Against the Stability and Growth Pact

The stability and growth pact regulated the fiscal policy of Euro bloc countries. It is currently suspended, because of Covid. There is an ongoing discussion of whether to reactivate it when the epidemic ends or whether to replace it with something else. I strongly advocate eliminating it and replacing it with nothing.

Very very rounghly, the pact limited cyclically adjusted public budget deficits to 0.5% of GDP. The possibility of suspending it during a crisis was explicit (also before most people thought that the crisis could be a pandemic).

I have written a lot, a whole lot, about the cyclical adjustment. I think it fair to say that the procedures used by the output gap working groups is not defensible. One problem with the Stability and Growth Pact is that it gives great power to technicians whose techniques would not be accepted by a peer reviewed journal or by a university hiring committee. One simple point is that the official methodology asserts that out of sample forecasting performance is not relevant to the assessment of a time series model (this is absolutely explicitly stated, yes, I should provide a link, also no I won’t). They have great power, because they have great power. Their claim of expertise is not subject to any verification based on evidence.

This is not the topic of this post (although I may get back to that). Here my questions are

1. Why is there a Stability and Growth Pact ?
2. Is their any justification fo the Stability and Growth Pact ?
3. What have the costs of the Stability and Growth Pact been ?
4. What are the risks of eliminating it and replacing it with nothing ?

1)This is a question about the cause of the pact not reasons for the pact. OK so I am not an expert on the actual history. This is a blog post with personal impressions, beliefs and hunches. I will not warn the reader again..

My understanding is that the cause of the stability and growth pact was concern, especially, German concern about the introduction of the Euro. Somehow it was decided that Europe should have a single currency (I don’t claim to know why). German’s were reluctant to give up the Deutsche Mark and very very reluctant to share a currency with Italians. Also in German the same word means “debt” and “sin”.

The result of the desire to convince Germany to accept the Euro were conditions on membership modified from conditions designed to exclude Italy (this was explicitly stated off the record). One was that public debt had to be below 60% of GDP (at a time when Italian debt was 120%). In the final treaty this was modified adding “or declining rapidly enough”. Also, the deficit was limited to 3% of GDP. In the event, Italy met the conditions and Germany didn’t (German public debt increased from slightly below 60% to slightly above 60% and was above 60% and increasing at the critical date). However, the rules were not made for Germany which was allowed to use the Euro. I think that, after this, there should be no discussion of respect for rules, commitment or credibility.

Now the rigid 3% (with exceptions for crises) was clearly silly, hence the decision to try to cyclically adjust (and the decision to hand great power to technicians whose mastery of technique is demonstrated by their appointment to DG EcFin).

I have no idea how the 0.5% was chosen. It would seem to me to be reasonable to have chosen a number such that debt over 60% of GDP would decline. Given 2% target inflation and what seemed before the stability and growth pact to be a very pessimistic prediction of long term average real GDP growth, I would have thought more along the lines of 2.4% (= (0.6)4%). I am sure the logic is that lower deficits are more virtuous than higher deficits and that virtue is rewarded.

I do not know of any convincing argument that a federal system with a common currency should have a fiscal compact. I grew up in a Federal country which uses the dollar and which does not have, has never had, and, by it’s constitution, can never have such a pact. There are many things wrong with the USA, but I don’t see how any is related to the absense of a growth and stability pact.

I think the logic was that high debt of one country would reduce confidence that its debt would be repaid and cause investors to demand high interest rates (clearly true) and that this would spill over, because Euro denominated sovereign debt of different sovereigns would have the same yield (so interest rates were, for a while, listed in the Economist for the Euro Bloc). This may or may not have been the guess, but it is definitely not true. If that was the original argument for a stability and growth pact, clearly it was based on an incorrect premise and there is no argument for a stability and growth pact.

The effects of extreme fiscal irresponsibility in a country which uses the Euro are now well known. The Greek state was unable to pay its debts. At the time and afterwards the interest rates on some Euro denominated debt were the lowest ever recorded in human history and were lowet than had ever been thought possible. It is true that contagious loss of confidence hurt countries other than Greece. Those included Italy, Spain and Portugal, but notably those are not the countries who want to reactivate the Stability and Growth Pact.

Some smart people (one of which is my daughter Kathy Waldmann) have noted that a lot of bad reasoning about fiscal policy is based on the analogy of a state and a household. This does not help us understand why there is a Stability and Growth Pact. Different households borrow in the same currency and yet have not felt the need to limit each other’s borrowing by a pact (which would be called a law not a treaty). I personally face no legal restrictions on my personal borrowing. This isn’t a problem for you, both because my bankruptcy wouldn’t create problems for you and mostly because no bank will lend large amounts of money to me, and certainly not without collateral. Like US states, US households, Greek households, Italian households and even German households do not legally restrict each others’ borrowing.

I have a problem writing this post. I am trying to argue that there should not be a reactivated Stability and Growth Pact or anything similar. My problem is that I can’t find an argument for such a pact to refute. I know that all respectable European policymakers agree that there should be such a thing and I really don’t know why.

I’m going to post this. I haven’t figured out why the hell there is any consideration of reactivating the Stability and Growth Pact. This post has been a draft for days as I try to think. I am going to hit publish, because I think that might cause me to think of something I didn’t write (this is a theraputic post by a bear of very little brain).