The fiscal compact: maybe inevitable, hardly sensible

This is an extended version of a column published in the Irish Examiner, Saturday 4 Feb 2012. http://www.examiner.ie/business/business-features/with-our-fiscal-policies-is-the-compact-right-for-ireland-182591.html

The fiscal compact that we have now seen agreed to, the Not Quite an EU treaty as it has been termed, is a curates egg. At one level, like mom, apple pie, puppies and sunshine, its hard to disagree with the lofty notion aspired to, the notion of government finances being run in a coherent, sensible sustainable fashion. But, like the curates egg, it is good and bad. The bad elements to my mind outweigh the good and for that reason, at this stage, it is not at all clear to me that we should take it on board. The government had an opportunity to take on board a (soft) fiscal compact in the form of a private members bill tabled by Senator Sean Barret which would have addressed many of the concerns of the proposed compact without the hard numeric targets. That they did not kill the bill is testimony to the sense of such a rule being required, but that they did not progress the bill shows that there is no urgent will absent threats and cajoling. Had the barrett bill been progressed it would have strengthened the governments hand in that they could have gone to the treaty meetings with a fiscal rule in hand, and which might then have been able to be used as the basis for discussion.

The basic issue that the compact addresses is that all signatory powers must have a binding rule on how much government debt they are allowed to have, and if this is too much (defined as more than 60% of GDP) they will have to reduce it at a rate of 5% of the balance per annum, and to maintain a balanced or surplus budget. This is not sensible economics. It rules out any countercyclical government spending at least until the 60% balance is reached. To a great extent this is the same as the stability and growth pact, whose terms were breached early and often by Germany and France, now insisting that the rest of Europe swallow the medicine they themselves have persistently rejected without demur or sanction.

The basis of modern economic thinking (since 1930) is that governments should in principle be allowed to engage in countercyclical spending, increasing the relative size of government in bad times and shrinking it in good. In effect however this compact is the obverse of the rightly derided McCreevyism of ‘when I have it I spend it’ and takes economic policy back to the early 1920s. That worked well…

Some argue that the terms of the compact are essentially those that we agreed to under the Maastricht treaty and its attendant stability pact. The main difference here with the stability pact is the speed of adjustment which would imply that Ireland would face up to 20 years of austerity followed by an indefinite period of being unable to borrow regardless of fire flood or famine , and the threat. Instead of carrot and stick it is stick and stickier…The threat is that countries that do not adhere to the terms of the compact will not be able to access further aid from Europe after 2013. This of course should not be a problem for Ireland, if we believe the statements coming out of Merrion Street, as we plan to be back borrowing from the markets and thus will not need a second bailout. In fact, Minister Noonan has stated that it is ‘ludicrous’ to suggest otherwise.

Europe as a whole is significantly over the 60% limit. As of 2010 eurostat figures the majority of individual countries are also over. Thus the adoption of the compact suggests a prolonged massive de leveraging of the European sovereign bond market. The euro 17 countries as a whole need to reduce from 85% to 60%. At present terms that is a reduction of some 2.3 trillion euro. That is a massive fiscal drag to pose on Europe. And it will do nothing for growth, rather the opposite.

A further problem with the compact is that if it succeeds it will gravely damage the sovereign bond market. A large (but not overwhelming) stock and flow of relatively low risk assets are required to support pension and investment funds. A shrunken market will be less able to fulfil that role. The fiscal compact states a maximum permissible deficit of 0.5% of GDP. It is easy to work out that with modest growth of say 3% then the deficit rule will result in a long term debt to GDP ratio of below 20%. The fiscal compact therefore requires that over time trillions of euro of assets are removed from consideration of investors. The consequence of this will be an intensified move to safe have assets such as the (to be radically shrunken) German bund market , driving down further German interest rates. Investors will have to accept radically lower long term returns. Alternative investment classes seen as safe havens such as gold, or denominated in currencies such as the Norwegian kroner or Swiss franc will also attract investors, with knockon consequences,

The audi adverts from the 1980’s had the tagline “Vorsprung durch Technik“, or competitive edge gained via technology. This treaty should have the tagline “Vorsprung durch Sparmaßnahmen (vielleicht), or progress through austerity, maybe….There is little doubt that Germany has done very well out of the Euro. The german economic model is one where there are relatively low and stable wages and prices, enabling German companies to maintain their production and prices , the rest of the world becoming more or less competitive around them. German exports to the eruo area stand at approx. 40% of their total exports. This has fluctuated surprisingly little over the last decade. It is not credible but appears to be what we see emerging from Germany that they can wish to have a model whereby the rest of the euro area comits itself to ongoing (and perhaps fruitless ) austerity while simultaneously continuing to buy miele washing machines, BMW’s and so on. What is good for the Eurozone as a whole is good for Germany. But this message, if it is being put across in Germany, is not being made clear.
Ireland is only now beginning to really come to grips with the twin financial problems of the banks and the budget deficit. The drag that the banks will have on the state for the next decade is the role which the Anglo Irish bank promissory notes will play. In essence, to ensure that the exceptional liquidity granted to Anglo via its swapping the promissory notes does not become a permanent increase in money, the Central Bank, acting at the behest of the ECB, is requiring the repayment of same. This amounts to €3.1b per annum for the next decade. The ECB rationale is that if they do not do this here then it will set a bad precedent and could result in money supply increasing and this might, eventually, result in inflation. European inflation now is c 3% per annum. Hyperinflation, which destroyed the economy of Weimar Germany and is alleged as a proximate cause of the rise of Nazi Germany, is generally defined as being rates of c 50% per month. The scarring effects of the Weimar experience still scare the Bundesbank and its successor the ECB. But we are literally orders of magnitude away from this problem. In order to prevent the possibility of hyperinflation in Europe, the Irish taxpayer must engage in a money burning exercise. And we must now, under threat of being cut off from funds, engage in a more rapid deflation of the system than would be deemed optimal. We are being asked to pile austerity on absurdity. At the very minimum the state must seek the removal, in toto, of the Anglo promissory note burden. Then and only then can we see where the true trajectory of Irish fiscal policy might be found, and then and only then can we see if the Fiscal Compact makes sense for Ireland.