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December 13, 2011

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Posted: 13 Dec 2011 12:06 AM PST

"The European Instability and Stagnation Pact"

Posted: 12 Dec 2011 12:24 PM PST

Antonio Fatas:

The European Instability and Stagnation Pact, by Antonio Fatas: ...the European Stability and Growth Pact that seems to be delivering exactly the opposite of what the name of the title suggests: Instability and lack of growth.
European countries agreed to limit their government deficits and government debt (to 3% and 60% respectively) as part of the Maastricht Treaty that led to the creation of the Euro. The limits were not strictly enforced...
The constraints on fiscal policy were made more explicit through the Stability and Growth Pact that ... developed ... more specific interpretations of the limits as well as a process to deal with deviations from the rule. The Pact was a failure with many countries (including Germany) going above the deficit and debt limits. The rules were then rewritten once and just last weekend, during the European summit, there has been a proposal to rewrite them once again. This is what some have referred to as a proposal to create a fiscal union, which is clearly not the case. The proposal is simply about changing the enforcement rules of the Pact.
Academics have written extensively on how the Stability and Growth Pact was poorly designed and could not work (my own work can be found here, here or here. The criticisms can be summarized by the following three points:
- simple numerical limits are "too simple" to deal with fiscal policy. Applying the same rules to every country and every year makes no sense. And the moment you open the door for exceptions then the rules lose their meaning.
- enforcement of the Stability and Growth Pact does not work because the enforcers is the same group as the sinners. ...
- ...even if fines are applied, what would happen to a country in trouble (Italy today) if the other European countries imposed a fine on the Italian government? That their deficit would be even larger and it would simply make things worse.
The decision over the weekend was to improve the enforcement of the Stability and Growth Pact and it tries to address the second issue while it ignores the other two. What is worse is that it might not even addressed that issue. The proposal (to be approved) makes the fines automatic. They can only be overturned if a qualified majority of countries agree to it. This is a marginal change that is unlikely to work if many (more so the large) countries are the ones violating the rules. And the proposal ignores the fundamental problems of the Pact.
What is more concerning is that there is still no clarity on the goals of the Pact. The Pact and more so its implementation has always mixed goals such as sustainability with other goals such as coordination of fiscal policy and growth-oriented reforms. But there is no clarity on how these things mix together, and some times they do not. Long-term sustainability is a valid goal... But this does not imply that all countries should have the same fiscal policy all the time. In fact, we want fiscal policy in the short run to be different across countries. Coordination of fiscal policy (understood as one policy stance for all all the time) makes no sense in a monetary union.
And here is where we are today: starting with the concern about long-term sustainability we conclude that short-term austerity is the right policy for all European countries. But imposing coordination combined with a short-term focus on what should be a long-term goal will not deliver stability or growth. It will lead to stagnation in the region and instability in some countries as fiscal policy is not allowed to play a proper countercyclical role.

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