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Blogs review: The fiscal compact

What’s stake: The Treaty for Stability, Coordination and Governance, also known as Fiscal Compact has been negotiated and signed in a record amount of

Publishing date
16 March 2012

What’s at stake: The Treaty for Stability, Coordination and Governance, also known as Fiscal Compact has been negotiated and signed in a record amount of time. Its ratification is now the source of an important debate, especially in Ireland where it will have to be ratified through a referendum but also amongst the European Social Democrat parties that are now openly challenging it. Meanwhile, experts are increasingly divided over its effectiveness but they seem to converge on the importance of its symbolic nature. It has become an important pillar of the current European institutional changes and its growing challenge could have important repercussions on other ongoing negotiations (ESM, Eurobonds…).

How it differs from the revised SGP

The ECB issued an opinion on the “2 pack” which helps clarify the changes embedded in the fiscal compact. Bryan G summarized these changes over the existing Stability and Growth Pact in a response to Philip Lane:

(a) Requiring rapid convergence to Medium Term Objective (Glidepath rule);

(b) Limiting the scope for temporary deviations due to exceptional circumstances;

(c) Requirement for an automatic correction mechanism;

(d) Requirement for Member States that have been made subject to the excessive deficit procedure to put in place budgetary and economic partnership programmes;

(e) The ex-ante reporting of public debt issuance plans;

(f ) and defining the scope and procedures for Euro Summit meetings.

John McHale goes a step further and argues that actually (a) and (b) are written in a language that is extremely similar to the SGP and that therefore point (c) is the one critical element of the compact. The major innovation of the Compact is the domestically enforced correction mechanism, which is to be designed according to “common principles to be proposed by the European Commission” on which there is very limited clarity.

The TSCG vs. Keynes

Fintan O’toole argues that the Treaty’s essential goal is to outlaw Keynesianism by elevating it to the rank of what George Orwell called a “thoughtcrime”. It is crass ideological opportunism: using the crisis to transform one partisan view of economics into an unquestionable fact. We’re being asked to vote for a badly thought-out ideological power grab that seeks to outlaw one side of the argument about fiscal policy. This is as paradoxical as the “war to end wars” – a democratic debate to outlaw democratic debate on one of the defining issues of politics, a vote to limit the meaning of voting.

Henry Farrell and John Quiggin have a fascinating new paper on the relatively short-lived revival of Keynesianism during the Great Recession. In 2008-2009, it was important that a relatively small number of ‘star’ economists, mostly based in the US, made vigorous arguments for Keynesianism. It was also important that some key figures that previously had not been favorably disposed to Keynesianism changed their minds. This helped propagate the idea of Keynesian stimulus to economists who otherwise would likely have been inoculated against it. Some of these economists – such as the members of the German Council of Economic Experts – played a key role in changing the field of debate within Germany and other European countries. In 2010 in contrast, it mattered that there was a greater degree of disunity among economists in the US and within the IMF. It also mattered that a new group of elite economists – those associated with the European Central Bank – had entered the fray.

Martin Feldstein – one of the most important anti-Keynesians in the 1980s who converted to Keynesianism in the crisis – argues that what Europe needs is a fiscal union and that the current fiscal compact is a poor substitute. The original proposal to balance nominal deficits would have been catastrophic in the case of asymmetric shocks. The final form of the fiscal compact is a very mild agreement requiring each country to “balance its budgets over the business cycle.” For eurozone governments, that means that financial markets will now enforce what the political process cannot achieve. The EU’s fiscal compact, whatever its final form, will be little more than a sideshow.

The rules

Colm McCarthy focuses on the 1/20th or “glidepath” rule that forces a country with a debt to GDP ratio above 60% of deficit to reduce its debt to GDP by 1/20th every year. He points out that this was already a binding regulation of the council taken in 1997 and that it was never followed. He concludes by saying that it wouldn’t be a binding rule for Ireland. Either Ireland’s adjustment will fail – in which case it will in a program whose fiscal targets supersede the fiscal compact – or it will be in the clear – in which case the glidepath rule will not be binding because the structural fiscal position will be balanced or in surplus and the glide path rule will be respected.

Philip Lane argues that the fiscal compact will help governments avoid the twin problems of debt bias and fiscal pro-cyclicality. He also believes that the fact that the rules is designed on a structural basis allows for Keynesian stabilization. He, however, concedes that the range of plausible estimates for the structural balance will always be considerable (especially for a highly open economy like Ireland where the production function approach is more limiting). He also stresses that the importance of fiscal stability is even greater for members of a currency union, since the absence of national currencies means that fiscal policy is the main policy instrument available to manage domestic macroeconomic cycles. Finally, strong national fiscal discipline is a pre-requisite both for jointly issued Eurobonds, and to enable the ECB to maintain its extraordinary level of medium-term liquidity support (see the slides of his presentation here).

