Before S&P dropped the bombshell on Friday that France and Austria were losing their Triple-A-rating, most of the crisis reporting last week had been concerned with the different drafts for the new “Fiscal Compact” Treaty to be signed at the euro summit at the end of January. Government officials and legal experts across Europe were busy putting the promises made at the December summit into legal language and making it compatible with the existing EU treaties. ECB board member Jörg Asmussen, always a good representative of the mood in the German central banking scene, in the meantime, wrote a furious letter denouncing the draft as “substantially watering down” the initial promises made.
So what was in the latest draft which was really surprising or new? The answer is: Not very much. Even though Angela Merkel had been busy selling the treaty as an important step forward, the promises made in December were not overly impressive to start with. They basically consisted in putting some of the fiscal rules of the revised stability and growth pact and the so-called “six pack” on policy coordination (which includes such elements as the medium term balanced budget and the promise of bringing down the debt level annually by 1/20 of the ratio which exceeds 60 %) into a new treaty and requiring countries to add balanced budget amendments to the national constitutions. In short, most of it was about transforming secondary EU law into primary law. So, if you believe that governments in general try to follow EU law, the only difference is now that it will be much more difficult to change the rules should we find out that they are not optimal for managing a monetary union.
Materially, compared to the declaration made in December, only two things stand out in the latest treaty draft: First, there are no provisions for automatic sanctions. And second, the treaty draft allows countries to temporarily deviate from the requirements of having their budgets in balance or in surplus in case of an “unusal event outside the control” of the government concerned or “in periods of severe economic downturn”.
So, is this a big deal as Asmussen was claiming? The answer depends on where you see the origins of the crisis. If you believe that the current crisis is caused by irresponsible governments having always spent too much and taxed too little and if you believe that some European governments will always try to break any rule designed to limit their deficits, use all their powers in Brussels to get around sanctions and any possibility to cheat around fiscal rules, then this change might make a difference. Even the small changes then might have opened a possibility to run higher deficits than it would have been the case with an even stricter treaty. If these possibilities then are systematically exploited over years, possibly the debt level in the end would be higher than with a stricter rule.
While this narrative is popular in Germany, empirical facts cast some doubts on this interpretation. Spain and Ireland, two of the current crisis countries, for example had run budget surpluses over much of the late 2000s, and both the OECD and the European Commission had praised their sound public finances during this time. They had not been in conflict with the stability and growth pact prior to the crisis. And for Greece, the one European case of clearly permanently excessive deficits, one should remember that the problem was for a long time not that rules were too lax, but that the Greek government had misreported the deficits.
If you believe in contrast that at the bottom of the crisis was at least in some countries a boom and bust cycle, a real estate bubble and a banking crisis which let tax revenues plummet and government expenditure raise as the economies were pushed into recessions, then it is hard to see why the current deviation in the treaty draft from the initial promises should be a problem. The recession in Ireland and Spain were so deep and the deficits suddenly so large that no constitutional rule and no treaty provision would have been able to prevent those deficits. Macroeconomically, it just would not have been possible to quickly bring down the deficits to the balanced position. Among macroeconomic practitioners, it is common knowledge that there is only so much of a government budget balance you can correct in a given time frame without inflicting serious harm to the economy. The only effect stricter rules and sanctions would have had on a country like Spain is that they would have added insult to injury. Automatic financial sanctions would just have burdened the budget when public finances were already strained from the recession anyway. Even with constitutional amendments and EU treaties, you just cannot legislate away macroeconomic realities. So, one could even argue that the current wording makes the treaty more sensible than the prior promises as it at least introduces a little bit of flexibility into an overly inflexible austerity pact.
In the end, however, these small details will be completely irrelevant in solving the current euro crisis. The problem at the moment is not that countries are reluctant to cut their deficits decisively enough. The latest rating downgrades were not justified by insufficient cuts in government spending or insufficient tax increases. In contrast, S&P specifically made references towards the unfavorable economic outlook, the deepening recessions in the euro periphery and the inappropriate exclusive focus on austerity. Without growth, debt-to-GDP ratios will continue to rise over the years to come. And as this “fiscal compact” will do nothing to spur the economy, but will in contrast guarantee that fiscal policy will remain adverse to economic growth at least until the middle of this decade, it will contribute nothing to a solution of the euro area’s problems.
So, if you are interested in Europe’s future, stay tuned for the next crisis summits, the next frantic attempts to bring down interest rate or to top up rescue packages, and especially for the ECB’s actions. The exact wording of the new European Treaty, in contrast, you can just leave to lawyers and government officials.
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