency has always been the absence of a politically legitimate European state to regulate the issue of the currency and act as the guardian of its value.
A government that has no responsibility for the value of its national currency nor for the level of interest rates has no incentive to limit its borrowing. On the contrary, every nation in a currency zone has an incentive to borrow as much as it can get away with, acting as a free rider on the fiscal restraint of other members. This has always been recognised as a potential problem of currency unions — and was the reason why the Stability Pact was devised.
The Italian Government, and its electorate, have much less responsibility for the stability of the euro than they had for the lira.
More importantly, the ECB has no obligation to the Italian Government at all. Until the creation of the euro, there was always a symbiotic relationship between the issue of a currency and the borrowing of the State. The State needed its own currency to finance its operations and to ensure that it would always be able to raise the money it needed to pay its officials and soldiers and to service its outstanding debts. A central bank was created to act as a lender of last resort, not only to the banking system and the financial markets but also ultimately to the State itself.
In the eurozone, every government is now effectively borrowing in a foreign currency, over which it has no control. The Italian Government can now go bust in a way that was never possible when it borrowed in its own currency. Italy’s debt downgrade is the first ominous example that investors are beginning to understand this distinction. In the long run, a monetary union consisting of sovereign nations with completely independent tax and spending policies is unlikely to be sustainable; the eurozone will either evolve into a full-scale economic federation or break up.
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