The OFCE Blog uses model simulations to show the likely impact of the new rules (including the obligation to reduce the public debt by 1/20th every year if its level is over 60% of GDP). They find that they are detrimental on several counts for four different countries, even leading to deflation in some simulations. This holds true whether compared to the current Stability and Growth Pact or to alternative rules.

A political instrument subject to ratification uncertainty

Antonio Vitorino argues that the TSCG is primarily a political instrument at the service of the dialectic between solidarity and responsibility and that its economic contribution is somewhat irrelevant. He argues that there are some subtle additions that allow for European institutions to enhance the growth components of the Treaty that are not sufficient. Finally, institutionally speaking, the Treaty has re-launched a debate about the institutional balance of power within the EU and in particular the role of the parliament and the Commission. In the French context Charles Wyplosz makes the point that, if the debate around fiscal rules has one upside, it is that austerity is now politically palatable. There is still some work to do to consolidate in a right way (i.e. decreasing spending and not raising taxes), but it will at least force mainstream politicians to stop using permanent deficits.

But politics might also endanger implementation of the pact. In Ireland, the referendum tilts towards a yes, but might be difficult. Jacob Kierkegaard argues that this could be an occasion for the Irish to demand concessions on their banking liabilities. In France, Martin Kessler notes that, although Francois Hollande is clearly a Europhile and a moderate, he asked for a renegotiation of the Treaty, leaving his demands of “more growth measures” unclear. Some think that, if he was elected, the influence on his left side might lead him to be a difficult partner for Chancellor Merkel in the first months of his mandate.

There are also risks that the principles of the treaty will be broken even if voters no not form the main obstacle. In Spain and in the Netherlands, it will be difficult to implement the requirements of the pact as soon as 2013. While Spain managed to modify its path to consolidation, it will still be difficult to reach the target for 2013. More unexpectedly, the Netherlands seems to be in the same situation, and the Labor party has threatened to block the Treaty, breaking the culture of consensus around European matters. The SPD in Germany might follow suit in a vote that requires two thirds of both chambers. Olaf Cramme argues that this is evidence of an “Europeanization of national politics” – and that the treaty might be at the origin of this new phenomenon.

The Beyond Brussels blog also outlines that there is uncertainty as to whether Article 8.2 of the Treaty would apply to non-euro countries that have signed up the pact. “If the Court finds that the Contracting Party concerned has not complied with its judgment, it may impose on it a lump sum or a penalty payment appropriate in the circumstances and that shall not exceed 0,1 % of its gross domestic product. The amounts imposed on a Contracting Party whose currency is the euro shall be payable to the European Stability Mechanism. In other cases, payments shall be made to the general budget of the European Union.” In the text, there seems to be no difference between a eurozone country and a non-eurozone country. But according to the Danish PM, Denmark will, for example, not be met by penalties from the European Union if it is in breach with the deficit criterion. Denmark will only be punished if it does not implement a budget-law similar to the one outlined in the fiscal compact.

*Bruegel Economic Blogs Review is an information service that surveys external blogs. It does not survey Bruegel’s own publications, nor does it include comments by Bruegel authors.

About the authors

  • Jérémie Cohen-Setton

    Jérémie Cohen-Setton is a Research Fellow at the Peterson Institute for International Economics. Jérémie received his PhD in Economics from U.C. Berkeley and worked previously with Goldman Sachs Global Economic Research, HM Treasury, and Bruegel. At Bruegel, he was Research Assistant to Director Jean Pisani-Ferry and President Mario Monti. He also shaped and developed the Bruegel Economic Blogs Review.

  • Shahin Vallée

    Shahin Vallée is head of DGAP’s Geo-Economics Program. Prior to that, he was a senior fellow in DGAP’s Alfred von Oppenheim Center for European Policy Studies.

    Until June 2018, Vallée was a senior economist for Soros Fund Management, where he worked on a wide range of political and economic issues. He also served as a personal advisor to George Soros. Prior to that, he was the economic advisor to Emmanuel Macron at the French Ministry for the Economy and Finance, where he focused on European economic affairs. Between 2012 and 2014, Vallée was the economic advisor to President of the European Council Herman Van Rompuy. This experience has put him at the heart of European economic policy discussions since 2012, in particular on issues related to the euro area and international policy coordination (IMF, G20). Having started his career working for social investment vehicles and entrepreneurship in Africa, he has also worked as a visiting fellow at Bruegel, a Brussels-based economic think tank, and as an economist for a global investment bank in London.

    Vallée is currently completing a PhD in political economy at the London School of Economics and Political Science. He holds a master’s degree from Columbia University in New York, a degree in public affairs from Sciences Po in Paris, and an undergraduate degree in econometrics from the Sorbonne.

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